Update alert: Proposed domestic tax penalties emerge in Luxembourg in enforcement of EU blacklist

We recently reported on the addition of the Cayman Islands to the EU list of non-cooperative jurisdictions for tax purposes (the “EU blacklist”) on February 18, 2020 and key consequences for private fund sponsors.

On March 30, 2020 the Luxembourg government proposed a draft law to implement new measures against countries on the EU blacklist (the “Lux Draft Law”).  The Lux Draft Law would, if enacted, deny tax deductions for Luxembourg entities for certain payments of interest and royalties to related parties (as defined) that are in jurisdictions on the EU blacklist.  It is proposed that this law will be effective January 1, 2021.  As a result of the recent update to the EU blacklist, this could in principle catch such payments to entities in Cayman if Cayman is still on the EU blacklist as at January 1, 2021.

For Private Fund Sponsors, if Cayman remains on the EU blacklist then the Luxembourg proposed measures could potentially result in additional tax costs for a Cayman entity (e.g. a fund or a subsidiary of a fund) that invests through debt financed Luxembourg entities into a portfolio company.

  • Cayman holdcos often debt finance a Luxembourg subsidiary as it generally enables a Luxembourg subsidiary to reduce its net effective tax rate in Luxembourg (subject to existing interest deduction rules and evolving anti-hybrids rules).
  • That said, it is expected that tax transparent entities, such as Cayman limited partnerships, are to be excluded from the Lux Draft Law. Specifically, we currently expect Luxembourg companies paying interest (or royalties) would instead need to look through transparent entities (including a Cayman partnership) to identify any non-transparent limited partners that are organised in an EU blacklist country and who are the beneficial owners of the payments.  However this will need to be confirmed over the coming months as the Lux Draft Law proceeds through Luxembourg’s legislative process.

The development in Luxembourg results from recommendations made by the EU Council’s Code of Conduct Group for member states to implement “defensive measures” against blacklisted jurisdictions.  The EU Council recommended that member states implement at least one of the suggested legislative measures: non-deductibility of costs in computing local tax, the application of local controlled foreign company (CFC) rules, increasing rates of withholding tax, or limiting access to participation exemptions on profit distributions.  Luxembourg has opted for the first of these.

Similar measures should be expected in other member states by 2021, although some already maintain similar blacklists and implement related measures at a domestic level, predating the EU Council recommendations.  A 2016 EU Commission survey found that at least twelve member states already denied certain deductions based on features of the payee jurisdiction’s tax system (such as a zero tax rate).  Of those, seven member states linked this measure to a blacklist.  Member states who still maintain domestic blacklists may reflect the changes made to the EU blacklist in their next update.  However, the implementation of these measures will vary between jurisdictions.

The Luxembourg draft law has not yet been enacted and so the final details are not yet known.  A watching brief is therefore needed by Private Fund Sponsors who use Luxembourg investment platforms.

When the Cayman Islands was added to the EU blacklist, it was anticipated that it would seek to be removed from that list at the October 2020 meeting of the EU Economic and Financial Affairs Council.  The proposed Luxembourg measures may further motivate the Cayman Islands to achieve that.

Note, however, that even if the Cayman Islands does come off the EU blacklist before January 1, 2021, the proposed Luxembourg changes described above may mean that Private Fund Sponsors who use Luxembourg investment platforms will nevertheless still need to consider whether any investors in other jurisdictions, if on the EU blacklist, could impact deductibility of interest payments from Luxembourg.