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New Defensive Measures for Blacklisted Jurisdictions: What impact will Luxembourg’s recent announcement have on Cayman-domiciled funds?

  • Global
  • Financial services and markets regulation
  • Financial services and markets regulation - Hedge funds
  • Financial services

07-04-2020

On 30 March, the Luxembourg Government published a new draft law (the Draft Law) which looks set to increase the Luxembourg tax burden for transactions realised with enterprises based in jurisdictions on the EU’s list of “non-cooperative countries and territories for tax purposes” (Annex 1, also known as the ‘blacklist’). The Draft Law proposes amendments to Article 168 of the Luxembourg Income Tax Law which would refuse the deductibility in Luxembourg of interest and  royalties paid or due to entities or persons established in Annex 1 jurisdictions.

The Government ’s move follows the EU’s 18 February re-classification of Cayman Islands as an Annex 1 jurisdiction. Understandably, the timing of these related developments in two of the world’s pre-eminent financial centres has raised eyebrows across the hedge fund industry.

In this briefing we follow up on our previous update on the situation in the Cayman Islands, discuss the Draft Law and asses what impact (if any) it might have on Cayman-domiciled funds?

See our previous briefing “Cayman Islands Added to Annex 1: What Managers Need to Know”.

For background Annex 1 currently includes the following jurisdictions: American Samoa, Cayman Islands, Fiji, Guam, Oman, Palau, Panama, Samoa, Seychelles, Trinidad and Tobago, US Virgin Islands, and Vanuatu. The list of non-cooperative jurisdictions will be updated by Luxembourg on a yearly basis, reflecting the applicable Annex 1 at that time.

Background

The Council of the European Union has been encouraging Member States to enact “tax defensive measures" with regard to the Annex 1 listed jurisdictions since December 2017.

In this context, Luxembourg has imposed specific reporting requirements for transactions between Luxembourg companies and related enterprises located in Annex 1 jurisdictions since February of 2018. From May 2018, the Luxembourg tax authorities have also issued defensive measures aiming at strengthening tax audit in Luxembourg on structures or arrangements involving Annex 1 jurisdictions. These measures will continue to apply in addition to the Draft Law provisions.

However, in December of 2019, the Economic and Financial Affairs Council (ECOFIN) resolved that Member States should adopt at least one of the further defensive measures put forward by the EU’s Code of Conduct Group (CoCG) by June 2021. This resolution appears to have been the driving force behind the new Draft Law. The list of proposed CoCG measures (as set out in our previous briefing) includes:

  • denying deductions for costs and payments otherwise deductible (non-deductibility of costs);
  • including income from entities resident or established in blacklisted jurisdictions in the tax base of taxpayer income (controlled foreign companies’ rules);
  • applying higher rate withholding taxes to payments received from a blacklisted jurisdiction (withholding taxes);
  • denying or limiting exemptions on profit distribution received from subsidiaries from backlisted jurisdictions in certain circumstances (exemption restrictions);
  • introducing special documentation requirements; and
  • introducing new anti-abuse provisions.

With the Draft Law, Luxembourg appears to have opted for the first of the CoCG’s recommendations. More announcements are expected to follow as authorities coordinate to meet the June 2021 deadline. However, because most Member States already apply many (if not all) of these measures for non-double tax treaty jurisdictions, or tax neutral jurisdictions (such as the Cayman Islands), we are not expecting to see new defensive measure in every jurisdiction.

The specifics of the Draft Law are discussed below, but it is important to note at this point that (in its current form) the new measures are only set to apply from the beginning of the 2021 fiscal year. The Cayman Premier has signalled his firm commitment to seek re-designation of the Cayman Islands at the earliest opportunity (October 2020) and, provided this campaign proves successful, Cayman enterprises will avoid falling in-scope of the new law.

New legislative measures, including the recent implementation of the Cayman Private Funds Law, 2020 and the Mutual Funds (Amendment) Law, 2020, are already being held up at clear evidence of the Cayman government’s firm commitment to being removed from the blacklist by the end of 2020.

What changes will be introduced by the new Draft Law?

As announced, the Draft Law provides that interest or royalties, accrued or paid, should not be deductible for tax purposes when the following cumulative conditions are met:

  • the beneficiary of the interest or royalties is a collective entity (i.e. a tax opaque entity) – this means that payments made to a partnership should not fall within the scope of the proposed new rule;
  • the collective entity, which is the beneficial owner, is an “associated enterprise” of the person owing the interest or royalties, as defined under Luxembourg transfer pricing rules (i.e. enterprises are deemed associated when one enterprise participates, directly or indirectly, in the management, control or share capital of the other, or if the same persons participate, directly or indirectly, in the management or share capital of both enterprises); and
  • the collective entity, which is the beneficial owner of the interest or royalties, is established in a non-cooperative jurisdiction for tax purposes (as set out under the EU’s Annex 1).

An exemption to the non-deductibility rules will apply if the entity requesting a deduction is in a position to demonstrate that the transaction resulting in the payments of interest or royalties is put in place for valid reasons which reflect economic reality.

New rules will take effect from January 2021 and will be updated each year to reflect any changes to the countries listed under Annex 1.

Conclusion

Once you dig past the headlines, the new Draft Law is unlikely to have a significant impact on transactions between Luxembourg taxpayers and Cayman-domiciled funds. If the Cayman Islands manages to secure its removal from Annex 1 in October, enterprises based in the three-island chain will fall outside the scope of the proposed defensive measures.

At present, this development looks likely. There is clear precedent for re-designation –  Bermuda and the Bahamas have both been added and subsequently removed from Annex 1 – though, perhaps unsurprisingly, the EU has not issued any announcements confirming plans to ‘de-list’ at this stage.

Even if the Cayman Islands do fall in-scope, the exemption for sound business transactions (see above) should provide a work around for affected firms.