On 23 December 2022, the Luxembourg Parliament adopted bill n°8080 related to the budget for 2023 (the "Budget Law 2023" – see our newsflash on the budget bill here), which contains, among others, clarifications on the application of the Luxembourg reverse hybrid mismatch rule (“RHMR”) as enshrined in Article 168quater of the Luxembourg income tax law (“LITL”).
The RHMR targets situations where an entity is treated as tax transparent in Luxembourg but as tax opaque in the jurisdiction(s) of its investors leading to a non-taxation of the income in any of the jurisdictions. Hence, the RHMR aims at eliminating the double non taxation outcome by considering, under certain conditions, the Luxembourg tax transparent entity as a resident taxpayer for corporate income tax purposes.
The clarifications provided with regards to the conditions of application of the RHMR apply retroactively as of 1 January 2022.
Conditions of Article 168quater LITL
Prior to the Budget Law 2023, the RHMR under Art. 168quater LITL, applied where the following cumulative conditions were met:
- An entity or arrangement incorporated or established in Luxembourg is treated as transparent for Luxembourg tax purposes. This may, for instance (but not limited to), encompass a Luxembourg SCS, SCSp or SNC; and
- One or more non-resident “associated enterprises” is/are entitled, directly or indirectly to at least 50% of the voting rights, capital, or profits of the Luxembourg entity or arrangement and are established in a jurisdiction that considers such Luxembourg entity or arrangement as tax opaque under its/their domestic tax rules. This condition requires that a double 50% threshold is met. Firstly, the 50% threshold that the investor or shareholder of the Luxembourg entity or arrangement must meet to qualify as an “associated enterprise” which is not as such mentioned in Article 168quater LITL but is imbedded in the definition of “associated enterprises”. The notion of “associated enterprises” means any investor or shareholder that is entitled directly or indirectly to 50% or more of the voting rights, capital, or profits of a Luxembourg entity or arrangement on a “standalone” or “acting together basis. Secondly, the non-resident “associated enterprises” must globally (jointly) be entitled to 50% or more of the voting rights, capital, or profits of the Luxembourg entity or arrangement and consider it as tax opaque under their domestic tax rules. Thus, resulting in a mismatch in qualification of the Luxembourg entity or arrangement.
Where the aforementioned cumulative conditions are met, the Luxembourg entity or arrangement qualify as a Reverse-Hybrid Entity.
Luxembourg tax consequences
The Reverse-Hybrid Entity will be considered as a resident taxpayer in Luxembourg (despite its general tax transparency for Luxembourg tax purposes). Therefore, the portion of its net income that is not taxed in Luxembourg or elsewhere will become subject to Luxembourg corporate income tax (including unemployment fund contributions) at a rate of 18.19% for the year 2023.
Clarifications by implementation of the Budget Law 2023
The Budget Law 2023 clarifies the conditions of application of the reverse hybrid rule by stipulating that the mere absence of taxation of the income realized by a non-resident associated enterprise must be due to a difference in the tax qualification of the Luxembourg entity or arrangement. Where for example the absence of taxation is due to the tax status of the non-resident associated enterprise, the RHMR will not apply.
This clarification is in line with the rationale of the BEPS Action 2 Report - Neutralizing the effects of hybrid mismatch arrangements - which states that “the reverse hybrid rule will not apply unless the payment attributed to the investor would have been included as ordinary income if it had been paid directly to the investor (i.e., the interposition of the reverse hybrid must have been necessary to bring about the mismatch in tax outcomes)”.
|It is assumed that the three investors do not act together||Tax treatment of the SCSp under the Investor’s domestic tax rules||Investor is an “associated enterprise” of the SCSp entitled to 50% or more of the voting rights, capital, or profits in the SCSp||Investor is subject to taxation in its country of tax residence|
|Investor A||Tax Transparent (Taxation of the attributable income)||No||Yes|
|Investor B||Tax Opaque (No taxation of the attributable income)||No||No (subjective exemption)|
|Investor C||Tax Opaque (No taxation of the attributable income)||Yes||Yes|
While Investor A and Investor B do not qualify as “associated enterprises”, Investor C meets the required threshold. In addition, Investor C is entitled to 50% of the voting rights, capital, or profits in Lux SCSp and is incorporated in a jurisdiction that treats Lux SCSp as tax opaque. Due to this difference in tax qualification of Lux SCSp, the Luxembourg RHMR will apply. This means that Lux SCSp will become taxable in Luxembourg on a portion of its income.
As a variation to the above example, it is assumed that Investor C benefits from a subjective tax exemption in its jurisdiction. The Luxembourg RHMR will not apply because the absence of taxation is not the result of a mismatch in tax qualification of Lux SCSp (but is merely due to the tax-exempt status of Investor C).
Remaining uncertainties ?
While the Budget Law 2023 clarifies the conditions of application of the RHMR, it seems that there are still uncertainties with regards to the Luxembourg tax consequences triggered by the said rule.
According to a literal interpretation of Art. 168quater LITL as amended by the Budget Law 2023, if the RHMR is applicable, the Reverse-Hybrid Entity would become taxable on its net income that is neither taxed in Luxembourg, nor elsewhere.
In the initial scenario depicted above, this means that if the RHMR is triggered, Lux SCSp would become taxable in Luxembourg on the portion of the net income attributable to Investor B and Investor C given that both investors are resident in a jurisdiction that considers Lux SCSp as opaque and do not tax the said income.
Against this interpretation, the State Council commentaries to the Budget Law 2023 provides that only the portion of income attributable to the “associated enterprises” triggering the application of the reverse hybrid rule should become taxable in Luxembourg at the level of the Reverse-Hybrid Entity. Hence, if one considers the comments from the State Council, only the portion of the net income attributable to Investor C (sole investor meeting the conditions to trigger the RHMR) would become taxable in the hands of Lux SCSp.
It remains to be seen if and when the Luxembourg tax authorities or tax courts may shed some more light on the above. Stay tuned for further updates.
Thanks to the clarification provided by the Budget Law 2023, certain tax-exempt investors may no longer be considered as causing the application of the RHMR even though they consider the Luxembourg tax transparent entity as opaque. This clarification is particularly relevant for Luxembourg funds established under the legal form of a partnership and which are held by a significant number of tax-exempt investors resident in jurisdictions such as France, Hong-Kong, Singapore or the US which generally treat certain Luxembourg partnerships as tax opaque. Fund managers that manage such funds will need to assess the tax status of the investors and carefully manage the application of the RHMR to ensure tax neutrality. It is then important that fund managers consider the application RHMR when structuring the fund but also at the time of the drafting of the legal documentation.
Our tax team remains at your disposal should you need any clarification or assistance.