A Closer Look at Luxembourg’s Nondeductibility of Payments Draft Law

The Cayman Islands is the world’s leading jurisdiction for raising capital. It had 10,992 funds regulated under the Mutual Funds Law at the end of 2018 and 10,916 at the end of the first quarter of 2019.¹ The industry’s positive outlook is reflected in the Cayman Islands Monetary Authority’s statistical digest for 2018, which shows a reporting funds net asset value for that year of $3.916 trillion.² This represents approximately half of the global alternative fund flows.

Path Toward the Luxembourg Draft Law

The EU published its first list of noncooperative jurisdictions on December 5, 2017. That EU list included 17 jurisdictions in Annex I that were deemed to have failed to meet the relevant tax transparency criteria: fair taxation and implementation of base erosion and profit-shifting measures. Since the first release, there have been multiple changes to the EU list, each based on recommendations made by the EU’s Code of Conduct Group (COCG).³ The current EU list’s Annex I includes 12 jurisdictions: American Samoa, the Cayman Islands, Fiji, Guam, Oman, Palau, Panama, Samoa, Seychelles, Trinidad and Tobago, the U.S. Virgin Islands, and Vanuatu. Seychelles, Trinidad and Tobago, Panama, and (once ratified) Oman have double tax treaties with Luxembourg.

On November 25, 2019, the Council of the European Union published a COCG report encompassing the group’s work in the second half of 2019. Among other topics, the document included a detailed report on the EU list including new guidance on defensive measures against noncooperative jurisdictions.⁴ The guidance invited all member states to apply defensive tax measures vis-à-vis the listed jurisdictions starting January 1, 2021, with the goal of encouraging them to comply with Code of Conduct fair taxation and transparency criteria. The report was endorsed during the December 5, 2019, Economic and Financial Affairs Council meeting. Luxembourg was reproached for failing to address elements of its tax system that were allegedly facilitating aggressive outbound payment tax planning.⁵

On March 31 Luxembourg took the first step to implementing the guidance. A draft law was transmitted to parliament disallowing, under specific circumstances, the deduction of interest and royalties paid or owed by Luxembourg corporate taxpayers to related enterprises established in a jurisdiction appearing on the EU list.

Understanding Defensive Measures

The draft law provides for a denial of the interest or royalties paid⁶ or owed deduction for corporate taxpayers if the beneficial owner⁷ meets any of the following conditions:

• The recipient is a corporate entity as defined in the Luxembourg Income Tax Law. This means that only payments to Cayman Islands corporations such as LLCs (as opposed to partnerships) are covered by the draft law.

• The recipient is a related enterprise as defined by article 56 of the Luxembourg transfer pricing provision of the Income Tax Law.⁸

• The recipient is established in a jurisdiction or territory on the EU list.

The Beneficial Owner Concept

The above criteria need to be assessed regarding the beneficial owner. However, there is no definition of beneficial owner under Luxembourg law. It is not to be confused with the Luxembourg concept of economic owner in which the economic owner of an asset bears the asset’s economic risks (gain or loss) and holds the asset’s decision-making rights.⁹

In the absence of a domestic definition, it may be useful to refer to EU law. The interest and royalty directive (IRD, 2003/49/EC) and the savings directive (2003/48/EC) both refer to the beneficial owner concept. While the IRD has no definition of beneficial owner, the savings directive refers to “any individual who receives an interest payment or any individual for whom an interest payment is secured, unless he provides evidence that it was not received or secured for his own benefit.” The savings directive definition provided little clarification and was repealed on January 1, 2017.

The best source for the definition of beneficial owner may be the Danish cases of February 26, 2019,¹⁰ in which the Court of Justice of the European Union discussed the concept of beneficial owner versus a conduit company. According to the CJEU, the following factors indicate a conduit company:

• funds received by the interposed entity are almost immediately passed on to entities that do not meet the conditions of the withholding tax exemption, leaving behind only an insignificant taxable margin;

• inability to use the funds received economically (contractually or in substance); and

• the company’s sole activity is the receipt of dividends or interest and their transmission to the beneficial owner or other conduit companies.

While these indicators may be useful in assessing the concept of beneficial owner, they can also make things more complicated. For example, the question may arise as to whether payments made to a feeder fund incorporated under the legal form of a corporation (for example, in Jersey or Guernsey) ultimately held by multiple investors through Cayman Islands corporate vehicles could violate the rules. It may be difficult to ascertain who in the chain is the beneficial owner.

Nevertheless, beneficial owner references are justified in the commentaries to the draft law to ensure that the defensive measure is effective and can catch indirect payments made to jurisdictions on the EU list through vehicles resident in jurisdictions not on the list. A typical case could be one in which payments are made as part of back-to-back financing or licensing activities.

