Louis Thomas & Agata Jankowiak (KPMG Luxembourg): Limit to tax deductibility of interest
Louis Thomas, KPMG Luxembourg
Agata Jankowiak, KPMG Luxembourg
Introduction of the 30% EBITDA limit to interest deductibility and its impact on treasury activities of Luxembourg companies as of 1 January 2019
On 19 June 2018, the Luxembourg government issued a bill of law (hereafter ‘Draft Bill’) for the transposition of the EU Anti-Tax Avoidance Directive (ATAD) into the Luxembourg domestic tax law.
One of the changes of the Draft Bill that should be particularly observed is the interest limitation rule. The introduction of this rule is expected to reshape the landscape of the EU and Luxembourg corporate taxation of financing activities as it significantly restricts deduction of the payments linked to borrowing, either intra-group or external.
The Draft Bill incorporates the mandatory provisions of the ATAD and includes several options and exemptions offered by the directive. Unfortunately, the proposed text includes a number of terms and provisions that lack precision or remain unclear and vague.
“On 19 June 2018, the Luxembourg government issued a bill of law (hereafter ‘Draft Bill’) for the transposition of the EU ATAD.”
Targeted taxpayers and main exemptions
The interest limitation rule encompass all of Luxembourg’s tax resident companies as well as Luxembourg’s permanent establishments of foreign tax resident companies. Therefore, from the point of view of the interest limitation rule it should be irrelevant whether a group chooses to run its treasury business in Luxembourg in the form of a corporation or through a branch.
In accordance with the spirit of the ATAD, the Draft Bill implements certain exemptions from the rule. The first one concerns the threshold of EUR 3 million. All taxpayers subject to the interest limitation rule will be able to deduct their exceeding borrowing cost up to that amount notwithstanding the remaining rules governing the interest barrier rule.
The second exemption (grandfathering clause) covers the deduction of the expenses incurred in relation with loans concluded prior to 17 June 2016. Unrestricted deductions on such loans will be permitted until their termination. However, for this rule to apply, there can be no subsequent modifications to the terms and conditions of the loan agreement. Taking the specific circumstances of the treasury business into account, it remains to be analyzed on a case-by-case basis whether the cash pool agreements concluded prior to the cut-off date of 17 June 2016 can benefit from the grandfathering proviso. These agreements are not long-term loans, and one could argue that the objective of the ATAD is not to tackle cash pooling (as long as they do not include factually long-term loans).
There is also the so-called exemption for financial undertakings. This notion encompasses several financial institutions such as banks and insurance undertakings that operate based on the EU regulations precisely enumerated in the Draft Bill. Most of the Luxembourg treasury companies operating as internal, unregulated ‘banks’ of multinational enterprises will not qualify for this exemption.
Exceeding borrowing expense
The interest barrier rule aims to restrict the deduction of the exceeding borrowing expense.
The Draft Bill attempts to define the notion of the borrowing expense. The definition is, however, far from clear. According to the proposed text, the borrowing expenses are to be understood as interest expenses on all forms of debt, other costs economically equivalent to interest and expenses incurred in connection with the raising of finance. Further, the proposed article includes a non-exhaustive list of the items falling within the scope of the definition. The explanations presented by the Luxembourg government suggest that the list is to have only an illustrative character. The problem with such an approach is that the notion of the interest and the notion of the costs economically equivalent to interest or expenses incurred in connection with the raising of finance are not properly defined in the Luxembourg tax law and, therefore, will leave room for discussions in the future.
The interest provision included in the Draft Bill is almost an exact copy of the one proposed by the ATAD, except that the ATAD requires this key concept to be defined in the national law of the Member States. The Draft Bill, however, does not reach beyond the minimum language of the ATAD. In accordance with the traditional rule of the interpretation, where the Luxembourg tax law does not specifically define a given notion, and subject to specific comments in the exposé des motifs, the accounting principles of Lux GAAP should be retained as one of the important criteria that can be used for tax purposes. Therefore, it seems that the accounting law and choices in the accounting policy may drive the determination of the borrowing costs.
As for the excess, the Draft Bill dictates that it should be established as a difference between the amount of the interest income and other equivalent income and the amount of the borrowing expense. Even more surprisingly, the Draft Bill proposes no definition or even an indication how the interest income should be understood. At first sight, it seems that the definition of the interest must be built symmetrically to the one of the borrowing expense. Such was the initial idea presented by the BEPS project. In accordance with this concept, once an accounting item is considered to constitute an ‘expense’ on ‘borrowing’ in the hands of a ‘debtor’, it will need to be automatically qualified as ‘interest income’ in the hands of a ‘creditor’.
