ATAD Luxembourg Implementation: Interest deduction limitation

In a nutshell: what are the interest deduction limitation rules?

The interest deduction limitation rules ("IDLR") limit the deductibility of interest payments and aim as such the avoidance of an excessive erosion of the tax base of a taxpayer by means of excessive interest payments. Indeed, this disallowance of interest deduction for Luxembourg tax purposes will increase the taxable basis of the corporate taxpayer accordingly. The IDLR will be included in the Luxembourg income tax law ("LITL") by means of a new article 168bis.

Are the IDLR a new concept for Luxembourg?

Whilst the rule itself is a new concept for Luxembourg (compared to, for instance, Germany, which introduced similar provisions already 10 years ago), the limitation of interest deductibility isn't. Indeed, there are already measures that tackle excessive debt financing and tax deductible interest payments, such as the Luxembourg thin capitalization rules or the transfer pricing rules requiring that the arm's length principle shall apply for Luxembourg tax purposes on all intra-group transactions.

In a nutshell: how does the IDLR work?

"Exceeding borrowing costs" shall be deductible from the taxable basis of a taxpayer in the tax period in which they are incurred only up to the higher of (i) 30% of such taxpayer's earnings before interest, taxes, depreciation and amortization ("EBITDA") or (ii) EUR 3 million. Exceeding borrowing costs are considered as being the deductible borrowing costs that are in excess of the taxable interest and similar income received by the taxpayer.

Exempt income, and expenses connected to this exempt income, is not taken into account for the computation of EBITDA. Depreciation and amortisation that are added back for the computation of EBITDA are the amounts of depreciation and amortisation deductible for tax purposes only.

This new rule is a "minimum standard", meaning that Luxembourg, whilst having to implement this rule, had, however, some flexibility. As such, we welcome that the Luxembourg legislator chose the maximum 30% EBITDA limitation and not a lower percentage and included in the ATAD Draft Law the safe harbour provision. This clause provides that exceeding borrowing costs should always - irrespective of a taxpayer's EBITDA, be deductible for at least EUR 3 million, which was the highest possible amount set out by ATAD (e.g., the safe harbour is limited to EUR 1 million in the Netherlands).

Back to top

Can you explain in more detail the computation of the exceeding borrowing costs?

The exceeding borrowing costs are defined by the ATAD Draft Law as the deductible borrowing costs that are in excess of the taxable interest income and other taxable economically equivalent income realised by the taxpayer. In this respect, the ATAD Draft Law includes a definition of "borrowing costs", which is very large, and includes interest expenses on all forms of debt (i.e., intragroup funding and third party financing), other costs economically equivalent to interest, as well as expenses incurred in relation with debt funding. The ATAD Draft Law includes in this respect a non-exhaustive list of which some are duplicated hereafter: payments under profit participating loans, imputed interest on instruments such as convertible bonds and zero coupon bonds, amounts paid under alternative financing arrangements (e.g., Islamic finance), capitalised interest included in the balance sheet value of a related asset, or the amortisation of capitalised interest, guarantee fees relating to financial arrangements or handling charges or similar expenses relating to the borrowing of funds.

Are there any exceptions to the IDLR?

There are indeed exceptions to the IDLR.

(a)          Standalone entities

The deduction of exceeding borrowing costs is entirely permitted for so-called standalone entities. To be considered as a standalone entity, two conditions must be fulfilled:

• the taxpayer is not part of a consolidated group for financial accounting purposes; and
• the taxpayer has no associated enterprise (in the meaning of the new definition of associated enterprise under the new CFC rules) or permanent establishment in a country other than Luxembourg.

About the last condition, it is interesting to note that ATAD seems to require the absence of associated enterprises and permanent establishments generally, and it may thus be considered that the Luxembourg legislator has slightly extended the list of entities that may be considered as a standalone entity provided by ATAD.

