Tax authorities release guidance on interest deduction limitation rules (art. 168bis LITL)

Guidance from the Luxembourg tax authorities on the interest deduction limitation rules (ILR) set out in Article 168bis of the Luxembourg income tax law (LITL) were long awaited. With Circular L.I.R. n°168bis/1 dated 8 January 2021 (the Circular), the tax authorities provide their interpretation of these already applicable and complex rules in relation to the interest deduction limitation.

The ILR were introduced as part of the law dated 21 December 2018 transposing the EU Anti-Tax Avoidance Directive (ATAD 1) into Luxembourg domestic tax law. The ILR are based on the outcome of the OECD’s Project against base erosion and profit shifting (BEPS) and more specifically on the final report on Action 4 of the BEPS Project which was published back in October 2015.

Pursuant to the ILR, which are applicable as from 1 January 2019, excess borrowing costs (i.e. tax-deductible borrowing costs which exceed underlying interest income and economically equivalent income) are only deductible to the extent that they do not exceed the higher of 30% of the taxpayer’s earnings before interest, taxes, depreciation and amortization (EBITDA) or EUR3 million.

Clarification on the concepts of “borrowing costs” and “exceeding borrowing costs”

Article 168bis LITL broadly defines borrowing costs as i) interest expenses on all forms of debt, ii) other costs economically equivalent to interest and iii) expenses incurred in connection with the raising of finance, and illustrates this definition with a non-exhaustive list of items which are to be considered as borrowing costs. The Circular follows the same list of items as set out in the LITL while providing some clarifications and examples. In particular, we note that only foreign exchange gains or losses that relate proportionately to the interest part of a debt are included in the definition of borrowing costs (i.e. foreign exchange gains and losses arising from the principal are not taken into account).

Pursuant to the definition of the law, exceeding borrowing costs correspond to the amount of tax deductible borrowing costs which exceed underlying interest income and other economically equivalent taxable revenues realized by the taxpayer. No clarification was provided on what is to be considered as revenues which are “economically equivalent” to interest income.

The Circular lays down a principle of coherent symmetry, according to which interest income and other economically equivalent income constitute, for the purposes of the ILR, the counterpart of the borrowing costs as defined in Article 168bis LITL. Thus, if the amounts incurred are not considered as borrowing costs by the debtor, they should not be considered as interest income or other economically equivalent income by the beneficiary (rationale applicable a contrario). The Circular states that this principle would be clear, "at least in a purely national context". Hence, difficulties of interpretation are likely to remain in the context of international structures.

Guidance on loans concluded before 17 June 2016 (grandfathering rule)

Article 168bis, paragraph 7 LITL excludes from the scope of application of the ILR, additional borrowing costs in relation to loans concluded before 17 June 2016, so long as the loans are not subsequently modified.

The Circular clarifies what is meant by a “subsequent modification” of the loan by providing non-exhaustive lists of actions that (i) are typically considered as modifications within the meaning of the ILR (i.e. causing the loss of the benefit of the grandfathering rule) and (ii) are not considered as modifications (i.e. maintaining the benefit of the grandfathering rule). The Circular states in particular that changes in the term, interest rate or to one or more parties of the loan are considered to be subsequent modifications to the extent they were not contractually provided for before 17 June 2016. On the other hand, the transfer to Luxembourg of the registered office or central administration of a collective undertaking which is party to a loan concluded before 17 June 2016 (without modification of the conditions of the loan) is not deemed to be a subsequent modification.

Other guidance

The Circular also provides for more guidance such as how the ILR should interact with other tax provisions which may lead to a total or partial denial of the deductibility of interest costs (e.g. anti-hybrids rule under ATAD 2, or the “recapture rule” under the participation exemption regime). In such cases, the Circular states that these non-deductible costs should be disregarded for purposes of the application of Article 168bis LITL.

Where the ILR applies to a taxpayer holding an interest in a tax transparent entity, the Circular specifies that the taxpayer realizes, in proportion to the interest it holds in that entity, the deductible borrowing costs, taxable interest income and other economically equivalent taxable income of that entity. In its income tax return, the taxpayer must provide information on the fraction of these deductible borrowing costs and taxable interest income in order to determine the amount of exceeding borrowing costs.

The Circular does not address all practical cases and concerns. It is notably unfortunate that no guidance is provided on the application of ILR in the case of investments in so-called "distressed" debt (i.e the acquisition of non-performing loans or other distressed debt instruments at sub-nominal value). Whether or not income derived from the sale or repayment of debt acquired at a discount constitutes “interest or economically equivalent income” is still subject to debate, at least in a cross-border scenario.

The above is a brief description of the guidance provided by the tax authorities in the Circular and is therefore not exhaustive. Our team members would be happy to discuss this in further detail and remain at your disposal.