Luxembourg moves to introduce hybrid mismatch tax clampdown

The  Luxembourg government is planning to tighten up the rules on use of hybrid mismatches in line with the EU Anti-Tax Avoidance Directive 2 (ATAD 2), which has to be adopted in EU member states by 2020

When the rules come into force from 1 January 2020, they will affect Luxembourg permanent establishments (PEs) of foreign entities. In addition, provisions targeting reverse hybrid mismatches will be applicable to Luxembourg transparent partnerships that would be treated as opaque by their non-resident owners as from 1 January 2022.

ATAD 2 is an update to the original ATAD 1, announced in 2016, which was designed to curb tax avoidance practices in the context of intra-EU transactions. The second iteration of the directive, ATAD 2 targets a wider range of tax reliefs and advantages obtained by taxpayers resident in EU member states as it nets hybrid mismatches, including the hybridity of a financial instrument or an entity within the context of tax transactions involving non-EU countries. ATAD 1 only covered intra-EU member state activity.

EU member states have until 1 January 2020 to implement ATAD 2 into domestic law, although there is a two-year deferral for provisions targeting reverse hybrids, which the Luxembourg government has retained.

‘The government has chosen to use a wording close to the text of the Directive and to apply the exceptions granted by ATAD 2,’ said William Jean-Baptiste, partner at Ogier, based in Luxembourg. ‘The Draft Law provides clarification on some crucial questions, in particular regarding the application of the new rules to investment funds. However, at this stage, it still needs to go through the Luxembourg legislative process and we expect that some amendments will be made, in particular input from the Luxembourg Council of State.

‘The first criteria to consider when assessing the application of the Draft Law is the existence of a mismatch effect.

‘Hybrid mismatches are defined as arising when a payment leads to the realisation of a mismatch effect which is defined as a double deduction: when the same payment is deducted for tax purposes in the jurisdiction where the payment has its source (payer jurisdiction) and in another jurisdiction (investor jurisdiction); or a deduction without inclusion: when a payment is tax deductible at the level of the payer but not included in the taxable income of the recipient,’ said Jean-Baptiste.

There is also a second test in the draft legislation which references the existence of a structured arrangement or capital ownership, voting rights or profits entitlement link. From the draft law, when a hybrid mismatch arises between associated enterprises, for example, being related through a 50% or more capital ownership, voting rights or profits entitlement (a threshold of 25% applies in relation to payments under a financial instrument). This would also apply between a head office of an entity and a permanent establishment; between two or more permanent establishments of the same entity; and in cases of dual tax residence.

Council Directive (EU) 2017/952 of 29 May 2017 sets out compliance requirements for ATAD 2.

Sara White

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