Luxembourg: Clarifications on the newly introduced profit participating incentive scheme

In brief

On 11 February 2021, the Luxembourg tax authorities released Circular L.I.R. No. 115/12 ("Circular") on the profit participating incentive scheme introduced by the 2021 Budget Law of 19 December 2020. 

The new provisions of Article 115, number 13a of the Luxembourg Income Tax Law (LITL), applicable since 1 January 2021, allow for a 50% exemption on profit participating bonuses granted by employers to their employees to the extent certain conditions are met. 

This new tax incentive for individuals is in line with the government's Coalition Agreement of 3 December 2018, which also included the abolishment of the stock options regime, as well as the modernization of the current tax system for "impatriates." For further information on those topics, please read our Tax Alert of 28 November 2020 and our Tax Alert of 18 December 2020.


Contents

The purpose of these changes is to maintain Luxembourg's attractiveness for employees and highly skilled workers.

The Circular clarifies the conditions of application of the profit participating incentive scheme, providing some examples of bonus computation. Other documents to complement the Circular were made available by the Luxembourg tax authorities, namely, the FAQ on the profit participating incentive scheme (FAQ) and the form that needs to be filed by employers using the profit participating incentive scheme.

Key takeaways 

  • Eligible employers and employees: The new profit participating incentive scheme is available to Luxembourg companies and Luxembourg individuals working for a Luxembourg company and subject to Luxembourg income tax law.
  • Limited to 25% of the annual gross salary: The 50% exemption only applies to the portion of the participating bonus that does not exceed 25% of the gross annual salary amount before the incorporation of other benefits in cash or in kind of the tax year in which the profit participating bonus is allocated to the employee.
  • Limited to 5% of the previous year's positive net result: The total amount of profit participating bonuses an employer can distribute cannot exceed 5% of the previous year's positive net result of the company.
  • Mandatory electronic filing requirements: An electronic communication form should be mandatorily filed by the employer to the competent withholding tax office. The form should contain the relevant information on the allocation of the profit participating incentive scheme to employees.

In depth 

The 50% exemption of the profit participating bonus paid by the employer to the employees is based on the positive net result that the employer has achieved for the financial year preceding the one under which the participating bonus is allocated to employees to the extent the following conditions are met.

Eligible employers and employees

The new tax incentive scheme is available to Luxembourg companies and Luxembourg individuals working for a Luxembourg company and subject to Luxembourg income tax law. The exemption provided for in Article 115, number 13a of the LITL is granted in the context of an employment contract existing between the employer granting the profit participating bonus and the employee receiving it. The eligible employer is the one recorded as such in the Luxembourg tax authorities' registers for the given employee (i.e., the one whose national identification number appears in the "Employment" section of the employee's tax return). Therefore, the FAQ provides that any consideration in a "group" context should be excluded. 

Company's partner or shareholder

In addition, the benefits of the exemption are not restricted to a certain number of employees or the nature of their employment (employee, managing partner or other).

For any profit participating bonus allocated to a share capital company's partner or shareholder receiving salary from the company (even if this partner or shareholder is the only employee benefiting from such a bonus), this profit participating bonus is to be considered income from employment within the meaning of Article 95 of the LITL and the exemption set forth in Article 115, number 13a of the LITL will be granted to the extent the other conditions are met. 

Limited to 25% of the annual gross salary

Definition of annual gross salary

The 50% exemption only applies to the portion of the participating bonus that does not exceed the 25% threshold of the gross annual salary amount before the incorporation of other benefits in cash or in kind of the tax year in which the profit participating bonus is allocated to the employee.

For the purpose of the threshold computation, the FAQ provides that regular annual remuneration should be understood as ordinary salary including any element of salary such as additional hours or periodic bonuses but excluding cash benefits such as payment of a 13th month salary, interest subsidies, travel expenses, expense reimbursements and benefits in kind. 

The 25% threshold should be computed without incorporating the profit participating bonus. 

Nondeductible social security contributions

The Circular provides clarifications on the tax treatment of social security contributions with respect to the exempt portion of profit participating bonus in the context of determining the amount of salary income subject to withholding tax. Generally, social security contributions in relation to exempt salary are not deductible from the taxable income in accordance with Article 110 (1) of the LITL. Consequently, the portion of social security contributions in relation to the exempt profit participating bonus should not be deductible. To determine the nondeductible amount of social security contributions, the Luxembourg tax authorities would expect employers to apply the "rule of three" (corresponding to the same portion of the exempt participating bonus). This will have an impact on the determination of the salary amount subject to withholding tax because it will be necessary to add back the portion of nondeductible social security contributions therefore determined.

