By Derk Prinsen, with NautaDutilh

Most US companies investing in infrastructure projects in other countries set up offshore holding companies through which to own the investments. This is done to prevent the earnings from the projects from being subjected to US income taxes until they are repatriated to the United States.

Such holding companies are sometimes put in Luxembourg. Its favorable tax laws and extensive tax treaty network make Luxembourg a clear choice for US companies looking to do business in Europe.

This article discusses some of the latest investment structures using hybrid instruments and entities in Luxembourg and also covers recent developments in the international arena that improve on Luxembourg’s already strong viability in international tax planning.

Why Luxembourg?

One challenge in foreign tax planning is how to move earnings across international borders without triggering a withholding tax. Most countries collect withholding taxes on dividends, interest, rents, royalties and payments to service contractors when such amounts cross the border.

One way to reduce withholding taxes is to take advantage of special reduced rates under tax treaties. However, that only works if the taxpayer establishes a considerable presence in the countries where elements of his ownership structure are situated. One way of repatriating profits to the US, for example, without having those profits suffer foreign withholding tax at the border, is to channel these profits through a foreign branch situated in a country with which the US has concluded a tax treaty. Most tax treaties — and many domestic tax regimes — exempt from withholding tax transfers of earnings across the border from a branch to its foreign head office. But this strategy only works if the branch qualifies as a “permanent establishment” under the relevant tax treaty. In treaty terms, a permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on. So the taxpayer has to build up a certain measure of activity in the branch before it qualifies as a permanent establishment, which is likely to entail significant expense.

Luxembourg’s tax law contains provisions that make it easier to qualify for the treaty relief for earnings deriving from a permanent establishment. For example, a nonresident who is a partner in a Luxembourg partnership can be deemed to have a permanent establishment in Luxembourg, even if the partnership does not carry on the level of activity in Luxembourg normally required to qualify as a permanent establishment. The conditions for the applicability of these provisions are relatively easy to meet. If the partnership is a limited partnership, at least one of the general partners has to be a Luxembourg resident company whose capital is divided into shares.

Another advantage of Luxembourg law is that it is relatively simple to qualify for a tax break known as the “participation exemption” in Luxembourg. If a shareholding falls under the participation exemption, dividends and capital gains arising from it are exempted from Luxembourg corporate income tax. The Luxembourg corporate income tax law stipulates that the permanent establishment of a non-resident taxpayer is entitled to the participation exemption provided that the taxpayer is a company whose capital is divided into shares, that it is resident in a state with which Luxembourg has concluded a tax treaty, and that the shareholding meets certain other requirements such as a one-year holding period and a minimum size or minimum acquisition price. If the subsidiary is not located in an EU member state, there are some additional “comparable tax” requirements: the subsidiary’s profits must be subject to tax at a rate amounting to at least 15% and the basis of assessment should be comparable to the Luxembourg corporate income tax basis of assessment. (This requirement is likely to be relaxed; see this article’s conclusion.)

The permanent establishment and participation exemption provisions can be used for structuring US outbound investments into Europe as shown in Figure 1. If US Co owned the shares in EU-resident Target directly, dividends paid by Target to US Co would probably be subject to withholding tax in Target’s state of residence. But if the ownership of Target were structured as in Figure 1 and if the requirements of the “EC parent-subsidiary directive” are met, then dividends paid by Target would be received by US Co without suffering foreign withholding tax.

The EC parent-subsidiary directive is a rule that the member countries of the European Union have had to incorporate into their domestic tax laws. It requires member countries to exempt from withholding taxes dividends paid by subsidiaries resident in one member country to parent companies resident in another member country. The directive stipulates that the parent company must own a certain proportion of shares or voting rights in the subsidiary and observe a certain holding period. The subsidiary must be subject to tax. The parent as well as the subsidiary must have a specified legal form. A recent amendment of the EC parent-subsidiary directive has relaxed its requirements and broadened its scope considerably.