Given the fundamental meaning of the exceeding borrowing expense in the concept of the interest limitation rule and its operation in practice, the somewhat light consideration and obscure definition thereof in the Draft Bill may be a difficult point of analysis in the future.
All treasury companies will need to proceed to a careful analysis of their affairs and income/expense accounting posts. At a high level, however, it seems that only those expenses relating to the borrowings (be it interest paid on the loans taken or any other associated expenses such as foreign exchange losses, guarantee fees, bank charges, underwriting fees, etc.) that exceed the income on any form of lending, long- or short-term (that the income should include interest and all associated revenues), should be affected by the new rules.
Mechanism of the fixed ratio rule
The core of the interest limitation rule is the restriction of the tax deductibility of interest expenses incurred by a taxpayer that exceeds 30% of tax-adjusted EBITDA.
The Draft Bill provides for an autonomous definition of tax-adjusted EBITDA that differs from a usual financial or accounting understanding of this term. The notion is explained by reference to the tax figures and requires it to be calculated by adding back to the net income (i.e. taxable basis), the tax-adjusted amounts for exceeding borrowing costs as well as the tax-adjusted amounts for depreciation and amortization.
In terms of timing, the Draft Bill provides for two types of carry-forward rules. First, the unused EBITDA can be carried forward for five years. This means that if the amount equal to 30% of EBITDA of a taxpayer in a given year exceeds the deductible interest expense claimed in that year, the taxpayer will be allowed to increase the permitted deduction in one of the following five years by the unused amount of 30% of EBITDA. Secondly, the taxpayer will be permitted to track the excessive expenses that it could not deduct in a given year due to the insufficient EBITDA ratio and claim its deduction once EBITDA increases to permit the deduction.
Other measures proposed by the Draft Bill, such as CFC provisions or hybrid mismatch rules, may interact with the interest limitation rules. The order of application of those provisions and their interactions will need to be determined. The Draft Bill contains no conflict-of-law rules and potentially those issues may need to be resolved through references to the ideas presented by the OECD in the framework of the BEPS project.
“The general 30% EBITDA interest limitation rule under the ATAD included a provision for a safe harbor for companies that are part of a consolidated group.”
The general 30% EBITDA interest limitation rule under the ATAD included a provision for a safe harbor for companies that are part of a consolidated group. The implementation of this exemption is optional for the EU Member States and two alternative worldwide group ratio escape rules are offered: a group equity ratio (that refers to capital structure of the group, its equity-to-assets ratio vs the capital of the company) and a group earnings ratio (based on the group interest-to-earnings ratio vs that of the company).
The Draft Bill opts for the first alternative: under the group equity escape rule, a taxpayer should be allowed to deduct the total of its exceeding borrowing costs if the taxpayer’s equity-to-assets ratio is comparable to (or higher than) the equivalent ratio of the consolidated group.
At this stage, the interest limitation provisions offered by the Draft Bill closely follow the recommendations of the ATAD and comply with all its mandatory aspects. Yet, the various exemptions chosen by the Luxembourg government that the ATAD laid as optional will enable the Luxembourg financial market to remain attractive and competitive. This approach is clearly a positive sign. There are numerous questions and several uncertainties on the interpretation or practical implications. It will require time, experience, many in-depth analysis and discussions to address them or perhaps even some guidelines from the tax authorities in circular letters.
With regard to the treasury activities, although Luxembourg corporations should be prepared for the Draft Bill and assess the impact of the interest limitation rule, it seems that they should not be significantly affected by the interest limitation provision. Indeed, a lot of income streams and expenses of treasury companies may fall within the definition of interest. To that extent, the exceeding borrowing costs of treasury activities should be rather limited or if not, the limitation of their deduction should have a rather limited impact on the overall tax position of a company on a standalone basis. There may, however, be a significant impact on long-term financing activities, especially in connection with the financing of assets other than receivables or qualifying participations (i.e. intellectual property, shares in non-taxable subsidiaries, plants or machinery, etc.).
 Council Directive (EU) 2016/1164 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
 The list includes: Payments under profit participating loans, imputed interest on instruments such as convertible bonds and zero coupon bonds, amounts under alternative financing arrangements, such as Islamic finance, the finance cost element of finance lease payments, capitalized interest included in the balance sheet value of a related asset, or the amortization of capitalized interest, amounts measured by reference to a funding return under transfer pricing rules where applicable, notional interest amounts under derivative instruments or hedging arrangements related to an entity's borrowings, certain foreign exchange gains and losses on borrowings and instruments connected with the raising of finance, guarantee fees for financing arrangements, and arrangement fees and similar costs related to the borrowing of funds.