Luxembourg Budget Law 2023 enacts clarification to Reverse Hybrid Entity Rule

• Luxembourg’s Budget Law 2023 clarifies that the Reverse Hybrid Entity Rule only applies where the non-taxation of net income results from a difference of classification and that only the share of the net income attributable to associated enterprises triggering the application of the Reverse Hybrid Entity Rule is subject to corporate tax at the level of the Luxembourg entity or arrangement.
• The Law also excludes fossil gas and nuclear energy investments from the benefit of the reduced subscription tax rate applicable for undertakings for collective investment.
  

Executive summary

On 15 December 2022, Budget Law 2023 (the Law) was approved by the Luxembourg Parliament. Subject to some legal steps being completed, the Law is expected to be published in the Official Gazette and to come into force before year end.

In addition to the extension for filing the annual corporate income, the municipal business and net wealth tax returns from the current due date of 31 March to 31 December as from tax year 2022 and 2023, respectively, it clarifies that the Reverse Hybrid Entity Rule will only apply if the non-taxation of the income attributable to a nonresident investor that is an associated enterprise in a Reverse Hybrid Entity is due to hybridity.

Moreover, the Law excludes investments in the fossil gas and nuclear energy sectors from the benefit of the reduced subscription tax (applicable to undertakings for collective investment) as introduced by the Budget Law 2021.1

Detailed discussion

Scope of the Reverse Hybrid Entity Rule

The Luxembourg law implementing the European Union (EU) Anti-Tax Avoidance Directive (ATAD II) extended, with effect from financial years starting on or after 1 January 2020, 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 mismatches, according to which, 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 are subject to Luxembourg corporate income tax (CIT).

This rule only applies 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 is 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.

Clarification on the application of the Reverse Hybrid Entity Rule

The wording of the 2019 law implementing ATAD II may cause uncertainty on the application of the Reverse Hybrid Entity Rule in case of associated enterprises that are not taxable in their jurisdiction of residence due to reasons that are unrelated to hybridity (e.g., tax-exempt investors).

Therefore, the Law completes the Reverse Hybrid Rule with text that the non-taxation of the net income of the associated enterprise(s) must result from a difference of classification of the Luxembourg tax transparent entity or arrangement.

As a result:

• Associated enterprises that benefit from a subjective tax exemption and for which the non-taxation of the net income consequently is not due to a difference of classification of the Luxembourg entity or arrangement are not to be taken into account to calculate the threshold of holding in aggregate of a direct or indirect interest of at least 50% of the voting rights, capital interests or rights to profit in the entity or arrangement for the Reverse Hybrid Entity Rule to apply.
• Where the Reverse Hybrid Entity Rule applies, only the share of the net income attributable to one or more associated enterprises triggering the application of the Reverse Hybrid Entity Rule will be subject to CIT at the level of the Luxembourg entity or arrangement. In other words, the net income attributable to investors who are not associated enterprises is not subject to CIT, regardless of whether such net income is taxed under the Luxembourg Income Tax Law or the laws of any other jurisdiction.

This clarification takes effect as from tax year 2022 when the Reverse Hybrid Entity Rule applies for the first time.

Restriction to the application of the reduced subscription tax

The 2021 Budget Law introduced reduced subscription tax rates for undertakings for collective investment or individual compartments of such funds that invest a specific portion of their net asset value in determined sustainable economic activities, as defined by the Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment and amending Regulation (EU) 2019/2088 (EU Taxonomy Regulation).

Through the Delegated Regulation (EU) 2022/1214 of 9 March 2022, the European Commission decided to define fossil gas and nuclear energy as sustainable economic activities under the EU Taxonomy.

As the Government is opposed to nuclear energy and committed to the ecological transition in the context of environmental and climate protection prioritizing the development of renewable energy, the Law excludes investments in those activities from the reduced subscription tax.