For Luxembourg tax purposes, US Co will be deemed to have a permanent establishment in Luxembourg — by virtue of its partnership interest in Luxembourg SCS — and thus no withholding taxes will apply on distributions from Luxembourg SCS to US Co.

The Luxembourg SCS in Figure 1 is a “société en commandite simple”or limited partnership. The general partner, which is Luxco 1, and Luxco 2 are “sociétés à responsabilité limitée”’ (s.à.r.l.s), or limited companies.

Luxco 1, Luxco 2 and SCS should elect to be treated as transparent entities for US tax purposes. This means that US Co will be treated as owning the shares in Target directly for US tax purposes, which should help US Co qualify for direct foreign tax credits in the US for any taxes Target pays on its earnings in its home country.

Luxco 2 shields gains on the Target shares from Luxembourg’s municipal business tax. This tax is imposed on commercial enterprises by the municipality in which the enterprise is situated. If the taxpayer is also subject to corporate income tax, the basis of assessment is the same as for that tax. An SCS is not a taxpayer for corporate income tax purposes in Luxembourg and the basis of assessment for the municipal business tax is determined on the basis of slightly different rules.

Using Hybrid Entities

For Luxembourg tax purposes, limited companies are always treated as corporations, whereas for US tax purposes they can opt for transparency. (“Transparency” means that the entity is treated as a disregarded entity or partnership, depending on the number of owners. It is not considered a taxpayer for US purposes. Any tax is imposed on the owners directly.) A US outbound investment structure that makes excellent use of the hybrid nature of these companies is the structure often referred to as the “Luxco 1/Luxco 2” structure. (The structure used to be known as the BV1/BV2 structure, until the government of the Netherlands put an end to its use on grounds that it was abusive.) Figure 2 shows the Luxco 1/Luxco 2 structure.

US Co makes an interest-bearing loan to Luxco 1. Luxco 1 uses the proceeds of the loan to make an equity invest-ment in Luxco 2, of which it then owns all of the shares. Luxco 2 uses the cash it received as equity to make an interest-bearing loan to another company labeled “foreign acquisition vehicle,” which uses the proceeds of the loan to acquire Target or finance a project. The foreign acquisition vehicle sets off interest payable to Luxco 2 against the revenues from its investment by means of tax consolidation.

Luxco 1 and Luxco 2 form a fiscal unit for corporate income tax purposes, which allows the companies to submit consolidated tax returns. The effect of the fiscal unit is that the interest paid by Luxco 1 to US Co is effectively deductible from the interest Luxco 2 receives from the foreign acquisition vehicle. The Luxembourg tax authority will generally consider the interest paid and the interest received by the members of the fiscal unit as arm’s length, provided that the unit annually reports a small taxable margin. This margin typically amounts to 0.25% of the proceeds of the loan from US Co, but it is inversely proportional to the size of these proceeds and can, therefore, be lower than that.

One downside of this structure is that it will not reduce the group’s net worth tax. Net worth tax is an annual tax of 0.5% of the net asset value of a company. Luxco 1 and Luxco 2 cannot form a fiscal unit for net worth tax purposes. The equity-financed loan from Luxco 2 to the foreign acquisition vehicle would be subject to net worth tax. The corporate income tax due by the fiscal unit can, however, be set off against the net worth tax due by Luxco 2 (subject to certain conditions).

In the US, Luxco 1 elects to be treated as a disregarded entity while Luxco 2 elects to be treated as a corporation. So for US tax purposes, US Co is seen as making an equity investment directly in Luxco 2. From a US perspective, it is probably desirable that the foreign acquisition vehicle also opts to be treated as disregarded so that it is viewed as a branch of Luxco 2. The effect of these elections should be that US tax is deferred on revenues from the foreign investment so long as Luxco 2 does not distribute profits to Luxco 1. Another reason why Luxco 2 should not distribute profits is that it would lead to a recapture of the interest deductions claimed by Luxco 1. Interest paid by Luxco 1 to US Co would not be subject to Luxembourg withholding tax provided that Luxco 1 observes a certain debt-to-equity ratio in how it finances its equity investment in Luxco 2. The exit from the structure consists of Luxco 1 using the proceeds of the liquidation of Luxco 2 to pay interest and repay principal to US Co.

