Answer ... Special rules limiting the application of the participation exemption regime:
No participation exemption applies to dividends received from or paid to EU collective entities in case of non-genuine arrangements put into place for the main purpose or one of the main purposes of obtaining a tax advantage which defeat the object or purpose of the EU Parent-Subsidiary Directive. In addition, if a dividend paid to the Luxembourg corporate entity is tax deductible in the EU member state of the subsidiary - that is, in the country of source - it remains taxable at the level of the Luxembourg parent company, meaning that the EU participation exemption regime is denied.
The Luxembourg controlled foreign corporation (CFC) rule allows the taxation of a Luxembourg corporate taxpayer on undistributed income from an entity or permanent establishment which qualifies as a CFC if it is derived from non-genuine arrangement implemented with the main purpose to obtain a tax advantage. In this case, an arrangement or a series thereof shall be regarded as non-genuine to the extent that the CFC would not own the assets which generate all or part of its income and would not have undertaken the related risks if it were not controlled by a Luxembourg taxpayer where the significant people functions linked to these assets and risks are carried out and are instrumental in generating the CFC’s income. The CFC rule does not apply if the accounting profit of the CFC does not exceed €750,000 or 10% of its operating costs for the tax period.
General anti-hybrid rules:
Article 168ter of the Income Tax Law implements EU Directive 2017/952 of 29 May 2017 (the “Anti-Tax Avoidance Directive 2”) and provides for a comprehensive framework to tackle hybrid mismatches. These rules apply since 1 January 2020 and replace the existing hybrid mismatch rules which were introduced as part of the 2019 tax reform when implementing EU Directive 2016/1164 of 28 January 2016 (the “Anti-Tax Avoidance Directive”). Hybrid mismatches typically result from a different tax treatment of an entity or financial instrument under the laws of two or more jurisdictions and may result in deduction without inclusion outcomes or double deductions. To neutralize the mismatch outcomes, according to the primary rule, the deduction of a payment is denied to the extent that it is not included in the taxable income of the recipient or is also deductible in the counterparty jurisdiction. When the primary rule is not applied, the counterparty jurisdiction may apply a defensive rule, requiring the deductible payment to be included in the income or denying the duplicate deduction, depending on the nature of the mismatch. When a hybrid mismatch involves a third state, the responsibility to neutralise the effects of hybrid mismatches is placed on the EU Member State.
Article 168ter further provides for rules that target imported hybrid mismatches that shift the effect of a hybrid mismatch between parties in third countries into the jurisdiction of EU Member States through the use of a non-hybrid instrument. Finally, Article 168ter provides for rules that neutralize double deduction outcomes in case of tax residence mismatches (that is when an entity is resident for tax purposes in two or more jurisdictions).
Article 168quater implements also the Anti-Tax Avoidance Directive 2 and provides a so-called reverse hybrid rule which will enter into force as from tax year 2022. A reverse hybrid is an entity that is treated as transparent under the laws of the jurisdiction where it is established but as a separate entity (i.e. opaque) under the laws of the jurisdiction(s) of the investor(s). The reverse hybrid mismatch rule aims at eliminating double non-taxation outcomes through the treatment of reverse hybrids as resident taxpayers.
Limitation to the deduction of interest:
Subject to certain conditions and limitations, ‘exceeding borrowing costs’ shall be deductible only up to 30% of the corporate taxpayer’s earnings before interest, tax and amortisation, or up to an amount of €3 million, whichever is higher. Taxpayers that can demonstrate that the ratio of their equity over their total assets is equal to or higher than the equivalent ratio of the group can (under certain conditions) fully deduct their exceeding borrowing costs.
Transfer pricing principles
Article 56 of the Income tax law provides a legal basis for transfer pricing adjustments where associated enterprises deviate from the arm’s length standard. In other words, where a Luxembourg company shifts advantages to another group company, the Luxembourg tax authorities may increase the company’s taxable income (upward adjustment). Conversely, where a Luxembourg company receives an advantage from an associated company, the taxable income of the Luxembourg company may be reduced by a downward adjustment.
Furthermore, Article 164(3) of the Income Tax Law provides that hidden distributions (i.e., direct or indirect advantages granted by the company to its shareholder which, absent the shareholding relationship, would otherwise not have been granted) are non-deductible from the taxable basis of the company.
Although there are no general rules on thin capitalisation, in practice the tax authorities apply a debt-to-equity ratio of 85:15 for the holding of participations (as well as for real estate assets located in Luxembourg). Excessive interest payments may be treated as hidden profit distributions.