(b)          Financial undertakings

The deduction of exceeding borrowing costs is entirely permitted for financial undertakings, which includes a large number of entities such as, for instance, credit institutions, insurances or reinsurances, pension funds, certain AIFs and UCITS, as well as certain types of securitization vehicles (within the meaning of the article 2, point 2 of the EU Regulation n° 2017/2402 of 12 December 2017).

(c)          Long-term public infrastructure projects

The ATAD Draft Law excludes from the IDLR all interests paid on loans used to fund long-term public infrastructure projects where the operator, borrowing costs, assets and income are all located in the EU.

(d)          Safe harbour for certain existing loans

Luxembourg has chosen to include the favourable provision offered by the ATAD, according to which loans concluded before 17 June 2016 will not be impacted by the IDLR, implementing thus a grand-fathering period for certain existing loan arrangements, exclusive of any subsequent amendments. The ATAD Draft Law has been amended to clarify that loan arrangements concluded before 17 June 2016 but amended thereafter may still benefit from the safe harbour clause, except the amendments made thereafter.

(e)          Group ratio exception

If a taxpayer is part of a consolidated group for financial accounting purposes, the taxpayer may, upon express demand, deduct all its exceeding borrowing costs, provided that the taxpayer can demonstrate that the ratio of its equity over its total assets is equal to or higher than the equivalent ratio of the group and subject to the following conditions:

• the ratio of the taxpayer's equity over its total assets is considered to be equal to the equivalent ratio of the group if the ratio of the taxpayer's equity over its total assets is lower by up to two percentage points; and
• all assets and liabilities are valued using the same method as in the consolidated financial statements drawn up in accordance with the International Financial Reporting Standards ("IFRS") or the national financial reporting system of an EU Member State.

Back to top

Are there any other favourable options included within the ATAD Draft Law in relation to IDLR?

Luxembourg has indeed taken over other options that make its IDLR regime rather attractive, compared to IDLR regimes of other Member States. These options granted to Luxembourg taxpayers are mainly twofold:

• carry forward of exceeding borrowing costs without time limitation; and
• carry forward of unused interest deduction capacity during a given tax period, computed by the excess of 30% of the taxpayer's EBITDA compared to its exceeding borrowing costs, for a maximum of five years.

Is there any favourable option that has not been taken over in the ATAD Draft Law?

Unfortunately yes, but subject (fortunately) to the information included in last paragraph here below. Luxembourg has at this stage not used the option given by ATAD to extend the IDLR to companies that are within a tax unity, meaning that the IDLR will have to be determined at the level of each individual entity. This is very unfortunate, as also underlined by the State Council in its commentaries. To show the negative impact by the absence of such option included in the ATAD Draft Law, a rather straightforward example has been included hereafter.

If the IDLR could also be applied at the level of the tax unity, no exceeding borrowing costs would occur and the tax base of HoldCo would amount to "€0". However, in the absence of this option, the IDLR will have to be determined at the level of HoldCo and LuxCo separately. As such, exceeding borrowing costs would occur at the level of HoldCo in an amount of €100mio, as it would only receive dividend distributions or equity reimbursements from LuxCo. Consequently, HoldCo, in the absence of any EBITDA, would be able to deduct €3mio only. Therefore, the tax base of HoldCo would in this scenario where the tax unity option isn't available amount to €97mio.

However, the Luxembourg Minister of Finance, Pierre Gramegna, announced during the today's vote of the ATAD Draft Law that the Luxembourg government will in 2019 amend the ATAD Draft Law to allow Luxembourg taxpayers in a tax unity to apply the IDLR on a consolidated basis to counterbalance the negative effects detailed above. In his speech, the Luxembourg Minister of Finance specified that this option hadn't been taken over initially to analyse first how other Member States would act as regards this option. Indeed, a right balance needs to be made between on the one hand assuring that Luxembourg isn't always considered as using tools not in line with the approach taken by other Member States, and on the other hand maintaining the attractiveness of Luxembourg generally. Considering that not only the usual competitors but also even our neighbouring countries have made use of this option, the Luxembourg government does not see any need for Luxembourg not to include this option given by the ATAD. As such, the recent decision to amend the ATAD Draft Law accordingly in 2019. However, this will require some substantial changes to the Luxembourg tax laws and as such, need – in view of the Finance Minister - a bit of time before the proposed amendment to the ATAD Draft Law will be submitted in 2019. Further developments will follow in due course.

