Starting in March 2021, Luxembourg has applied a defensive measure towards countries listed on Appendix I of the European Union (EU) list of non-cooperative jurisdictions for tax purposes (the EU List). Under certain circumstances, the deduction of interest and royalties owed by Luxembourg corporate taxpayers to related enterprises that are corporations established in a jurisdiction that is on Annex I of the EU List is denied, unless the taxpayer proves that the transaction that gives rise to such expenses is used for valid business reasons which reflect economic reality.
The Luxembourg Tax Authority has now issued an updated Circular (the Guidance) providing further guidance on the application of said measure.
This Alert summarizes the content of the Guidance.
Background on the EU List
The EU published its list of non-cooperative jurisdictions for the first time on 5 December 2017, setting forth in Annex I at that time 17 jurisdictions deemed to have failed to meet the tax transparency, fair taxation and implementation of anti–base erosion and profit shifting (BEPS) criteria established by the European Commission. Since the release of the EU List, there have been multiple changes to its composition based on recommendations made by the Code of Conduct Group for Business Taxation. The latest version of Annex I to the EU List was published in the Official Journal of the EU (OJEU) on 3 March 2022 and currently includes nine jurisdictions (American Samoa, Fiji, Guam, Palau, Panama, Samoa, Trinidad and Tobago, the US Virgin Islands and Vanuatu).
On 5 December 2019, the Economic and Financial Affairs Council (ECOFIN) endorsed a report on the progress achieved by the Code of Conduct Group for Business Taxation, which included in particular a detailed state of play on the EU List. It also included guidance on further coordination of national defensive measures in the tax area towards non-cooperative jurisdictions. The guidance invited all Member States to apply legislative defensive measures in taxation related to the listed jurisdictions, aiming to encourage those jurisdictions’ compliance with the Code of Conduct screening criteria on fair taxation and transparency. In this context, Luxembourg introduced the aforementioned defensive measure in its tax legislation with effect from 1 March 2021, in addition to specific reporting requirements in relation to transactions of Luxembourg companies with related enterprises located in jurisdictions that are included in Annex I that were already imposed since tax year 2018.
Criteria for the listing on the EU list
The Guidance recalls the criteria that jurisdictions are screened on to be considered cooperative for tax purposes and thus not to be included on Annex I, being:
Tax transparency (e.g., the jurisdiction should exchange tax data with all EU Member States through automatic exchange of information)
Fair taxation (e.g., the jurisdiction should not have harmful preferential tax measures)
Implementation of BEPS measures (e.g., the jurisdiction should commit to implement the Organisation for Economic Co-operation and Development (OECD) anti-BEPS minimum standards, which concern measures against harmful tax practices and treaty shopping, country-by-country reporting and the improvement of dispute resolution).
The Luxembourg measure
Scope of application of the defensive measure
The Circular recalls that the defensive measure applies to collective entities that are subject to Luxembourg corporate income tax (the taxpayers), meaning to resident collective entities and to nonresident collective entities with respect to their Luxembourg income.
The Circular furthermore defines the concepts of “interest” and “royalties” for the application of the said measure. These definitions are to a large extent aligned with EU legislation, viz. Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (the Interest and Royalty Directive), and with articles 11 and 12 of the
The term “interest” thus refers to interest and arrears due in relation to receivables of any nature, whether secured by mortgage and whether carrying a right to participate in the debtor’s profits, and in particular interest and arrears from bonds or debentures, including premiums and prizes attaching to such securities. Penalty charges for late payment are not regarded as interest for the purpose of this provision.
The term “royalties” means consideration of any kind owed for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, and for information concerning industrial, commercial or scientific experience.
The rule applies to interest or royalties that are owed, irrespective of whether they are paid or remain outstanding. Reference is made to the accounting principles, according to which transactions and events are recognized when they occur and not only upon payment or collection. This also means that interest or royalties that have accrued before the entry into force of the Law, i.e., before 1 March 2021, remain deductible even if actual payment occurs after 1 March 2021.
Conditions for the application of the defensive measure
The deduction of interest or royalties owed is denied when the beneficiary of the interest or royalties meets three conditions cumulatively.
The first condition relates to determining: (i) who the beneficiary of the interest or royalty is; and (ii) the legal form of the beneficiary, namely that it must be a collective entity within the meaning of the Luxembourg tax legislation. This requires analyzing if the recipient is the beneficial owner of the income. If this is not the case, the fulfillment of the conditions must be assessed at the level of the beneficial owner instead of the recipient.
The Guidance explains that the determination of the beneficiary and the assessment whether it is the beneficial owner has to be made based on Luxembourg tax legislation. According to Luxembourg tax legislation, the beneficial owner of the interest or royalty is the person to whom the income is actually attributable from an economic perspective. If it thus appears from the economic reality that the recipient is not the collective entity that economically benefits from the interest or royalty, the latter must be considered for the application of the defensive measure.
