Luxembourg Draft Budget Law 2023 clarifies Reverse Hybrid Entity Rule

Luxembourg’s Draft Budget Law clarifies application of the Reverse Hybrid Entity Rule and provides that it will not apply to the extent the nonresident investor in such entity benefits from a subjective tax exemption in its jurisdiction of residence.

If adopted, this clarification will take effect as from tax year 2022 when the Reverse Hybrid Entity Rule applies for the first time.

Executive summary

On 12 October 2022, Luxembourg’s Minister of Finance submitted the 2023 draft budget law (Draft Budget Law) to Parliament.

In addition to the extension for filing the annual corporate income, municipal business and net wealth tax returns from currently 31 March to 31 December as from tax year 2022 and 2023, respectively, the Draft Budget Law clarifies that the Luxembourg Reverse Hybrid Entity Rule will not apply if the nonresident investor in a Reverse Hybrid Entity benefits from a subjective tax exemption in its jurisdiction of residence.

This Alert details the suggested clarification to the Reverse Hybrid Entity Rule.

Detailed discussion

Background

The Luxembourg law implementing the European Union Anti-Tax Avoidance Directive (ATAD II) extended, with effect from financial years starting on or after 1 January 2019, the territorial scope of the anti-hybrid mismatch provision to third countries and addressed hybrid permanent establishment mismatches, hybrid transfers, imported mismatches, and dual resident mismatches. It also introduced a provision addressing the taxation of “Reverse Hybrid Entities” that applies for the first time in tax year 2022.

Scope and rules

As from tax year 2022, transparent entities or arrangements that are incorporated or established in Luxembourg are, under certain conditions, treated as corporate taxpayers and will be subject to Luxembourg corporate income tax (CIT).

This rule will only apply to an entity or arrangement (e.g., a partnership such as a limited partnership (société en commandite simple; SCS) or a special limited partnership (société en commandite spéciale; SCSp)) if one or more nonresident associated enterprises holding in aggregate a direct or indirect interest of at least 50% of the voting rights, capital interests or rights to profit in the entity or arrangement are located in one or several jurisdictions that regard the entity or arrangement as opaque (Reverse Hybrid Entity).

Where these conditions are met the Reverse Hybrid Entity will be subject to CIT, but only for that part of its income that is not otherwise taxed in Luxembourg or in another jurisdiction (including that of the investor). The tax liability of the Reverse Hybrid Entity is limited to CIT and does not extend to municipal business tax nor to net wealth tax.

Suggested clarification

The wording of the law as its stands today may cause uncertainty on the application of the Reverse Hybrid Entity Rule in presence of associated enterprises that are tax-exempt in their jurisdiction of residence.

The intention of the suggested amendment is to remove this uncertainty by completing the Reverse Hybrid Rule with a wording that the non-taxation of the net income of the associated enterprises must result from a difference of classification of the Luxembourg tax transparent entity or arrangement.

If adopted, this clarification will take effect as from tax year 2022 when the Reverse Hybrid Entity Rule applies for the first time.