Tax experts Giuliano Bidoli and Sophie Richard explain the background and what it means for private equity funds using Luxembourg as a hub.
On 29 May 2017, the Council of the EU unanimously adopted the Council Directive amending Directive (EU) 2016/1164 (ATAD 1 was adopted on 12 July 2016) regarding hybrid mismatches with third countries (ATAD 2)
ATAD 2 builds on the provisions of ATAD 1, which contained measures to prevent hybrid mismatches between EU Member States (MSs). ATAD 2 now also includes hybrid mismatches with third countries and adds cases not covered by ATAD 1.
Member States have until 31 December 2019 to transpose the ATAD 2 provisions, ready to be applied from 1 January 2020. Measures on reverse hybrids will need to be transposed before 31 December 2021 with effect from 1 January 2022.
The aim of ATAD 2 is to implement measures on hybrid mismatches consistent with the rules recommended by the OECD BEPS report on Action 2. ATAD 2 includes additional measures from the BEPS Action 2 report, and provides for secondary rules, which were not necessary in an intra-EU context. It expressly refers to the BEPS Action 2 recommendations as a source of illustration or interpretation, in so far as they are consistent with the provisions contained in the directive.
ATAD 2 extends the scope of ATAD1 which applied to situations of double deduction or deduction without inclusion resulting from the use of hybrid financial instruments or hybrid entities. The new directive now also includes situations involving permanent establishments, reverse hybrids, imported mismatches, hybrid transfers, and dual residence.
The directive applies to all taxpayers subject to corporate tax in one or more MSs, including the permanent establishments (PEs) in one or more MSs of entities resident for tax purposes in a third country. The rules on reverse hybrid mismatches also apply to entities treated as transparent for tax purposes by a MS.
A hybrid mismatch will generally arise in situations:
The term “associated enterprises” generally encompasses a minimum participation of 25%, including voting rights, capital and profit entitlement. This percentage is increased to 50% in cases involving hybrid mismatches that result from payments to or by a hybrid entity, payment to an entity with one or more PEs, payment to a disregarded PE, deemed payment between a head office and a PE or between two PEs, double deduction, imported mismatches, and reverse hybrid mismatches.
The rule also covers a person who acts together with another person in respect of the voting rights or capital ownership of an entity. That person shall be treated as holding a participation in all of the voting rights or capital ownership of that entity that the other person holds. There is no further detail included in ATAD 2 to understand the exact scope. Referring to BEPS Action 2 report (recommendation 11.3), the rule could, for example, target the case of an investment vehicle where its interests, held by various minority shareholders, are managed by the same person.
The private equity sector is particularly affected by the rules applying to payments made under a financial instrument involving a deduction without inclusion. The rule foresees that the EU payer will have to deny the deduction if the payment is not included within a reasonable period of time and if the mismatch outcome is attributable to differences in the characterisation of the instrument or the payment made under it. The payment will be treated as included within a reasonable period of time if:
Close attention should also be paid to the imported mismatch rules where, for instance, a loan granted to an EU target company is funded by a loan between its non-EU parent company and another non-EU group company. Where this situation causes a hybrid mismatch – and the non-EU jurisdictions do not provide for any remedy – the rule spells out that the EU target company should deny the deduction to the extent of the mismatch.
Luxembourg is a well-known holding location and, over the past two decades, has become the jurisdiction of choice for many private equity funds, due to the location of the funds and the structuring and financing of acquisitions.
It is, therefore, important to understand if and how ATAD 2 will have an impact on the typical tried-and-tested structures and instruments issued by Luxembourg companies for financing such acquisitions.
Take the following example:
The investment vehicle, a Cayman limited partnership (LP), will use one of its Luxembourg subsidiaries as the investment platform. The funding is provided by a Cayman LP to the Luxembourg company in the form of ordinary shares, split into various classes to be used to finance the acquisition of the shares held in Acquisition HoldCo. Moreover, the Luxembourg company will grant a shareholder loan to its target which is financed by Preferred Equity Certificates (PECs). Interest payments under the PECs funding the shareholder loans should in general be tax-deductible in Luxembourg, while it is expected that the Cayman LP would not be subject to tax on its income.
We have recently advised on a similar case, where the rules were found to have a limited impact to the extent that the Cayman LP was a tax-exempt vehicle. Indeed, the preamble in ATAD 2 clearly states that a payment under a financial instrument should not, however, be treated as giving rise to a hybrid mismatch where the tax relief granted in the payee jurisdiction is solely due to the tax status of the payee or the fact that the instrument is held subject to the terms of a special regime.
On the other hand, the rule may have an impact in certain cases where the look-through approach of the BEPS 2 report is considered – for instance, for US investors and where the payment leads to a hybrid mismatch at their level. However, the US investors would additionally need to be considered associated enterprises or to be acting under a structured arrangement, as detailed above.
Additionally, ATAD 2 clearly states that the instrument (in this case the PEC instrument) would not be considered as a hybrid instrument, provided it is reasonable to expect that:
As the PEC mainly finances the shareholder loan, the intra-group financing activity will be supported by a transfer pricing study in Luxembourg. This would confirm that the terms of payment under the PECs – including the interest rate – are at arm’s length. Finally, one would have to consider the potential impact of any imported mismatch rules at the level of the target company.
Convertible Preferred Equity Certificates (CPECs) are instruments through which private equity funds can fund Luxembourg companies used to acquire shares in a target company. The income – dividends, capital gains or liquidation proceeds – should be tax exempt at the level of the Luxembourg company: the application of the participation exemption regime makes the non-deduction of the CPECs redemption tax-neutral. In these circumstances, therefore, there should be no impact at the level of the Luxembourg company.
Given the complexity of ATAD 2, and the lack of detail provided so far, its implementation in each member state will need to be closely monitored.
Nevertheless, firms should start reviewing the potential impact of ATAD 2 on their existing structures immediately – and whether some degree of restructuring might be necessary. That calls for a thorough understanding of the tax treatment of each investor and each entity and, in particular, the potential impact of relevant mismatch rules.
For further information please contact:
Giuliano Bidoli - Partner
KPMG in Luxembourg
Sophie Richard - Senior Manager
KPMG in Luxembourg