Whether the beneficiary is a collective entity as listed in the Luxembourg Income Tax Law is based on the characteristics of the foreign entity as derived from the legal and statutory provisions applicable to it.
The Circular indicates that an entity that is considered to be tax transparent according to Luxembourg tax rules cannot be the beneficiary of the interest or royalty, so that the partners holding directly or indirectly through one or more other tax transparent entities an interest in said entity are to be considered as beneficiaries for purposes of the defensive measure. The income derived by a tax transparent entity is, under Luxembourg tax law, attributable to its partners in proportion of their holding in the entity. Insofar as the partners are also the beneficial owners of the interest or royalty, the defensive measure applies to them insofar as they are collective entities established in a jurisdiction that is on Annex I of the EU list and to the share of interest or royalty attributable to them.
The second condition to be fulfilled is that the beneficiary is a related enterprise under the meaning of the Luxembourg transfer pricing provision of the Luxembourg Income Tax Law. The concept of “related enterprise” covers any enterprise participating, directly or indirectly, in the management, control or capital of another enterprise, or situations where the same persons participate, directly or indirectly, in the management, control or capital of two enterprises.
Finally, the third condition requires the beneficiary of the interest or royalty to be established in a jurisdiction that is on Annex I of the EU List.
Given that the EU List is constantly evolving, the Law clarifies which version of the EU List a taxpayer should refer to in order to determine if interest or royalties owed are subject to the defensive measure. Examples in the Guidance illustrate the mechanics.
As of 1 March 2021, the rule applies with respect to those jurisdictions listed in the latest version of Annex I of the EU List as published in the OJEU of 26 February 2021.
Effective 1 January of each subsequent calendar year, the rule will apply with respect to those countries and territories that are included in Annex I of the EU List in its latest version as published in the OJEU before that date. As a result, as from 1 January 2022, it is the list as published on 12 October 2021 that applies.
Removals from Annex I of the EU List are taken into consideration regarding interest or royalties owed as from the date of publication in the OJEU of the EU List enacting the removal of a country or territory from the EU List. Consequently, if a given country is taken off Annex I during a given year, the non-deductibility will cease to apply in respect of this country from the date of publication in the OJEU of the revised Annex I that enacted the withdrawal of the country in question.
Consequences of the application of the defensive measure
Where the three cumulative conditions are met, the entire amount of interest or royalty is non-deductible. The Guidance clarifies that any interest that cannot be deducted under the defensive measure is also excluded from the scope of the interest limitation rule, which limits the deductibility of taxpayers’ borrowing costs to the higher of 30% of tax EBITDA (Earnings (taxable profits) before Interest, Tax, Impairments, Depreciation and Amortization) or €3 million.
Application of the safe-harbor rule
Even if the aforementioned conditions are all met, the provision will not apply if the taxpayer proves that the transaction that gives rise to the interest or royalty owed is used for valid commercial reasons which reflect economic reality. The interest or royalty can then be deducted, subject, as the case may be, to other provisions of the Luxembourg Income Tax Law limiting or denying the deduction of this interest or royalty.
The taxpayer must be able to provide the taxation office with all evidence proving that the operation that gives rise to such expenses has been implemented for valid business reasons which reflect economic reality, and in particular all supporting documentation that may support the explanations provided by the taxpayer.
The Guidance explains that it would not be sufficient to simply state economic reasons, but such reasons, taking into account all relevant facts and circumstances, need to be considered “real” and representing an economic advantage that exceeds a potential tax benefit resulting from the operation.
The application of the safe-harbor rule is assessed by the taxation office on a case-by-case basis in the light of the factual circumstances. The Guidance confirms that a ruling request can be filed to determine if the reasons brought forward for a transaction envisaged by the taxpayer that gives rise to the interest or royalty owed are considered to be valid commercial reasons which reflect economic reality. Such ruling request will be subject to the general ruling procedure as set forth in Luxembourg law.
Administrative defensive measures
The Circular indicates that particular attention will be paid to transactions of collective entities with related enterprises located in non-cooperative jurisdictions for tax purposes that are included in Appendix I. Therefore, since tax year 2018, taxpayers are required to indicate in their tax returns if they had transactions with related enterprises located in jurisdictions that are included in Annex I.
Details of those transactions, such as the amount of the transaction, income and expenses linked to the transaction and the detail of receivables and debts towards such related enterprises, must be provided upon request by the tax administration. The tax authority will apply administrative measures of reinforced control, beyond and independently of the application of the legal defensive measure, if taxpayers rely on structures or arrangements involving non-cooperative jurisdictions for tax purposes that are included in Annex I.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Tax Advisory Services Sàrl, Luxembourg City
Ernst & Young LLP (United States), Luxembourg Tax Desk, New York
Ernst & Young LLP (United States), Luxembourg Tax Desk, Chicago