Tax optimization: New Regulations On Hybrid Instruments
Hybrid instruments are the result of disparities between national laws. Indeed, there are two types of interpretation of the instrument : some states may be interested in the shape of the instrument while others to its substance. For example, the United States focuses on the form while Luxembourg does base on its substance. Internationally, one is faced with discrepancies between tax regimes in the State of origin of the income and in the State of residence of the beneficial owner. These instruments can be regarded as debt or equity depending on the country.
This dichotomy from which stem these hybrid financial instruments leave room for tax optimization. Indeed, revenues from debt securities are generally tax deductible in the State of the source as it is in that case a payment of interest while capital income (dividends) is subject to a total or partial exemption or to a tax credit in the State of residence of the recipient. Therefore, the use of these hybrid instruments can result in a “double non-taxation.”
This favorable profit participating loan UK treatment is coveted by corporate groups that have largely benefited from it in the past. Most US investments in Europe pass through the Luxembourg hub as US companies hold Private Equity Certificates of the Luxembourg company. These are regarded by the US as capital generating dividends while Luxembourg regards them as debt incurring deductible interest.
Nevertheless, at international and European level, these hybrid instruments are today limited, causing new implications for tax purposes and income tax act. Indeed, the OECD recommendation to exclude those instruments from the Parent-Subsidiary regime has been followed by the European Union, which adopted amendments to the Parent-Subsidiary directive in order to fight tax optimization by combining anti-hybrid and anti-abuse rules. It thus provides that profits distributed by a subsidiary may be subject to an exemption in the State of the parent company “insofar as they are not deductible by the subsidiary.” Furthermore, the tax arrangements will benefit from the tax benefit of the directive only if they are authentic, that is to say if they reflect the economic reality. Therefore, hybrid instruments need to provide a direct connection between income and activity contributing to this income in order to benefit from tax exemption.
For more information on hybrid instruments and optimization in Luxembourg, do not hezitate to contact us:
Hance Law Lawyers, 3A, Sentier de l’Espérance – L-1474 Luxembourg
www.hance-law.com – Tel: 352 274 404 – firstname.lastname@example.org