Back to top

Could you please explain the impact of the IDLR on securitisation transaction?

A Luxembourg securitisation vehicle ("SV") may always deduct all its exceeding borrowing costs under the IDLR, provided however only if it falls into the scope of article 2) item 2 of Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation. Unfortunately, number of SVs may not fall within this scope, and will as such not automatically be excluded from the IDLR.

We share the opinion of the State Council, which explained in its commentaries that based on the current restrictive definition of a standalone entity, a Luxembourg securitisation vehicle should not fall therein. It is rather unfortunate that, at this stage, the Luxembourg legislator did not take the opportunity to include as a standalone entity the SV performing transactions falling within the amended Luxembourg law of 22 March 2004 on securitisation. This would have been in line with aim of ATAD (aiming at tackling (big) corporations by limiting the excessive deduction of their tax base by means of excessive interest payments) and the concept of the SV under Luxembourg law (being a passive and neutral vehicle implemented to perform securitisation transactions).

Hence, an uncertainty remains as regards the application and effects of the IDLR on SVs. This uncertainty is rather unfortunate considering the importance of Luxembourg place as regards securitisation transactions. The today's announcement by the Luxembourg Minister of Finance, Pierre Gramegna, during the vote of the ATAD Draft Law must therefore be welcome. Indeed, he confirmed that a deeper analysis of the IDLR and their impacts on Luxembourg securitisation vehicles, considering their importance for the Luxembourg financial place, would be made in 2019 in order to assess the need for any further amendment of the ATAD Draft Law. The aim would be to ensure, to the extent possible, that Luxembourg remains a prime jurisdiction within Europe for securitisation transactions.

When will this rule be applicable?

The IDLR will be applicable as of 1 January 2019.

What will be the impacts of the IDLR in Luxembourg?

Though this rule is new in the Luxembourg tax legislation, it will not have an impact on all Luxembourg tax resident entities. Indeed, our current thin-capitalisation and transfer-pricing rules tackle already excessive debt financing and non-arm's length interest payments. Further, this rule should not impact Luxembourg companies carrying out back-to-back financing activities. The same should be true for investment structures that do not require tax deductibility, such as typical foreign real estate investments where the right to tax is mainly in the country of source (i.e., where the real estate is located).

However, a case-by-case analysis will nevertheless have to be performed to check the impacts of the IDLR on any investment structure generally, or on certain aspects only (e.g., on the Luxembourg recapture rules).

Considering that Luxembourg chose to include in the ATAD Draft Law most of the options available under the ATAD in relation to IDLR, we believe that Luxembourg has a very attractive card to play within the EU as regards IDLR. In this context, the absence in the ATAD Draft Law of (i) the option given by ATAD to extend the IDLR to companies that are within a tax unity as well as (ii) the clarification that all types of securitization vehicles falling within the Securitisation Law do not fall within the IDLR, are rather unfortunate. As such, the today's announcement by the Luxembourg Minister of Finance during the vote of the ATAD Draft Law (i.e., amendment of the ATAD Draft Law in 2019 to allow Luxembourg taxpayers in a tax unity to apply the IDLR on a consolidated basis, and reassessment of the IDLR and their impacts on Luxembourg securitisation vehicles to ensure, to the extent possible, that Luxembourg remains a prime jurisdiction within Europe for securitisation transactions) must be welcome.

Back to top

Authored by Gérard Neiens, Jean-Philippe Monmousseau, and Pierre-Luc Wolff

Hogan Lovells (Luxembourg) LLP is registered with the Luxembourg bar.