US companies that own projects in other countries usually hold them through offshore holding companies. The holding companies act as “blockers”; they prevent overseas earnings from being taxed in the United States until the earnings are repatriated.
Luxembourg is one of several popular countries for holding companies. Luxembourg has a wide network of tax treaties with other countries that can help in pushing down withholding taxes at project country borders when earnings are pulled out of a project country. In theory, income received by a Luxembourg holding company is subject to corporate income tax in Luxembourg at a 30.38% rate, but in practice, income that the holding company receives as dividends is usually exempted from tax under a “participation exemption.”
One form of holding company used in Luxembourg is called a “1929 holding company.” Such companies are exempted from corporate income taxes altogether in Luxembourg. However, the tradeoff is they do not qualify for benefits under Luxembourg tax treaties. Therefore, when they are used, it is usually in tandem with at least one other Luxembourg holding company. One reason to use one might be to provide a means to “strip” earnings from a project in another country by having the project company pay its earnings to Luxembourg as interest. Interest does not qualify for the “participation exemption.” Therefore, other ways must be found to shield the interest income from tax in Luxembourg.
Luxembourg narrowed the tax exemption for 1929 holding companies in April. The new rules take effect on July 1.
Under the new rules, a 1929 holding company will lose its tax exemption in any year in which at least 5% of the dividends it receives are from subsidiaries that were not subject to tax in another country at a comparable tax rate to the base tax rate in Luxembourg. The base rate in Luxembourg is currently 22%. Therefore, the tax in the other country must be at least 11%.
Any 1929 holding company that loses its tax exemption will be able to claim benefits under Luxembourg tax treaties. Existing holding companies are “grandfathered” from the change in law through 2010.