The State Council suggests clarifying this concept by adding the following wording:

the beneficial owner is the individual or entity that benefits economically from the interest and royalty owed or paid and has the ability to freely determine the use of such proceeds without being obliged legally or contractually to remit such proceeds to another individual or entity.

Exception to the Rule

The deduction of interest or royalties will not be denied if the taxpayer can prove that the transaction was implemented for “valid commercial reasons that reflect economic reality” (the economic reality test). It is insufficient to simply state the economic reasons. They must be considered real and represent an economic benefit exceeding any potential tax benefit from the operation.

Economic Reality and the Abuse of Law

The concept of economic reality appears in the Luxembourg Adaptation Law article 6 general antiabuse rule (which reflects the general antiavoidance provision of the anti-tax-avoidance directive (ATAD, 2016/1164)). Because the GAAR and the draft law use identical wording, it may be asked whether the standard applied should be the same. Both provisions target the same objective, albeit in a different manner. The Luxembourg GAAR economic reality concept is meant to allow a tax benefit that would have otherwise been denied. Similarly, the economic reality concept under the draft law is intended to reinstate a tax benefit otherwise denied.

If no such explicit exception had been provided in the draft law, taxpayers would not have been able to invoke the GAAR’s “valid commercial reasons” argument to claim deductibility. The GAAR’s burden of proof falls first on the Luxembourg tax authorities to demonstrate the absence of valid commercial reasons, to which the taxpayer can then respond.¹¹

For those reasons, and because of the exact wording, economic reality standards in both the GAAR and the draft law should be interpreted in the same manner. In light of the Danish cases, this may be a high bar to meet, even for the investment fund industry, despite its well-justified commercial use of Cayman Islands vehicles. One may wonder if the approach taken in France, in which a taxpayer is able to demonstrate that the payments correspond to a real provision of services and are in line with the arm’s-length character, is not a more reasonable test to meet.¹²

Definition of Interest

The draft law defines interest largely based on definitions provided under article 2 of the IRD:

This would, for instance, cover some payments made as part of Islamic finance practices such as sukuk.¹³

The Luxembourg Securitization Market

According to the Luxembourg Securitization Law, a securitization vehicle’s commitments to remunerate investors for issued bonds or shares and other creditors qualify, at least at the level of the investors, as interest on debt even if paid as returns on equity. These commitments are deductible under some conditions — for example, where relevant, under the application of interest limitation rules.

Note that the draft law only applies to payments to related enterprises,¹⁴ which may in practice limit its application to securitization vehicles.

Evolution of the EU List

Because the EU list is evolving and may face increased political pressure for expansion, there may be more jurisdictions on future versions of it that have entered into double tax treaties with Luxembourg. Any disallowed payments made to entities tax resident in jurisdictions with which Luxembourg has a double tax treaty¹⁵ may conflict with the nondiscrimination clause of these treaties.¹⁶ This may create the need for an exception to the draft law’s disallowance of deductibility of payments made to residents of those double tax treaty jurisdictions.

In its opinion, the State Council states that the provision will not apply in those situations as a result of the hierarchy of norms whereby treaties override domestic provisions.

The draft law also includes timing criteria for drawing up the initial version of the EU list and for future updating. The Luxembourg government will propose to parliament that completion of the provision include the creation of a domestic noncooperation jurisdictions list, effective January 1, 2021, whose contents will be based on the latest version of the EU list as published in the Official Journal of the EU at the time of the proposal. The domestic list can only include jurisdictions that are also on the EU list. The domestic list will apply to interest and royalties paid or owed from January 1, 2021, and will be updated once a year, again upon proposal by the government to parliament, as follows:

• changes made will be effective January 1 of the calendar year following the year of the proposal and will apply to interest and royalties paid or owed from that date;

• the list can only be updated with those jurisdictions included in Annex I of the EU list (as published in the Official Journal of the EU) on the date of the proposal; and

• removals from the domestic list will be taken into consideration for interest or royalties paid or owed from the date of publication in the Official Journal of the EU of the removal of the jurisdiction from the EU list.

Conclusion

ECOFIN’s December 2019 resolution requires all member states to implement one of the defensive measures suggested by the COCG¹⁷ by January 1, 2021. The Luxembourg draft law in response to that resolution sensibly balances the interests of all parties involved, including the fund industry. It restricts the deduction denial to recipients and beneficial owners that are:

• corporate entities (partnerships are not covered);

• related enterprises; and

• the beneficial owners of royalty and interest payments.

Also, the deduction of interest or royalties will not be refused if the taxpayer can prove that the transaction was implemented for valid commercial reasons reflecting economic reality.