As an example, an employee received an annual gross salary of EUR 10,500 including EUR 1,500 of profit participating bonus. The amount of social security contributions amounts to EUR 1,160.25. Since the exempt portion of the profit participating bonus amounts to EUR 750 (50% of EUR 1,500 is exempt), the portion of social security contribution considered non-deductible would be EUR 82.88 (750,00 / 10,500) x 1,160.25). The salary subject to withholding tax should therefore amount to EUR 8,672.63 (10,500 – 1,160.25 – 750 + 82.88).

Specific cases

  • Payment of the profit participating bonus before the end of the reference year for the purpose of the 25% threshold computation 

In case of the payment of a profit participating bonus before the end of the year, the foreseeable annual salary is used to calculate the 25% threshold. This estimate must be made based on all the data available or likely to affect the amount of the remuneration of the beneficiary. Any possible adjustment of a salary during the year, after the payment of a profit participating bonus, having an impact on the 25% threshold (i.e., the exemption granted has been overestimated) triggers a regularization of the withholding tax to be made by the employer.

  • Retirement, change of employer or part-time employment

The 25% threshold is computed in relation to the annual gross salary that the employee has received or will receive from the employer. In case an employee leaves the current employer during the year and the profit participating bonus has been paid because of retirement or a change of employer, the employer who proceeded with the payment will, if necessary, reassess the withholding tax on the salary, taking into account the annual salary finally paid and to be considered for the purpose of the computation of the 25% threshold. The same will apply if the employee reduces or increases their working hours (e.g., a change from 40 hours per week to 20 hours per week).  

  • Employees subject to foreign taxes on their Luxembourg salary 

If an employee works for a certain number of days abroad and these working days are not taxable in Luxembourg by virtue of a double tax treaty, their global annual salary is to be taken into account to compute the 25% threshold. When it comes to determining the portion of salary income taxable in Luxembourg and the exempt portion, the split must be made according to the days worked in Luxembourg and those worked abroad during the year of the payment of the profit participating bonus. Any change in the working day breakdown between Luxembourg and the state having an impact on the salary withholding tax computation will trigger an adjustment to be made by the employer. 

  • Exceeding portion of the 25% threshold

The portion exceeding the limit of 25% of the annual salary, before the incorporation of benefits in cash or in kind, cannot benefit from the 50% exemption and it is to be taxed as nonperiodic income. 

Limited to 5% of the previous year's positive net result

Definition of a positive net result

The total amount of profit participating bonus an employer can distribute cannot exceed 5% of the previous year's positive net result of the company. The FAQ defines a "positive net result" as the net profit of the employer as it appears on the last balance sheet closed before 1 January of the year during which the profit participating bonus will be paid to the employee. If it is a commercial company, the result of the year considered for the purpose of the 5% threshold should be the one booked in Account 142 in accordance with the standardized chart of accounts (i.e., commercial profit after the deduction of taxes).   

Divergent exercise

For divergent exercises, the FAQ provides that the net profit as indicated at the end of year N (i.e., which is in year N+1 as a consequence of the diverging exercise) should be taken into account to compute the 5% threshold for the profit participating bonus paid in year N+2.

Mandatory filing requirements

An electronic communication form should be mandatorily filed by the employer to the competent withholding tax office. The form should contain the relevant information with respect to the employer (i.e., name, address, tax identification number, tax year, net result from the preceding year, date of allocation of the profit participating bonus, etc.), as well as information with respect to the allocation of the profit participating incentive scheme to employees (i.e., a list of beneficiaries, tax identification number, gross salary amounts, profit participating bonus amount and exempt amount).

Conclusions

The Circular and the FAQ released by the Luxembourg tax authorities provide clarifications and guidance on the conditions under which the profit participating incentive scheme applies. In addition to the recently modernized "impatriate" tax scheme, these new provisions are in line with Luxembourg's objectives to increase its attractiveness for employees and highly skilled workers. The implementation of the new scheme requires certain conditions to be met and compliance with certain mandatory filing requirements. We therefore highly recommend carefully monitoring such implementation. Our Luxembourg Baker McKenzie experts in employment law and tax law would be happy to assist you in setting up this opportunity.


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