As a reminder, the reverse hybrid provisions were part of a set of measures implemented by the Law of 20 December 2019 ("Law") transposing the amended (EU) Directive 2016/1164 (ATAD I) regarding hybrid mismatches with third countries (ATAD II)² aimed at circumventing situations of double nontaxation resulting from those hybrid mismatches. By application of the implemented provisions, Luxembourg transparent partnerships may become liable to corporate income tax in relation to their net income, to the extent that it is not otherwise taxed under Luxembourg domestic tax law or the law of any other jurisdiction. This is provided that one or more associated nonresident entities (i) are holding in aggregate a direct or indirect interest in 50% or more of the voting rights, capital interests or profit entitlements in the Luxembourg partnership and (ii) consider the Luxembourg partnership as a taxable person (opaque entity). The reverse hybrid rules are applicable as of 1 January 2022.

Since its entry into force, many practical issues have been raised by tax professionals requesting clarifications from the legislator and the Luxembourg tax authorities (LTA).

The 2023 Budget Bill (Law of 23 December 2022) amended Article 168quater LITL, clarifying the conditions in which the reverse hybrid provisions apply. Indeed, the legislator confirmed that the reverse hybrid rule only applies when the nontaxation of the income paid by the payor to the entity results from the difference of tax qualification of an entity seen as tax-transparent in the country of establishment (e.g., Luxembourg) and tax-opaque in the jurisdiction of the investors. In accordance with the legislator's intention, the reverse hybrid provisions should not apply where the nontaxation of the income is due to the investor's tax-exempt status.

The Circular therefore provides necessary clarifications on the consequences of reverse hybrid's tax status in the meaning of Article 168quater LITL, as well as clarification on the determination   of the reverse hybrid entity's net income and tax due. The Circular finally provides guidelines in relation to the compliance obligations of such entity.

Key takeaways

• In the meaning of Article 168quarter LITL, taxpayers do not qualify as resident taxpayers in the meaning of Article 159 LITL, which consequently precludes the application of the participation exemption regime as set forth under Article 166 LITL, as well as the application of the Controlled Foreign Companies (CFC) provisions (Article 164 LITL), interest deduction limitations rules (Article 168bis LITL) and anti-hybrids provisions (Article 168ter LITL).
• As a reverse hybrid will become taxable due to the application of Article 168quater LITL, some of the LITL provisions become applicable, such as Article 162 (1) LITL, which refers to Part I of the LITL in relation to determining the taxable income, capital gain or liquidation proceeds, for instance.
• The only categories of income subject to tax as a result of the application of Article 168quater LITL are capital income (Article 97 LITL), income arising from real estate renting (Article 98 LITL) and other income (Article 99 LITL) to the extent that they are not taxed under the LITL or under the laws of other jurisdictions.
• The net income of the reverse hybrid should be determined in accordance with Article 103 LITL, in other words deducting the acquisition expenses (Article 105 LITL) from the revenue (Article 104 LITL).
• If the revenue or the expenses of the reverse hybrid are denominated in another currency, the foreign exchange rate applicable is the one retained on the day of the payment. A tolerance is granted for using the foreign exchange rate applicable as of 31 December of the fiscal year.
• The fact that the entity becomes taxable further to the application of article 168quater LITL has no impact on the value of the reverse hybrid's assets and liabilities. In other words, no step-up of the entity's assets and liabilities is to be realized at the time the partnership becomes a reverse hybrid entity (no application of Article 102 (4a) LITL).
• The income paid by the reverse hybrid does not qualify as capital income, and no withholding tax should we levied on distribution made (no application of Article 146 LITL).
• Deemed dividend income received by the reverse hybrid may benefit from a partial tax exemption (50%) as set forth under Article 115 (15a) LITL. This partial tax exemption initially applied to Luxembourg resident individuals and Luxembourg companies to the extent that the Luxembourg participation exemption regime did not apply.
• Foreign eligible taxes may be credited against the taxes due by the reverse hybrid entity in proportion to the part of the relevant income that has been subject to tax at the level of the reverse hybrid entity.
• A new Form 205 dedicated to reverse hybrid entities has been released and must be submitted to the LTA by reverse hybrid entities.

For further information and to discuss what this development might mean for you, please get in touch with your usual Baker McKenzie contact.

1 Circulaire du directeur des contributions L.I.R. n°168quater/1 du 9 juin 2023.

2 European Union (EU) Directive 2017/952 of 29 May 2017 amending (EU) Directive 2016/1164.