Using Hybrid Instruments

Instruments that are treated as equity for tax purposes in one country and as debt in another — “hybrid” instruments — also offer means of structuring US outbound investments. Preferred equity certificates, or “PECs,” issued by a Luxembourg company to its US Co parent company are a well known example by now. Figure 3 shows a structure based on PECs.

PECs can be treated as equity for US tax purposes and, at the same time, as debt for Luxembourg tax purposes. To qualify as equity for US tax purposes, a PEC must have equity characteristics such as a long term (50 years or more), subordination to other debt, a return that accrues to the extent that the issuer has sufficient income, and a return that is payable if and when the issuer’s board decides (and only when the issuer is sufficiently solvent). The PEC may be stapled to shares in the capital of the issuer to help with equity classification in the US.

The treatment of PECs as debt for Luxembourg tax purposes means that the arm’s-length return is not subject to Luxembourg withholding tax and the return is deductible for corporate income tax purposes. The principal is also not subject to capital duty, a non-recurring 1% duty on contributions of capital. PECs are also treated as debt for net worth tax purposes.

Luxco can, for example, invest the proceeds of the PECs issue in an EU-resident subsidiary. Provided that the shares in this subsidiary qualify under the EC parent-subsidiary directive and meet the requirements for the Luxembourg participation exemption, dividends and gains deriving from the shares in the subsidiary are neither subject to withholding tax in the subsidiary’s home country nor to Luxembourg corporate income tax. The deduction of the return on the PECs is not needed in that case. Nevertheless, the fact that this return is not subject to Luxembourg withholding tax means that dividends paid by the subsidiary can be passed on to US Co without suffering withholding tax. If Luxco assumes the form of a limited company (an s.à.r.l.) it should be able to elect transparency for US tax purposes. Alternatively, it could elect treatment as a corporation for US tax purposes and this could result in a deferral of US taxation until the return of the PECs is declared by Luxco’s board.

Investing the proceeds of the PECs in a shareholding raises the issue of thin capitalization: the Luxembourg tax authority could treat part of the return on the PECs as a dividend to the extent that Luxco finances the acquisition of the shareholding with less than 15% equity. That part of the return would be subject to Luxembourg withholding tax. The thin capitalization issue could be circumvented by means of convertible PECs, or “CPECs.” The precise workings of CPECs are beyond the scope of this article.

Another ‘hybrid’ instrument that can be used to structure US outbound investments is the mandatorily convertible zero coupon bond, or “MCZCB,” as shown in Figure 4. This instrument is hybrid in that the issuer accounts for it differently than the recipient does. An MCZCB is, in the first place, a zero coupon bond. It does not yield interest. Luxco 2 issues it to Luxco 1 at a discount. The discount should reflect the net present value of the interest that would be due on the issue price if it were an interest-bearing loan. Second, the MCZCB is mandatorily convertible into new shares issued by Luxco 2 at the end of its term. The term would normally be linked to the term of the project in which Luxco 2 would invest.

At the level of Luxco 2, the issue of the MCZCB gives rise to a liability. Initially, the size of this liability on the balance sheet of Luxco 2 is equal to the issue price of the MCZCB. Luxco 2 has to revalue the liability under the MCZCB from year to year, until it reaches the nominal value of the MCZCB. The revaluation gives rise to costs that are deductible from the revenues from the project. The margin between the costs and the revenues is subject to Luxembourg corporate income tax. By fine tuning the terms and conditions of the MCZCB, thereby bearing in mind the expected return on the investment in the project, the margin can be kept to a minimum — for example, 0.25% of the issue price of the MCZCB.

