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12.2.1. Main Rules

An earning stripping based interest deduction barrier has been implemented in Luxembourg effective from 1 January 2019. Prior to that, there were no specific thin-capitalization rules in Luxembourg, but related party debt was required to be at arm's length. When interest deviated substantially from an arm's length amount, the debt was to be re-characterized as capital, and interest payments were to be considered as hidden distributions. When related party loans were used to finance the holding of participations, a debt-to-equity ratio of 85:15 was generally used. Interest payments exceeding that ratio would be disallowed as a deductible item, recharacterized as a hidden distribution, and subject to dividend withholding tax.

Luxembourg’s interest deduction barrier is in compliance with the EU Anti-Tax Avoidance Directive (ATAD) and limits the deductibility of excess interest on non-resident related party loans. The restriction may be applied at a group (fiscal unit) or individual entity level. As per the rules, the deductibility of interest charges is restricted to 30% of EBITDA or a EUR 3 million safe harbor, whichever is higher.

Interest in excess of the deduction cap may be carried forward indefinitely, and unused interest capacity may be carried forward for 5 years.

Exceptions to the above-mentioned restriction include:

  • Stand-alone entities that are not part of a group;
  • Financial undertakings;
  • Loans used to finance a long-term public infrastructure projects; and
  • Application of the safeguard (equity escape) clause by the member entities of a consolidated group. The safeguard clause provides that where a taxpayer is a member of a consolidated group, and the taxpayer's equity/asset ratio is equal to or greater than the equivalent group ratio, the taxpayer is exempted from the interest deduction limitation rules and allowed to deduct all excess borrowing costs in a year. The application of the safeguard clause is subject to certain eligibility requirements.  The comparison of the ratios has to be made by using the same valuation method (either IFRS or under the financial information system) for both the taxpayer and the consolidated group and after applying any required adjustments and restatements. As long as the taxpayer's equity/asset ratio is not more than two percentage points lower than the consolidated group ratio, the safeguard clause may be applied. The opt-in for the safeguard clause has to be requested by the taxpayer  for each operating year. When taxpayers opt for the application of the safeguard clause, no unused capacity to carry forward to future years can be considered as materialized, and no excess non-deductible borrowing costs of the prior fiscal year can be deducted.

On 8 January 2021, the Luxembourg tax authorities published a Circular which provides clarifications regarding borrowing costs subject to the deduction limitation rules, including a non-exhaustive list of specific borrowing costs. The circular also provides a non-exhaustive list of changes that are not considered as a subsequent modification of a loan entered into before 17 June 2016. The circular dated 8 January 2021 was replaced by the updated circular published on 2 June 2021, which included a new section on the safeguard clause covering eligibility requirements and the application rules as mentioned above. Further, the updated circular published on 28 July 2021 replaced circular dated 2 June 2021. The latest updated circular provides guidance on the eligibility requirements and application rules for members of a consolidated group and includes additional requirements for members of fiscally integrated groups.

The additional eligibility and application requirements for fiscally integrated groups are as follows:

  • Certain adjustments are required to be made in the financial statements of the integrated group to eliminate internal transactions between members of the integrated group and interests held, directly or indirectly, between the members of the integrated group;
  • The integrated parent company or the integrated subsidiary company must submit the request application for each financial year of operation in respect of which the benefits of the safeguard clause is claimed; and
  • An auditor report certifying the calculations for the determination of the ratios compared under the safeguard clause must be filed along with the income tax return by the integrated parent or subsidiary company.