Luxembourg tax authorities issue guidelines for reverse hybrid rules

On 9 June 2023, the Luxembourg tax authorities (LTA) issued a new administrative circular (Circular L.I.R n°168 quater/1) dealing with the interpretation of the provisions of article 164 quater of the Luxembourg Income Tax Law (LITL) which covers reverse hybrid entities (also referred below as the Circular).

Luxembourg’s reverse hybrid rules - background

As a reminder, the reverse hybrid rules have been introduced in Luxembourg further to the transposition of the Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries (ATAD II).

When dealing with a Luxembourg entity treated as transparent from a Luxembourg tax perspective (e.g. a Luxembourg partnership – société en commandite simple or société en commandite spéciale) but as opaque from the perspective of another jurisdiction involved, article 164 quater LITL provides that this Luxembourg entity would qualify as a reverse hybrid entity, which will be regarded as a taxpayer resident for corporate income tax (CIT) purposes with respect to the portion of net income which is not taxed in any jurisdiction.

The provisions of article 164 quater LITL apply only to the extent that the so-called “associated enterprise” test is fulfilled, i.e. if one or more associated non-resident entities hold(s) in aggregate a direct or indirect interest of 50% or more of the voting rights, capital interests or rights to a share of profit in the Luxembourg entity.

As the reverse hybrid rules are effective from 2022, the issuance of the Circular is a good first step for Luxembourg taxpayers wishing to file properly their 2022 tax returns in light of these new regulations, and within the new deadlines applicable to them (i.e. before 31 December 2023 for FY2022 tax returns).

In that respect, we also note that, on the same day, the LTA published a Q&A document aiming to help with the completion of the new form 205, which concerns the determination of the taxable basis of reverse hybrid entities.

A sui generis tax status for reverse hybrid entities

While the text of article 164 quater LITL referred to reverse hybrid entities as resident taxpayers subject to CIT for the portion of net income not taxed otherwise by application of the LITL, the Circular provides a definition by negation.

The Circular indeed indicates that a reverse hybrid entity is not a collective organisation as listed in article 159 LITL, which makes sense as this article covers, amongst others, capital companies, cooperatives or other types of associations. Consequently though, it also means that a reverse hybrid entity cannot be considered a taxpayer resident subject to CIT as a result of the application of article 159 LITL.

However, the Circular also specifies that few provisions of the LITL dealing with entities subject to CIT would apply to reverse hybrid entities, while the majority would not apply (e.g. the other provisions implementing ATAD).

Furthermore, the Circular rejects the possibility of treating a reverse hybrid entity as a physical person, even though the provisions of the LITL related to the taxation of individuals would, in theory at least, be applicable to these entities.

At first reading, the Circular gives the impression that the reverse hybrid entities will be subject to a patchwork of existing tax rules. Their specific tax status should rather be considered as a sui generis one, not falling within a well-understood Luxembourg tax concept.

On this point, the Circular highlights that reverse hybrid entities would be subject to CIT on income attributable to some or all of the non-resident shareholders of the reverse hybrid entity, under the concept of tax transparency, so that the existing tax rules applicable to them have been chosen to suit this specific situation.

How will the taxable basis of reverse hybrid entities be determined?

According to the Circular, the taxable basis of the reverse hybrid entities subject to CIT will be determined as follows:

Calculation of net income

Reverse hybrid entities would be subject to CIT only with respect to the following categories of (net) income:

• net income derived from movable capital as per article 97 LITL. In that regard, the Circular is explicit that distributions made by reverse hybrid entities are not subject to withholding tax (WHT) as they do not fall within the scope of article 97 LITL;
• net income derived from rental property defined by article 98 LITL; and
• net miscellaneous income covered by article 99 LITL (including notably gains on disposals or liquidation surplus).

Such net income is subject to CIT only to the extent the reverse hybrid entity has not otherwise been taxed under other provisions of the LITL or elsewhere (e.g. in another jurisdiction).

The net income of a reverse hybrid entity is assessed on a calendar basis and following a cash basis approach, so that only income effectively received (and not only accrued) and expenses paid from 1st January to 31 December of a given year are to be considered when calculating the taxable basis of the reverse hybrid entity.

When dealing with income and/or expenses in a currency other than Euros, the conversion should in principle be performed on the date when the income is received or the expenses paid. The Circular provides, however, for a simplified approach under which the conversion could be performed uniformly using either the exchange rate applicable as at 31st December or the average exchange rate for the year.

Non-deductible expenses

Non-deductible expenses are to be considered as non-deductible for the determination of the taxable basis of the reverse hybrid entities Luxembourg corporate taxes (i.e. CIT, municipal business tax and net wealth tax) and expenses incurred for religious, charitable or general interest.

Specific derogations

The Circular provides also for the application of the following rules for the determination of the taxable basis of the reverse hybrid entities:

• the absence of step-up in basis when the reverse hybrid entity acquires such tax status;
• the non-recognition of a realisation event when the reverse hybrid entity loses such tax status; and
• the application of the 50% dividend exemption of article 115 15 a) LITL to dividends received by the reverse hybrid entity (while the dividend exemption of article 166 LITL will not be applicable).

CIT rate

Net income subject to CIT would be taxed at the same rates as those provided for tax resident entities, i.e.:

• 15%, up to EUR 175,000;
• Between 15% and 16% for the EUR 175,001-200,000 band; and
• 17% for the proportion exceeding EUR 200,000.

New anti-abuse rule mechanism confirmed

With this set of rules, the Circular confirms implicitly that the reverse hybrid entity rules aim to tackle abusive situations whereby a certain type of Luxembourg entity would be used to circumvent the payment of taxes within the overall structure.

This conclusion is justified by the fact that the reverse hybrid entity would be solely subject to CIT on the proportion of its net income that has not been subject to tax in Luxembourg or in other jurisdictions. In this regard, the Circular specifies particularly that if the net income of the reverse hybrid entity includes income from movable property that was already subject to WHT (e.g. in an investment jurisdiction), said WHT is allocable in proportion to the relevant share of net income that would have been subject to CIT otherwise.

This is also supported by the fact that provisions of the LITL related to tax credits are also applicable to the reverse hybrid entities.

The Circular provides therefore further evidence demonstrating that the objective of the reverse hybrid rules is not to lead to situations of double taxation, but to avoid situations of double non-taxation.

Key take-aways

The Circular brings some preliminary clarifications for the application of the reverse hybrid rules transposed in Luxembourg. These clarifications are important for taxpayers directly affected by the application of reverse hybrid rules, in view of the preparation and subsequent filing of their FY2022 tax returns by the end of this year.

Certain important questions remain unanswered, such as the interaction (e.g. for SIFs and RAIFs) between the application of the reverse hybrid rules and the subscription tax for regulated investment funds, or any further explanations regarding the definition of collective investment funds which exempt Luxembourg concerned entities from the application of the reverse hybrid rules. We could also mention the absence of further guidance, for the time being, regarding the other ATAD II provisions transposed in Luxembourg.

Assessing the impact of the reverse hybrid rules calls for a simultaneous analysis of different factors, so do not hesitate to reach out to us should you have any questions on the ATAD II status applicable to your structure.