Luxembourg tax authorities’ Circular on interest limitation rule

On 8 January 2021, the Luxembourg tax authorities released the circular LITL n°168bis/1 ("the Circular") with respect to the interest limitation rule described in article 168bis of the Luxembourg Income Tax Law ("LITL") as introduced by the law of 21 December 2018 ("ATAD Law") which implemented the Council Directive 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market (known as "ATAD 1").

The below comments focus on the Circular comments which complement the provisions of ATAD Law.

Key words definitions

The Luxembourg tax administration gives its interpretation on important terms used in article 168bis LITL. The Circular begins by specifying that to determine 'exceeding borrowing costs', 'borrowing costs' should first be defined.

Borrowing costs

According to the Circular, 'borrowing costs' are divided into three categories: (i) interest expense on any type of debt; (ii) other costs economically equivalent to interest; and (iii) expenses borne in the context of financing. It should be noted that only borrowing costs, that are tax deductible, have to be considered when determining the exceeding borrowing costs. Hence, it should be first checked if any tax provisions other than the one provided by article 168bis LITL could lead to a total or partial denial of the tax deductibility of an expense (e.g. anti-hybrid provisions, article 45 paragraph 2 LITL and article 166 paragraph 5 number 1 LITL). If an expense based on this analysis is not tax deductible, the latter cannot be considered as a borrowing cost.

The interest limitation rule is applicable to interest expenses and any other cost which economically is equivalent to interest. The Circular specifies that deduction for depreciation of  doubtful or uncollectible debts, do not trigger borrowing costs at the level of the creditor.

To illustrate that concept, the Circular has provided for some comments to the non-exhaustive list of borrowing costs that was provided by ATAD Law:

(i) Any payments under profit participating loans

The Circular specifies that a profit participating loan gives the lender the right to receive, in return for the capital lent, a fixed remuneration and a variable remuneration depending on the borrower's profitability, for example, according to the borrower's profit or turnover. The definition of borrowing costs includes all sums paid as remuneration for participating loans.

(ii) Imputed interest on instruments

The Circular provides with examples for such category: bonds with coupon, zero coupon bonds, profit participating bonds, exchangeable bonds, convertible bonds etc. The Circular further explains that  the issue and redemption premiums owed by the issuer to the bondholder. are considered as borrowing costs.

In relation to zero coupon bonds, they do not give rise to any interest payment until their term to their subscribers. However, the subscribers are allocated a redemption premium at the maturity of the said bonds corresponding to the positive difference between the redemption price of these securities and their issuance price.

(iii) Amounts under alternative financing arrangements, such as Islamic finance

 The Circular defines the term "alternative finance" to financing methods which are outside the conventional financial system. Alternative financing mechanisms include, inter alia, instruments from the Islamic finance. As such, the definition of borrowing costs includes the amounts paid under these Islamic finance instruments, when they are comparable in terms of tax regime to conventional financial instruments. For instance, payments under Sukuk should be considered taxwise as interest.

(iv) Interest due under financial leases

The Circular specifies that a leasing contract can take different forms according to its content (e.g. financial lease, operating lease). Depending on the features of the contract, the asset which is the object of the contract is to be attributed for tax purposes either to the lessee (the contract is assimilated to a contract of sale) or to the lessor (the contract is assimilated to a leasing contract). For example, if the leasing contract is treated for tax purposes as a sale, the lessee is obliged to record on its tax balance sheet the asset and the debt towards the lessor. In this case, as is the case for any debt repayable in constant annual instalments, the annual instalments of the leasing contract must be split into a part representing the partial repayment of the debt during the operating year and a part representing the interest accrued during the same year. Only the part representing the accrued interest is affected by the provisions of article 168bis LITL. On the other hand, if the leasing contract is not treated for tax purposes as a sale, the payments under the leasing contract should not be considered, from the lessee perspective, as borrowing costs.

(v) Capitalised interest included in the balance sheet value of a related asset

The Circular explains that when the option to capitalize interest in the tax balance sheet value of an asset is chosen for tax purposes, capitalized borrowing costs are only affected by article 168bis LITL when they are or are likely to be deducted. This question arises in particular in the case of deduction for depreciation, amortization or disposal of the asset in question. Capitalised interest must be shown on a separate line in the amortization table attached to the tax return.

