The reverse hybrid rules apply as from the 2022 tax year to Luxembourg tax transparent entities (e.g. a Luxembourg SCS, SCSp etc.) that are treated as tax opaque from the perspective of the investors’ jurisdiction (i.e., income of such entity is neither taxable in Luxembourg nor in the residence state of the investor(s)).
Therefore, the primary function of these rules is to tackle double non-taxation outcome arising as a result of such mismatch in the qualification (i.e., tax transparent vs opaque) of the Luxembourg entity.
Where certain cumulative conditions are met, such entity is to be considered a “reverse hybrid entity” meaning that it will be considered as a resident taxpayer in Luxembourg subject to the Luxembourg corporate income tax (“CIT”) with respect to the income not subject to income tax at the level of the investors (in Luxembourg or abroad).
The reverse hybrid rules are of a particular importance for the Luxembourg funds industry (the Luxembourg partnership being very popular choice for fund vehicles), which is why these rules have attracted particular focus of fund managers. Careful assessment of the tax status of investors in such fund vehicles is required to avoid a potentially significant tax burden at the level of the fund.
The wording of the reverse hybrid provision causes some uncertainty both with respect to the conditions for the application of the reverse hybrid rules and for the Luxembourg tax consequences stemming therefrom.
Certain helpful clarification regarding the conditions for the application of the reverse hybrid rules were introduced by the 2023 Budget Law - most notably confirmation that associated enterprises (investors) benefiting from a subjective tax exemption in their country of residence do not trigger the application of the reverse hybrid rules.
The Circular provides some further clarification and guidelines on the application of the reverse hybrid rules, which are summarized below:
A “hybrid” tax status of a reverse hybrid entity under the Circular
Despite its tax transparency for Luxembourg tax purposes, a reverse hybrid entity is to be considered as a resident taxpayer in Luxembourg. The Circular refers to it as a resident taxpayer with the meaning of the reverse hybrid rules.
The limited tax residency status referred to above is important as it implies, as also confirmed by the Circular, that a reverse hybrid entity does not itself qualify for the general definition of Luxembourg tax residency as included in the Luxembourg income tax law. Consequently, many Luxembourg tax rules exclusively applicable to “ordinary” Luxembourg tax resident entities subject to CIT (for example the rules on participation exemption, controlled-foreign company rules, interest deduction limitation rules and anti-hybrid mismatch rules) are not applicable to a reverse hybrid entity. Instead, the Circular provides that a reverse hybrid entity is subject to the tax rules applicable to natural persons, notwithstanding the fact that considering its special tax status and the fact that a reverse hybrid entity is not actually a natural person, only a few provisions applicable to natural persons are equally relevant to reverse hybrid entities.
Taxable income of a reverse hybrid entity
The Circular identifies three categories of taxable income of a reverse hybrid entity:
- net income from movable capital and certain movable assets;
- net rental income; and
- other net income such as (speculation of long-term) capital gains on shares.
The net income falling into one of the three categories is to be determined on a cash basis by reference to the calendar year (notwithstanding a possible deviating accounting year).
It is important to note that only net income not otherwise subject to tax in Luxembourg or under the laws of any other jurisdiction may be subject to corporate income tax at the level of a reverse hybrid entity.
Income received and expenses incurred in a foreign currency must be converted in euros either (i) at the exchange rate of the day the income is received, and expenses are incurred; or (ii) at the year-end exchange rate or (iii) at the average exchange rate of the given the tax year.
The Circular explains that the reverse hybrid entity is not entitled to a step up in basis at the time it acquires the status of a reverse hybrid entity. This could mean that certain “build-in gains” attributable to prior years may finally become subject to Luxembourg corporate income tax when realized by a reverse hybrid entity. The Circular confirms that circumstances causing the entity to no longer be classified as a reverse hybrid entity by themselves do not create a taxable event in Luxembourg for the reverse hybrid entity.
The Circular further confirms the general understanding that profit distributions made by a reverse hybrid entity shall not be subject to Luxembourg dividend withholding tax.
Lastly, a reverse hybrid entity may benefit from a 50% corporate income tax exemption in relation to the receipt of qualifying dividends.
Starting from the 2022 tax year, reverse hybrid entities are required to file an annual tax return. The newly introduced "form 205" is the designated tax return form for these entities, and the tax authority (ACD) has provided a FAQ for reference. The form consists of two parts: the first part involves the distribution of net income among resident and non-resident partners of the reverse hybrid entity, while the second part is for reporting formalities specific to reverse hybrids.
Contact the authors or your usual Tiberghien Luxembourg contact if you have more questions or would like assistance filing form 205.