On 9 June 2023, the Luxembourg tax authorities have issued a first circular (No 168quater/1) on the application of the so-called reverse hybrid rules. This circular provides clarifications on notably the tax status of a hybrid entity in Luxembourg, how its taxable result is to be computed and the tax compliance obligations applicable to it. This is welcome guidance, as reverse hybrid entities need to file their first tax return in such quality by 31 December 2023.
As a reminder, the reverse hybrid rules apply where (i) non-resident investors, who are associated or deemed associated with a Luxembourg tax transparent entity (such as partnerships) are located in a jurisdiction or jurisdictions that regard such Luxembourg entity as a taxable person, (ii) such investors in aggregate hold 50% or more of interests, voting rights or rights to profits in the Luxembourg entity and (iii) such investors are not taxed on their share of the Luxembourg entity’s profits because of the mismatch (and not, e.g., because of the tax exempt status of the investors). If those cumulative conditions are met, the Luxembourg tax transparent entity is to some extent regarded as a resident taxpayer in Luxembourg and is subject to corporate income tax on its income to the extent that that income is not otherwise taxed in Luxembourg or abroad.
The law leaves a lot of room for interpretation and also does not address practical questions applicable to taxpayers in scope of the rules. The new circular clarifies some of those questions.
A reverse hybrid entity is not a full-fledged resident corporate taxpayer and accordingly will be subject to the tax rules applicable to natural persons. Certain corporate-specific provisions such as the Luxembourg participation exemption, as well as the interest deduction limitation rule and the ordinary anti-hybrid mismatch rules would therefore not apply.
Also, the circular specifies that distributions made by a reverse hybrid are not subject to withholding tax on profit distributions.
Determination of taxable result
The circular specifies that a reverse hybrid entity can derive income from movable capital, rental income and other net income within the meaning of articles 97 – 99 of the Luxembourg income tax law.
This notably entails that the taxable result of a reverse hybrid is determined based on the cash accounting method, i.e., by subtracting the cash expenses from the cash receipts that a reverse hybrid has made within a specific calendar year. This also means that accrual accounting will not apply to reverse hybrid entities. Hence, as long as the reverse hybrid entity has not received any income, it should not be liable to pay corporate income tax (CIT). Moreover, the cash accounting method also implies that a reverse hybrid entity is not entitled to a step-up in basis when becoming a reverse hybrid. Conversely, the Luxembourg tax authorities will not treat the exit of a reverse hybrid from the scope of the reverse hybrid rules as a taxable event.
By way of administrative simplification, the Luxembourg tax authorities will allow for cash receipts and expenses which are denominated in a foreign currency to be converted all at once either based on the year-end exchange rate or on the average exchange rate applicable to the tax year at hand.
Although reverse hybrid entities may not benefit from the participation exemption, qualifying dividends received by a reverse hybrid entity may benefit from a 50% exemption.
Finally, provisions regarding foreign tax credits and the deduction of foreign taxes may also apply for the determination of the taxable result of a reverse hybrid entity, in proportion with the income that is subject to CIT.
Tax compliance obligations
Reverse hybrid entities need to declare their income on an annual basis by way of a specific reporting form, the so-called ‘form 205’. That form, which applies to taxpayers that do not exercise a business enterprise in Luxembourg, allows the reverse hybrid entity to indicate how its profits will be split amongst its various partners and which part of the profits will be subject to corporate income tax in Luxembourg.