(vi) Amounts measured by reference to a funding return under transfer pricing rules

According to article 56bis LITL, transactions between affiliated enterprises should be remunerated as if they had been concluded between independent companies trading in comparable circumstances and under the conditions of full competition. The interest expenses may be adjusted, if necessary, to ensure compliance with the arm's length principle.

The Circular provides that any transfer pricing adjustment is subject to the interest limitation rule.

(vii) Notional interest amounts under derivative instruments or hedging arrangements related to an entity's borrowings

The Circular specifies that a derivative instrument is a security or contract between parties whose value varies according to that of an underlying asset which may be financial (e.g. shares, bonds, interest rates, currencies, stock market indices) or physical (e.g. agricultural or mineral raw materials). Derivatives include contracts commonly known as forwards, futures, options and swaps. Interests calculated on a notional basis that have in principle not been subject to a transaction or physical exchange under derivative instruments or hedging arrangements in relation to an entity's borrowing should be seen as borrowing cost.

(viii) Certain foreign exchange gains and losses on borrowings and instruments connected with the raising of finance

The Circular further explains that foreign exchange gains and losses, which relate to interest under a debt, should also fall within the definition of borrowing costs, to the extent that they are included in the taxable base. Foreign exchange gains and losses arising from the debt principal should not be taken into account.

(ix) Guarantee fees for financing agreements

This category covers, in particular, costs relating to a mortgage guarantee or any other type of guarantee taken in the context of a financial transaction.

(x) Arrangement fees and similar costs related to the borrowing of funds

According to the Circular, this category covers all financing costs incurred in the context of a financial transaction, in particular the fees related to the opening and maintenance of an account. However, this does not include the fees of the intermediaries (notaries, experts, etc.) involved in financing operations, when such fees are accessory expenses to the purchase price of the asset.

Exceeding borrowing costs

Article 168bis LITL does not define interest income and other income economically equivalent to interest. The Luxembourg tax administration takes the position that a symmetrical approach should be taken, i.e., interest and other income economically equivalent to interest should constitute the counterpart of the borrowing costs defined by article 168bis LITL. For instance, if a bond premium is considered as a borrowing cost for the issuer, this premium should also be considered as interest income at the level of the holder.

Fiscal EBITDA

Under article 168bis, paragraph 1, number 4, LITL, the taxpayer's EBITDA (i.e., Earnings Before Interest, Tax, Depreciation and Amortisation) is equal to the total net income increased by the exceeding borrowing costs,  amortisations and deductions for depreciation calculated. The Circular specifies that the exempt income (e.g. exempt dividends) of the taxpayer should not be taken into account for the determination of its fiscal EBITDA.

Interest limitation rule

As a reminder, under article 168bis LITL, tax  deductions  of exceeding borrowing cost are limited to 30% of the fiscal EBITDA, or up to an amount of EUR 3,000,000, whichever is higher. In other words, the taxpayer whose exceeding borrowing costs are not higher than EUR 3,000,000 can deduct said costs without any limitation. The Circular confirms that the interest limitation rule does not make any difference between borrowing costs contracted domestically, at a EU Member State or third country level. This limitation is applicable to each fiscal year. In case where the fiscal year has less than 12 months, the 30% fiscal EBITDA or EUR 3,000,000 is not prorated.

Article 168bis, paragraph 3 LITL provides for the possibility to carry forward the 'unused capacity to deduct interest' over the next five operating years.

Article 168bis paragraph 4 LITL provides that exceeding borrowing costs that could not be deducted in a fiscal year can be deducted in the next following fiscal year without any time limitation, within the limits of the interest limitation rule. The oldest exceeding borrowing costs should be deducted the first.

The Circular specifies that in the context of a tax neutral transformation of a collective undertaking into another collective undertaking, covered by article 170 paragraph 2 LITL, article 172 paragraph 5 LITL or article 172bis paragraph 4 LITL, the carry forward of exceeding borrowing costs is continued at the level of the transformed undertaking.

It should be noted that any transfer pricing adjustment needs to be taken into account for the determination of the interest limitation rule.

