VCL Luxembourg Flash Tax News – January 2021

Luxembourg tax authorities publish guidelines on interest deduction limitation rules

 Topics

  1. Introduction
  2. Definition of borrowing costs and interest revenues
  3. Carry forward of exceeding borrowing costs and unused interest capacity
  4. Exclusions from IDLR
  5. Conclusion

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On 8 January 2021, the Luxembourg Tax Authorities (LTA) published guidance (Circular L.I.R. n° 168bis/1, Circular) on the interpretation of the interest deduction limitation rule (IDLR) applicable for tax years starting as of 1 January 2019. The guidance clarifies, among others, the notion of borrowing costs and the grandfathering rule for loans predating 17 June 2016.

We would like to share with you our insights thereof.

  1. Introduction

The IDLR was introduced following the transposition of the European Anti-Tax-Avoidance Directive (EU) 2016/1164 (ATAD) into Luxembourg domestic tax law. We refer to our newsletter of August 2018 for more information on ATAD and implementation in Luxembourg.

There have been uncertainties as to how certain concepts of the IDLR, such as borrowing costs and income economically equivalent to interest should be interpreted in practice. For this reason, the LTA brought additional clarity on the scope of certain rules, definitions and concepts and provided numerical examples in the newly published Circular.

The IDLR limits the yearly deduction of so-called ‘exceeding borrowing costs’, meaning the amount by which otherwise deductible borrowing costs exceed taxable interest and economically equivalent revenues. The exceeding borrowing costs of a taxpayer will be deductible in a tax year only up to the higher of (i) 30% of the taxpayer’s taxable earnings before interest, tax, depreciation and amortization (EBITDA) or (ii) a minimis financial threshold of EUR 3 million.

Save for certain exceptions, the rule applies to Luxembourg resident corporate taxpayers and to Luxembourg permanent establishments of non-resident taxpayers.

  1. Definition of borrowing costs and interest revenues

The Circular clarifies that the following three categories qualify as borrowing costs for the purpose of the IDLR: (i) interest expenses on all forms of debt, (ii) other costs economically equivalent to interest and (iii) expenses incurred in connection with the raising of finance. In this respect, it was underlined that only business expenses and borrowing costs deductible for tax purposes in line with the Luxembourg income tax law (LITL) are subject to the IDLR. As a consequence, interest expenses relating to tax exempt dividend income or disallowed expenses under the anti-hybrid rule should be ignored for purposes of the IDLR. With respect to the Luxembourg recapture rule, only borrowing costs which remain deductible under the IDLR need to be accounted for.

In the absence of a legal definition of interest and economically equivalent revenues, the Circular indicates to apply a symmetrical approach by following the definition of borrowing costs upon qualifying income as interest or economically equivalent revenues as counterpart to borrowing costs.

The deduction for impairment of doubtful or irrecoverable receivables does not trigger any borrowing costs for the creditor.

In addition, the Circular includes a non-exhaustive list of borrowing costs eligible for the IDLR, mentioning, among others, the following:

  • Any amount, fixed or variable, payable under a profit participating loan;
  • Interest on and issuance of redemption premiums linked to financial instruments, such as zero-coupon bonds, exchangeable bonds and convertible bonds;
  • Only the finance cost element of financial lease agreements whereas operating lease payments are excluded;
  • Any adjustment made to comply with the arm’s length principle for transfer pricing purposes;
  • Interest calculated on the basis of a notional that has in principle been the subject of a transaction under derivate instruments (i.e. forwards, futures, options, swaps) or hedging arrangements related to an entity’s borrowings, especially interest rate swaps;
  • Foreign exchange gains and losses which are in connection to interest under a loan, while those in connection with the principal amount of a loan are excluded;
  • Guarantee fees for financing arrangements (i.e. costs of a mortgage guarantee); and
  • Arrangement fees related to the borrowing of funds (i.e. opening and account maintenance fees) whereas fees and commissions of intermediaries involved are excluded when they merely constitute incidental expenses to purchase price of an asset.
  1. Carry forward of exceeding borrowing costs and unused interest capacity

The Circular furthermore confirms that the carry forward of exceeding borrowing costs is not limited in time while the carry forward of so-called ‘unused interest capacity’ is limited to 5 years.

  1. Exclusions from IDLR 

a) Grandfathering rule

The IDLR excludes exceeding borrowing costs that arise from loan agreements having been entered into before 17 June 2016, known as the so-called ‘grandfathering rule’. The grandfathering rule would however not apply if ‘subsequent modifications’ to the agreements have been made after 17 June 2016.

In this context, the Circular confirms that the following amendments, among others, would not constitute subsequent modifications:

  • Amendments of the terms and/or interest rate of the loan, which were contractually agreed upon before 17 June 2016;
  • Drawdowns under an existing credit facility in accordance with terms and conditions contractually agreed before 17 June 2016;
  • Loans granted to a company before 17 June 2016 which subsequently migrates its registered office or central administration to Luxembourg, to the extent that the terms and conditions of the loans are not modified.

Where modifications have been made after 17 June 2016, the grandfather rule still applies to the exceeding borrowing costs linked to the initial terms and conditions of the loan, and the IDLR only applies to the additional exceeding borrowing costs which directly result from the subsequent modification.

b) Public infrastructure debt

Exceeding borrowing costs related to debt for the funding of long-term public infrastructure projects are also excluded from the IDLR provided that the operator, borrowing costs, assets and income all derive from within the European Union. Such projects would need to provide, upgrade or maintain assets of the general public interest, such as schools, universities and libraries.

c) Standalone entities and financial undertakings

The Circular specifically excludes standalone entities and financial undertakings from the IDLR. Standalone entities are taxpayers that (i) are not part of a consolidated group for financial accounting purposes, (ii) have no associated enterprises (i.e. an entity or individual holding directly or indirectly a participation of at least 25% in the taxpayer concerned[1]); and (iii) no permanent establishment located outside Luxembourg. The Circular emphasises that the association test is to be interpreted economically and that the 25% threshold needs to assessed both in a downward (subsidiaries) and upward (shareholders) manner.

  1. Conclusion

The Circular is a very welcome guideline on the application of the IDLR. In particular, although further clarifications are desirable, the confirmations on the symmetric approach provide clarity for the distressed debt sector on the tax treatment of interest income and economically equivalent income. It furthermore provides clarification on the concept of subsequent modification in light of the grandfathering rule for loans predating 17 June 2016 as well as the exclusion of the IDLR for standalone entities and long-term public infrastructure projects.

Taxpayers concerned should carefully review their positions taken in respect of the application of the IDLR.

We trust you find this publication useful and welcome the opportunity to answer any questions or comments you may have. We will keep you updated on any additional tax measures.

[1] The term ‘associated enterprise’ is to be interpreted in light of article 164ter(2) LITL.

 

Raffaele GargiuloRaffaele Gargiuolo

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Andrew de Vries

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Eduardo Trancho

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Gabriel Amar

Gabriel Amar

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Stephanie RaffiniStéphanie Raffini

Associate

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Diego Gonzalez Manso

Diego Gonzalez Manso

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Christina StrauvenChristina Strauven

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