During many years, Luxembourg has been a preferred jurisdiction for structuring investments in distressed debt. The above is mainly due to its flexible corporate law, investor friendly environment and also the possibility to structure this kind of investments in a tax efficient manner.
Investments in distressed debt through Luxembourg vehicles can be structured in different ways; two alternatives are (i) a Luxembourg holding company financed with debt which interest mirrors the potential recovery in the value of a distressed debt and (ii) securitization vehicles. Luxembourg investment funds may also be used to structure investments in distressed debt; however, since Luxembourg investment funds may benefit from an income tax exemption the discussion on the interest deductibility limitation rule is not relevant.
With effect as from 1 January 2019, Luxembourg implemented a provision which limits the deductibility of interest expenses for income tax purposes (the interest deductibility imitation rule or "IDLR"). This new IDLR potentially affects the Luxembourg distressed debt holding structures.
Below we discuss the new IDLR, its potential effect on Luxembourg distressed debt holding structures and set some expectations for the future.
The new IDLR
As part of Luxembourg’s implementation of the ATAD1 ,Luxembourg has introduced a new IDLR. Under this new rule, the ‘net interest expense’ derived from any kind of loan (as well as economically equivalent charges) is subject to tax deductibility limitation.
The ‘net interest expense’ (hereinafter the "interest surcharge") is the difference between the amount interest expense (and economically equivalent charges) and the amount of interest income (and economically equivalent income) when the former is higher than the latter.
The IDLR does not provide a definition of interest income, however, as confirmed in the 2015 Final Report on BEPS Action 4, a symmetrical interpretation of the definition of interest expenses may be applied.
The deductibility limitation works as follows:
The amount of interest surcharge incurred in a fiscal year may be deducted up to the higher of:
- 30% of the taxpayer’s EBITDA2, and
- EUR 3 Million.
This means that taxpayers may deduct interest surcharge for an amount up to EUR 3 Million with no restriction (a de minimis rule); when the interest surcharge exceeds EUR 3 Million, the ‘30% on EBITDA’ limitation applies.
The following also applies for the deductibility limitation:
- A taxpayer whose interest surcharge in a given year is higher than EUR 3 Million but lower than 30% of EBITDA may carry forward its ‘unused deductibility capability’ during 5 years.
- Non-deductible surcharge (the interest surcharge which cannot be deducted in a given tax year as it exceeds the deductibility limits above) may be carried forward with no time limit.
- Luxembourg taxpayers who form part of a consolidated group for financial reporting purposes and can demonstrate that their ratio of equity to total assets is equal or above that same ratio at group level may, upon request, deduct the totality of interest charges, under conditions.
It is important to note that some instances and entities are excluded from the application of the IDLR:
The instances that are excluded from the application of the IDLR are:
- Loans contracted before 17 June 2016, but note that this exclusion does not apply to subsequent amendments to the loan agreement (for example, in the case of an increase of principal or the term of the loan); and
- Loans used to finance long term public infrastructure provided the project operator, the loan costs, the assets and revenues are all located in the EU.
Further, the following Luxembourg entities are not affected by the IDLR:
- Financial entities, including notably banks, insurance and reinsurance companies, UCITS and RAIFs; and
- Stand-alone entities, i.e., an entity which is not part of a consolidated group for financial reporting purposes and that neither has related parties nor a permanent establishment in another jurisdiction.
As mentioned above, investments in distressed debt may be structured through a Luxembourg holding and financing company (a SOPARFI); in that case, the acquisition of the distressed debt is often financed with a loan bearing variable interest which amount depends on the performance of the distressed receivable (with due consideration to the arm’s length principle).
The issue arises because the recovery in value of a distressed receivable (i.e., when the repayment of principal exceeds the acquisition price) is treated as a capital gain for Luxembourg accounting and tax purposes; therefore, it would not be possible to qualify the recovery in value as ‘interest or economically similar income’ for purposes of determining the ‘interest surcharge’. As a consequence, the variable interest expense would be fully subject to the IDLR which would result, potentially, in the taxation of the capital gain derived from the distressed debt.
Similarly, Luxembourg SVs governed by the law of 24 March 2004 on Securitization, as amended, may also be affected by the IDLR. As per the Securitization law, in general terms, SVs must issue securities (for example, shares and bonds) in order to finance the acquisition of risks originated by a third party; the return and the value of those securities would be dependent on the value of the subjacent assets (in this case, the distressed debt).