Out of scope cases and further remark

Article 168bis, paragraph 7 LITL excludes from its scope of application the additional borrowing costs related to loans contracted before 17 June 2016, long-term public infrastructure project, standalone entities and financial undertakings.

Grandfathering clause (June 17, 2016)

Article 168bis, paragraph 7, LITL provides for a grandfathering clause covering loans contracted by companies before 17 June 2016, to the extent that the terms and conditions of such loans remain unchanged from 17 June 2016. It follows that in the event of a  subsequent modification in a loan after 17 June 2016,  the grandfathering clause will only apply to the initial terms and conditions of the loan as they were set before that date.

In principle, the following changes, which are not exhaustive, are to be considered as a subsequent modification of a loan concluded before 17 June 2016:

• modification of the term of the loan as of 17 June 2016, where such modification was not contractually provided until 17 June 2016;

• modification of the interest rate or the calculation of interest from 17 June 2016 where such modification was not contractually foreseen prior17 June 2016;

• modification of the amount borrowed from 17 June 2016 onwards;

• modification of one or more of the parties concerned as from 17 June 2016, where such a change was not contractually foreseen before 17 June 2016. It should be noted that restructuring such as mergers or demerger, do not jeopardise the benefit of the grandfathering clause, as these transactions, as such, do not result in a change in the initial terms of the loan.

In principle, the following changes, which are not exhaustive, are not to be considered as a subsequent modification of a loan concluded before 17 June 2016:

• modification of the term of the loan as of 17 June 2016, where such modification was contractually foreseen before 17 June 2016 and does not require the agreement of the parties concerned, but arises from the implementation  of the loan;

• modification of the interest rate or the calculation of interest from 17 June 2016, when such modification was contractually foreseen before 17 June 2016;

• draw-downs from a credit line from 17 June 2016 under a credit agreement entered into prior to 17 June 2016 in accordance with the terms and conditions of this agreement and in particular up to the maximum amount of credit provided before 17 June 2016;

• transfer to Luxembourg of the registered office or central administration of an entity that is a party to a loan entered into prior to 17 June 2016 without being any modification of the terms and conditions of the loan.

Long-term public infrastructure project

Article 168bis provides that are considered as out of the scope of application of the interest limitation rule, the costs relating to loans used to finance a long-term public infrastructure project, when the project operator, the borrowing costs, the assets and the income are all located in the European Union. Article 168bis LITL defines a long-term public infrastructure project as a project that is of public interest to provide, enhance, operate or maintain a high quality asset scale. The Circular further described the notion of public interest assets by giving common characteristics:

• the assets provide goods and services serving the public interest;

• these assets are provided, improved, operated or retained in projects involving a body governed by public law or a public entity either by contract or by a regulatory scope;

• the assets are large in scale;

• the assets are durable.

Examples of assets of public interest in the Circular include schools, swimming pools, nurseries, theatres, universities and libraries. The notion of long-term public infrastructure project may, under the certain conditions, refer to projects executed in accordance with procurement legislation or projects carried out within the framework of partnerships between a public and private partner, often referred to as "public-private partnership".

Standalone entities

Article 168bis LITL excludes from its scope of application the taxpayers who meet the definition of "standalone entity". The standalone entity is defined as "a taxpayer which is not part of a consolidated group for financial accounting purposes and which does not have an associated enterprise within the meaning of Article 164ter, paragraph 2 LITL or a permanent establishment situated in a State other than Luxembourg".

The Circular emphasis that it is necessary to verify the existence of a direct or indirect link of association between the taxpayer and the organization or an individual. This link of association must be analysed from an economic point of view.

Financial undertakings

A financial undertaking should not fall within the scope of the interest limitation rules. Companies which are not regulated by a European Directive or Regulation are not covered by this definition, except for the investment company in risk capital (known as "SICAR").

Further remark: participations in tax transparent entities

Finally, the Circular provides that where the interest limitation rule applies to a taxpayer who holds a participation in a transparent entity for tax purposes, whatever the nature of the activities carried out by such entity, the taxpayer realizes in proportion to the fraction held in this entity, the deductible borrowing costs, taxable interest income and other taxable income economically equivalent of that entity.