The guidelines of the Luxembourg tax authorities on the rules on the limitation of interest deduction (ILR) set out in Article 168bis of the Luxembourg Income Tax Act (LITL) were long awaited. With circular LIR No. 168bis / 1 of January 8, 2021 (circular), the tax authorities present their interpretation of these already applicable and complex rules with regard to the interest deduction limit.
The ILR was introduced into Luxembourg tax law as part of the law of December 21, 2018 implementing the EU Tax Avoidance Directive (ATAD 1). The ILR are based on the results of the OECD project against soil erosion and profit shifting (BEPS) and in particular on the final report on Action 4 of the BEPS project, which was published in October 2015.
According to the ILR, which applies from January 1, 2019, excess borrowing costs (i.e. tax-deductible borrowing costs that exceed the underlying interest income and economically equivalent income) are only deductible to the extent that they do not exceed the higher of 30% of the result of the Taxpayers before interest, taxes, depreciation and amortization (EBITDA) or EUR 3 million.
Clarification of the concepts of “borrowing costs” and “exceeding borrowing costs”
Article 168bis LITL broadly defines borrowing costs as i) interest paid on all types of debt, ii) other costs that are economically equivalent to interest, and iii) costs associated with raising funds, and illustrates this definition with a non-exhaustive list of items to be considered as borrowing costs. The circular follows the same list of items as in the LITL and includes some explanations and examples. In particular, we note that only foreign currency gains or losses that are proportional to the interest component of a debt are included in the definition of borrowing costs (i.e., foreign exchange gains and losses on capital are not included).
According to the definition of the law, the excess of borrowing costs corresponds to the amount of tax-deductible borrowing costs that exceed the underlying interest income and other economically equivalent taxable income of the taxpayer. No clarification was given as to what would be considered to be income “economically equivalent” to interest income.
The circular lays down a principle of coherent symmetry, according to which interest income and other economically equivalent income within the meaning of the ILR represent the counterpart to the borrowing costs defined in Article 168bis LITL. If the amounts incurred are not viewed by the debtor as borrowing costs, they should not be viewed by the beneficiary as interest income or other economically equivalent income (justification to the contrary). The circular states that this principle would be clear “at least in a purely national context”. Interpretation difficulties are therefore likely to persist in the context of international structures.
Instructions for loans taken out before June 17, 2016 (grandfathering rule)
Article 168bis (7) of the LITL excludes additional borrowing costs for loans taken out before June 17, 2016 from the scope of the ILR, unless the loans are modified later.
The Circular clarifies what is meant by “ex post modification” of the loan by providing non-exhaustive lists of actions that (i) are typically considered to be changes for the purposes of the ILR (ie, loss of benefit from the grandfathering rule cause)) and (ii) are not considered changes (i.e. maintaining the benefit of the grandfathering rule). The circular states in particular that changes to the term, the interest rate or one or more parties to the loan are considered later changes, unless they were contractually provided before June 17, 2016 [transfer to Luxembourg] The registered office or central administration of a collective enterprise participating in a loan concluded before June 17, 2016 (without any change in loan terms) is not considered to be a subsequent change.
The circular also contains further guidelines on how the ILR should interact with other tax regulations that could lead to a complete or partial rejection of the deductibility of interest costs (e.g. anti-hybrid rule according to ATAD 2 or “re-entry rule” according to ATAD 2) the participation exemption system). In such cases, the circular states that these non-deductible costs should not be taken into account for the application of Article 168bisLITL.
If the ILR applies to a taxpayer who has an interest in a tax-transparent company, the circular states that the taxpayer realizes the deductible borrowing costs, taxable interest income and other economically equivalent taxable income from that entity in proportion to the interest in that company . In his income tax return, the taxpayer must provide information on the proportion of these deductible borrowing costs and taxable interest income in order to determine the amount of the excess borrowing costs.
The circular does not address all practical cases and concerns. It is particularly regrettable that guidelines are not provided on the application of ILR to investments in so-called “distressed” debt instruments (ie the acquisition of distressed loans or other distressed debt instruments at sub-nominal value). Whether income from the sale or the repayment of debts acquired at a discount represents “interest or economically equivalent income” is still a matter of dispute, at least in a cross-border scenario.
The above is a brief description of the tax authorities’ guidance in the circular and is therefore not intended to be exhaustive.