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Hybrid Loophole Closing in Europe


On June 20, 2014 the European Union’s Council of Economic and Finance Ministers agreed to amend the EU Parent-Subsidiary Directive (PSD) to prevent double non-taxation resulting from hybrid loan arrangements. It is expected the amendment will be adopted during the upcoming Council of the European Union and would then be enacted in the domestic tax laws of the EU member states.

The PSD was originally intended to prevent tax obstacles within the EU. Prior to the proposed amendment, the PSD forbade the taxation of corporate dividends received by a parent company from its corporate subsidiary within the EU. As a result, the PSD promoted the free repatriation of profits between EU member countries and prevented double taxation of corporate income.

A tax loophole existed because certain EU countries permit companies to deduct distributions paid on financial arrangements that have both equity and debt features. Thus, under such a hybrid arrangement, the subsidiary could deduct the payment from its taxable income but the parent company would not have to include it, resulting in double non-taxation. The amendments to the PSD (the “Amended PSD”) will require EU members to “refrain from taxing such profits to the extent that such profits are not deductible by the subsidiary, and tax such profits to the extent that such profits are deductible by the subsidiary.”

Xavier Hubaux, Head of Tax at AMMC Law in Luxembourg commented, “For a Luxembourg tax resident company, this would mean that a dividend derived from a foreign subsidiary which deducted said dividend from its tax basis should be taxable at an aggregate corporate income tax and municipal business tax of 29.22% (assuming the Luxembourg company has its registered address in Luxembourg city). However, such dividend income may benefit from a 50% exemption based on article 115.15.a of the Luxembourg Income Tax Law under certain conditions, assuming the latter provision would not be regarded as to be amended in application of the Amended PSD (indeed, after the 50% exemption, the dividend would still be taxable at an effective tax rate of about 14.6%).”

The amendment should not result in the taxation of dividends where the holder or the issuer of the financial instrument is located outside of the EU. Xavier Hubaux adds: “Therefore, hybrid arrangements between EU Member States (Belgium, France, Luxembourg, UK, Germany, Poland, etc.) can still be contemplated in the future provided the holder or issuer of the instrument is not resident in an EU Member State; e.g. a Canadian company holding hybrid shares (distributions deductible in a EU Member State) would not be covered by the provision of the Amended PSD.”

However, other challenges to the use of hybrid financial instruments may be forthcoming. As part of its Base Erosion and Profit Shifting project (, the Organisation for Economic Co-operation and Development (OECD) is reviewing various options to neutralize the tax effects of hybrid arrangements. The OECD’s proposed solutions include a similar approach to that of the EU - tax the parent if the subsidiary received a deduction – or the opposite – disallow the deduction by the subsidiary if the parent is not going to be taxed on the income. There is a significant risk for double taxation if countries fail to harmonize their rules.

EU Member States will have to adopt the amendment into their domestic law by December 31, 2015. Therefore, existing intra-EU hybrid arrangements should reconsidered before this date as no grandfathering period is contemplated by the Amended PSD.