OECD Chapter X: how will this impact PE?
In this incredible success story, 2020 was a year of massive disruption due to global events such as Covid, political and social crisis in the US, Brexit and ATAD.
Additionally, 2020 was also the year of the OECD Chapter X report (“Chapter X” or “the Report”). Is this another significant disruption and what are its consequences for PE houses in Luxembourg? Let’s try to find out!
1. What is Chapter X?
In February 2020, the OECD released, for the first time, specific guidance for intra-group financing transactions, which was mainly integrated within the OECD Guidelines as “Chapter X”. As per its introduction, the purpose of the Report is to provide “guidance for determining whether the conditions of certain financial transactions between associated enterprises are consistent with the arm’s length principle”. The key areas covered relate to (i) characterization of instruments as debt or equity, (ii) treasury functions, including all intra-group financing and credit rating – which are most relevant for PE in Luxembourg - but also cash pooling and hedging, (iii) financial guarantees, (iv) captive insurance and (v) risk-free rates determination
2. Evolution or revolution?
There is nothing particularly new in the Report and all its concepts already exist in Luxembourg law. For instance, our domestic legislation - including parliamentary documents and case law - already sets the basis for classification of instruments as debt or equity and imposes commercial rationality (the latter is anchored in the law since 2016 with article 56bis (7) of the Income Tax Law).
Nonetheless, Chapter X now brings more guidance on applying those concepts, including how to determine acceptable debt at the level of the borrower (the “debt-to-equity ratio”) and how to assess the commercial rationality of any transaction.
Consequently, today, when setting up intragroup debt, correct pricing is no longer the only requirement. Indeed, in the past, we “only” needed to demonstrate that the interest rate of a debt did not differ from the one that would have been applied between third parties. Now we additionally need to provide support that all the other main conditions of the transaction are arm’s length and rational. This includes the debt-to-equity ratio, the arm’s length nature of terms and conditions and the reasons why no other Options Realistically Available (also called “ORA”) were preferred as funding methods.
Significant guidance is also provided by the Report in relation to the pricing of guarantees and the determination of credit ratings and should therefore similarly be carefully applied by PE in Luxembourg when applicable.
3. What are the risks?
Chapter X is therefore adding new compliance requirements that need to be integrated in our structuring if we want to avoid adverse tax consequences.
For instance, the balance of debt and equity funding provided by a group to a company should not differ from that which would exist if provided by third parties. Otherwise, for tax purposes, part of the amount of debt funding could be considered as excessive and reclassified as equity and the interest paid on such deemed equity as (non-deductible) dividend.
In PE contexts, considering that, usually, most incomes are dividends and therefore exempted, the biggest risk would nonetheless not be the non-deductibility of those interests/dividend but rather the risk that withholding tax would be levied upon their payment.
Similarly, interest-free debt funding usually raises questions and risks on their rationality that could lead to the requalification of those debts into equity, which may also trigger potential withholding tax exposure when the debt is repaid or even net wealth tax issues, if financing a non-qualifying participation.
Chapter X brings new risks of significant tax exposure. To consult, analyze and understand its potential impacts for every new transaction is therefore paramount.
Consequently, even if it is more an evolution than a revolution, Chapter X should be integrated at early stages of every implementation.