ATAD Luxembourg Implementation: Hybrid mismatches

On 18 December 2018, the Luxembourg Parliament (Chambre des Députés) approved the draft law n°7318 (the "ATAD Draft Law"), which implements into domestic law the EU anti-avoidance directive of 12 July 2016 ("ATAD").

In a nutshell: what are the hybrid mismatches rules?

Hybrid mismatches are the consequence of differences in the legal characterisation of financial instruments or entities and those differences appear in the interaction between the legal systems of two jurisdictions. The effect of such mismatches is often a double deduction (i.e., deduction in both Member States) or a deduction of the income in one Member State without inclusion in the tax base of the other Member State. To counteract the effects of such hybrid mismatch arrangements, rules need to be implemented whereby the deduction of a payment leading to such an outcome is denied in one of the two jurisdictions.

The ATAD Draft Law introduces a new article 168ter of the Luxembourg income tax law ("LITL") to tackle such cross-border hybrid mismatches.

Are the hybrid mismatches rules a new concept for Luxembourg?

To a certain extent only as Luxembourg has already implemented in the past a specific anti-avoidance rule providing the denial of the participation exemption regime as regards dividend distributions in cases where such distribution would give to the paying entity a deduction right in another Member State.

In a nutshell: when will the hybrid mismatches rules be applicable?

An hybrid mismatch is defined as the difference in the legal characterisation of a financial instrument or an entity when either (i) a structured arrangement between the taxpayer and a party established in another Member State or (ii) commercial or financial relations between the taxpayer and an associated enterprise established in another member State results in any of the following consequences:

  • a deduction of the same operational expenses or losses (also referred to "double deduction"); or
  • a payment results in a deduction without a corresponding inclusion in the total net income (also referred to "deduction without inclusion").

The hybrid mismatches rules under the ATAD Draft Law apply in accordance with ATAD only to arrangements within the EU (i.e., with other Member States but not with third countries).

For the purposes of the hybrids mismatches rules, the concept of "associated enterprise" is to be understood as the ATAD Draft Law’s definition of associated enterprise, except that the percentage of 25% is to be replaced by a percentage of 50%, however only in the case where the hybrid mismatch involves a hybrid entity.

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What will be the consequences if the hybrid mismatches rules apply?

In presence of a hybrid mismatch as defined above, the operating expenses in relation thereto will not be deductible to the extent that the latter are:

  • deductible in another Member State where such expenses have their source; and
  • not taxable in another Member State receiving the payment.

As a consequence of the above, the new hybrid mismatch rules will not be applicable to a Luxembourg taxpayer involved in a hybrid mismatch if the payment has its source in Luxembourg (as regards the double deduction) or if Luxembourg denies the deduction of such payment (as regards the deduction without inclusion). In those scenarios, the other Member State will have to deny the deduction right.

Could you please explain the difference between hybrid mismatches and non-hybrid mismatches?

The easiest is to provide a little example to stress this difference, which is however pretty important.

The payment will not be deductible at the level of LuxCo in scenario (i) as the income is exempt in the other Member State because of a different qualification of the legal instrument used to perform the payment. However, if the income is exempt in the other Member State due to, for instance, specific local provisions of such Member State (i.e., scenario (ii)), then the payment will be deductible at the level of LuxCo as the non-taxation of the income does not result from a different legal characterisation of the financial instrument.

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How is the presence of hybrid mismatches verified?

Upon request of the Luxembourg tax authorities, the taxpayer must be able to provide a declaration of the issuer of the financial instrument or any other relevant element such as tax returns, other tax documents or certificates provided by the tax authorities of the other Member State to prove the absence of deduction of the payment (in case of a double deduction), or the taxation of such payment in the other Member State.

When will this rule be applicable?

The hybrid mismatches rules will be applicable as of 1 January 2019.

What will be the impacts of the hybrid mismatches rules in Luxembourg?

The impact of this measure on the current Luxembourg tax structures should in our view remain, at least to a certain extent, limited since the scope of article 168ter LITL only covers hybrid mismatches within the EU. Further, a similar concept has already been included for the application of the domestic participation exemption regime as regards dividend distributions.

However, the Council Directive (EU) 2017/952 ("ATAD 2") amending ATAD as regards hybrid mismatches with third countries, which should be applicable in Luxembourg as of 1 January 2020, provides an extension of the hybrid mismatch rules under ATAD, including among others mismatch arrangements with third countries. The scope of ATAD 2 is expected to have a much bigger impact.

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