BUREN | Legislative proposal non-deductibility of interest and royalty payments to recipients established in EU blacklisted jurisdictions

On 30 March 2020, the Luxembourg government published a bill of law which aims to deny the deduction for income tax purposes of interest and royalty charges paid or due by Luxembourg taxpayers to related party companies established in blacklisted countries or jurisdictions.
 
Background 
On 5 December 2017, the Council of the European Union approved conclusions on the EU list of Non-cooperative tax jurisdictions. As part of these conclusions, the EU Member States agreed to put in place, by 1 January 2021, defensive measures which would aim to encourage the countries and jurisdictions included in the list to look for their delisting.
 
The first defensive measure implemented by Luxembourg in this respect was the administrative circular L.G. – A No. 64 of 7 May 2018, in which the Luxembourg tax administration indicates that it will pay special attention on transactions carried out by Luxembourg corporate taxpayers with related parties located in Non-cooperative tax jurisdictions. This administrative circular remains applicable.

Additional proposal
Under the recently published legislative proposal interest and royalty charges paid or due by Luxembourg taxpayers to related party companies established in blacklisted countries or jurisdictions would no longer be deductible for Luxembourg income tax purposes.

The new rule would apply to the beneficial owner of the interest / royalties charges; i.e., it would also apply in the case where the interest / royalty charges are paid or due to an entity established in a non-blacklisted jurisdiction but for the benefit (in the sense of beneficial ownership) of a company established in a backlisted country or jurisdiction.

This new rule would not apply if the Luxembourg taxpayer can prove that the transaction giving raise to the interest / royalty charge has taken place for valid commercial reasons that reflect the economic reality; in this respect, it should be noted that, as per the legislative works of the bill of law, it is not sufficient to simply list a number of commercial reasons that would motivate the transaction, but these commercial reasons should represent an economic benefit sufficiently important to justify the transaction. 

Once passed, the bill of law would enter into force on 1 January 2021. The Luxembourg Government will propose during the second half of 2020 the list of jurisdictions to be included in the blacklist, which will be based on the EU list of Non-cooperative tax jurisdictions. This list is to be updated once per year.

Currently, the EU list of non-cooperative tax jurisdictions includes: US Samoa, Cayman Islands[1], Fiji, Guam, Oman, Palau, Panama, Samoa, Seychelles, Trinidad and Tobago, US Virgin Islands, and Vanuatu.
 
Practical example
The new rule may impact some (commonly used) intra-group financing structures involving Luxembourg companies. Consider the following example:
 
A Cayman company (CaymanCo) grants an interest bearing loan to its Luxembourg subsidiary (LuxCo) which in turn on-lends the proceeds received to its subsidiary (GroupCo). LuxCo’s remuneration for its financing activity is an at arm’s length interest margin (the differential between the interest income and the interest expense).

To figure 1

Upon implementation of the new rule, the interest charge paid or due by LuxCo to CaymanCo would be considered as non-deductible for Luxembourg income tax purposes and, consequently, the full amount of LuxCo’s interest income would be subject to corporate income tax.

To figure 2

How we can help 
Taking into account the possible significant impact of this new rule, we recommend assessing whether this change may impact existing corporate structures and arrangements and whether any steps should be taken in order to mitigate adverse tax consequences.

[1] The Government of the Cayman Islands has already contacted EU officials to begin the process of being removed from the EU list of Non-cooperative jurisdictions; the Cayman Islands expects to be delisted on October 2020.