Luxco 1 has a receivable under the MCZCB that it can book at the issue price. The receivable does not have to be revalued for commercial purposes from year to year. Hence, the deduction that Luxco 2 can claim from year to year is not mirrored by taxable income in the hands of Luxco 1. The resulting overall deferral of taxation is turned into cancellation of taxation by converting the MCZCB into shares issued by Luxco 2 at the end of its term. Under a provision in Luxembourg’s tax law, Luxco 1 is not required to recognize a taxable gain on conversion. This provision does require, though, that the unrealized gain on the MCZCB, if any, is rolled into the shares that Luxco 1 obtains upon conversion. Those shares qualify for the participation exemption, so the gain realized upon disposal of the shares — whether through sale or liquidation of Luxco 2 — is exempted from corporate income tax. One of the requirements for the participation exemption is observation of a certain holding period. The shares received upon conversion of the MCZCB are deemed to have been acquired at the moment when Luxco 1 acquired the MCZCB. Assuming that the term of the MCZCB equals the holding period required for the participation exemption, Luxco 1 should be able to dispose of the newly-acquired shares directly after conversion without paying tax.

Luxco 1 is exposed to net worth tax over the period prior to the conversion of the MCZCB. Given that the MCZCB has been financed with equity, the full value of the MCZCB would be subject to net worth tax at the level of Luxco 1. There are strategies that can prevent the value of the MCZCB from being subject to net worth tax, such as owning the shares in Luxco 1 through a Dutch company that issues a hybrid loan to Luxco 1. Also, because the basis of assessment for the net worth tax is determined on January 1, the net worth tax burden can be saved by implementing the MCZCB structure after January 1 of the relevant year and eventually dismantling the MCZCB structure before January 1 of the relevant year.

Capital duty should not apply to the conversion of the MCZCB into shares of the issuer. The conversion of the MCZCB would be treated as a contribution of capital. Capital duty should not be due, however, because a contribution of all assets and liabilities falls under a capital tax exemption. The only assets and liabilities that Luxco 1 has are the receivable for the MCZCB and the shares in Luxco 2. The shares in Luxco 2 have to be amortized as part of the conversion.

Looking Forward

The four tax strategies discussed in this article are only a few of the many strategies that can help reduce the foreign tax exposure of US outbound investments. The Luxembourg tax authority is usually prepared to confirm the Luxembourg tax position of the relevant resident and non-resident entities by means of an advance tax ruling. Luxembourg is party to 43 treaties for the avoidance of double taxation. As a member of the European Union, the country has had to implement the numerous directives on direct taxation aimed at improving the internal market in the EU. Finally, in 2001 Luxembourg drastically reformed its tax laws, and this reform is generally considered to have greatly improved Luxembourg’s attraction as a stepping stone for cross-border transactions and investment.

The government submitted a number of bills in the second half of last year. One of these introduces an advantageous tax, legal, regulatory and accounting framework for securitizations in which the vehicle issuing the securities or the vehicle acquiring the securitized assets reside in Luxembourg. It also addresses the legal position of investors in securitization vehicles, the trans-fer of securitized assets in general and receivables in particular to the acquiring vehicle and the management of the securitized assets. Another bill aims to introduce a new form of vehicle for investments in private equity and venture capital, a société d’investissement à capital à risque (known as an “SICAR”). It will be subject to the supervision of the government body that oversees the financial sector, but under a much more liberal regime than regulated investment funds. A third bill implements the EU interest and royalties directive. The aim of this directive is the abolition of withholding taxes on intra-EU interest and royalties payments between related enterprises. The bill has a wider scope in that it abolishes the withholding tax on royalties irrespective of the recipient. Finally, the government has submitted a bill aimed at bringing the regime regarding tax-exempt entities known as “1929 holding companies” in line with the EU code of conduct for business taxation. One can infer from the bill that the comparable tax requirement for the participation exemption will be relaxed to a tax rate of 11% or more from its present level of 15%.