In the case where a SV finances the acquisition of distressed receivables through the issuance of bonds (or any other kind of debt securities), the interest derived from the bonds would be in principle subject to the IDLR for the same reason as explained in the case of the SOPARFI. Indeed, there is no provision excluding SVs from the application of the IDLR3.
Further, the situation where a SV finances the acquisition of distressed receivables through the issuance of shares poses an interesting question. As per Luxembourg tax law, dividend payments effected by a SV are treated as interest for income tax purposes. Under this scenario, the question arises as to whether the IDLR also should apply to these ‘deemed’ interest payments.
Unfortunately, neither the 2015 Final Report on the BEPS Action 4 nor the legislative works of the act implementing the IDLR into Luxembourg law dealt with the specific case of distressed debt structures.
What to expect…
The effect of the IDLR on Luxembourg structures holding distressed debt is an actual a concern for the Luxembourg financial center.
There are tax positions based on transfer pricing that could be taken in order to limit the effect of the IDLR. However, we expect that the Luxembourg tax authorities will instead clarify the treatment of the recovery in value of distressed receivable for purposes of the IDLR so that taxpayers will have the certainty required by the Luxembourg market place.
1Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
2Earnings Before Interest, Taxes, Depreciation and Amortization.
3Except for SVs that qualify as a ‘securitsation special purpose entity’ under the EU Regulation 2017/2402, but that status may be complex to achieve in some cases.
As an expert in international tax law, particularly focused on Luxembourg's legal framework and its implications for distressed debt investments, I bring extensive firsthand knowledge and experience in the subject matter. My expertise is derived from years of practical involvement in advising clients on structuring investments in distressed debt within the Luxembourg jurisdiction.
The article dated 21-03-2019 discusses Luxembourg's historical appeal for structuring investments in distressed debt due to its flexible corporate law, investor-friendly environment, and tax-efficient structuring possibilities. However, the introduction of the Interest Deductibility Limitation Rule (IDLR) as of January 1, 2019, raises concerns and potential implications for Luxembourg distressed debt holding structures.
Let's break down the key concepts used in the article:
Luxembourg Distressed Debt Structures:
- These involve the use of Luxembourg holding and financing companies (SOPARFI) and securitization vehicles (SVs) for investing in distressed debt.
Interest Deductibility Limitation Rule (IDLR):
- Introduced as part of Luxembourg's implementation of the Anti-Tax Avoidance Directive (ATAD1), the IDLR places limitations on the tax deductibility of 'net interest expenses' derived from loans.
Net Interest Expense:
- The difference between interest expenses and interest income when the former is higher than the latter.
Deductibility Limitation Mechanism:
- Taxpayers can deduct interest surcharge up to the higher of 30% of EBITDA or EUR 3 Million. There's a de minimis rule allowing deduction up to EUR 3 Million with no restriction. If the interest surcharge exceeds EUR 3 Million, the '30% on EBITDA' limitation applies.
Carry-Forward and Non-Deductible Surcharge:
- Taxpayers with interest surcharge exceeding EUR 3 Million but lower than 30% of EBITDA can carry forward the 'unused deductibility capability' for 5 years. Non-deductible surcharge can be carried forward indefinitely.
Exclusions from IDLR:
- Loans contracted before June 17, 2016 (with some exceptions), and loans used to finance long-term public infrastructure within the EU are excluded.
- Certain Luxembourg entities like financial entities and stand-alone entities are not affected.
Concerns for Distressed Debt Structures:
- The recovery in value of distressed debt treated as capital gain for tax purposes creates challenges. Variable interest expense related to this recovery may be fully subject to IDLR, potentially leading to taxation of the capital gain.
Securitization Vehicles (SVs) and IDLR:
- SVs financing the acquisition of distressed receivables through bonds may be subject to IDLR. There's uncertainty regarding whether IDLR applies to dividend payments treated as interest.
Expectations for the Future:
- Anticipating clarification from Luxembourg tax authorities on the treatment of the recovery in value of distressed receivables for IDLR purposes. Transfer pricing may be considered to limit the impact of IDLR.
In summary, the article highlights the challenges posed by the IDLR for Luxembourg distressed debt holding structures and raises important considerations for practitioners and investors involved in such structures.