What Would A GME Or AMC Quick Squeeze Imply For A Luxembourg Investor? – Tax

Since late January 2021, the price action on shares of video

games retailer GameStop Inc (“GME“) and

other heavily shorted companies like AMC Entertainment

(“AMC“) has attracted the attention of

the finance world. The story is presented as a group of individual

investors betting against short sellers and hedge funds and trying

to provoke a short squeeze, which many believe would mark financial

history. Online brokers, US congress members, financial news

outlets and online discussion boards have all been featured in this

fascinating, still unfolding, chain of events.

But this particular angle of the story is not the only one worth

looking at. The dramatic increase in GME share price from $4 to

more than $400 and from $3 to $19 a share for AMC in only a few

weeks has also created opportunities for certain investors holding

other securities of the companies.

For example, it was reported that Silver Lake, a US buyout firm,

was able to cash in on a convertible bond issued by AMC, which it

converted into shares of the company at a conversion price of

approx. $13, generating a huge and likely unexpectedly short-term

profit, which some fellow hedge fund managers and commentators

referred to as a “trade of a lifetime”. No specific

disclosure was made on the potential income tax impact of such

trade, however, and that is now the subject of the below

discussion.

What would a similar trade mean for European investors?

In Europe, while these kinds of securities and transactions may

be directly held and performed by tax-exempt institutional entities

like investment funds, a lot of global credit and special

situations managers structure such investments through the use of

one or several SPVs, which are often taxable corporate subsidiaries

holding a diversified portfolio of credit securities.

These SPVs are typically financed with debt, and interest

charges on such debt are, in principle, deductible from the taxable

basis of the SPV under certain conditions. However, as a

consequence of the EU-wide implementation of the Anti-Tax Avoidance

Directive (Directive (EU) 2016/1164 of 12 July 2016 –

ATAD“), Luxembourg has introduced

specific rules to limit the interest deductibility for tax purposes

(the “IDLR“). The limitation applies to

so-called “exceeding borrowing costs” (i.e. the amount by

which the borrowing costs exceed the interest income in a given

year) and corresponds to the higher of EUR 3mio or 30% of the tax

EBITDA per fiscal year.

In this context, the definition of what constitutes borrowing

costs is of paramount importance. On 8 January 2021, the Luxembourg

tax authorities issued a new Circular n° 168bis/1 (the

Circular“) in order to provide guidance

on the interpretation of the IDLR. Under the Circular, borrowing

costs may only concern deductible interest expenses, i.e.

non-deductible interest expenses, regardless of the reason for the

non-deductibility (e.g. anti-hybrid rules), do not qualify as

borrowing costs. Therefore, to apply the IDLR, one should first

consider whether the relevant expenses are deductible under the

other provisions of Luxembourg tax law. As a second step, the

nature of the expenses has to be checked to determine whether or

not they fall into the scope of borrowing costs within the meaning

of the IDLR. Where such limitations to the tax deduction apply, the

resulting potential tax charge may have a huge impact on the

fund’s returns.

While not all bonds or receivables are convertible, the impact

of additional equity contributed to issuers of plain-vanilla debt

may directly impact the valuation and recovery value of such debt.

Under the IDLR in Luxembourg, a deduction for impairment of

(presumably) irrecoverable receivables does not give rise to

borrowing costs on the part of the creditor. Hence, the reversal of

such impairment should likewise not constitute interest income.

This in turn means that gains on impaired or discounted debt

holdings may be offset by tax deductible interest charges only up

to a certain limit, thereby resulting in a potential increased tax

charge for their holders.

The conversion of debt into equity is more complex to analyse.

On the one hand, an exchange of assets is normally characterised

for Luxembourg tax purposes as a sale of the asset followed by the

acquisition of the other asset obtained in exchange, and therefore

a difference in value between the two should be a gain (or a loss).

However, under the Circular and the symmetry principle it laid

down, the characterisation of income and gains in the hands of the

holder of a security should in principle replicate that at the

level of the issuer. Therefore, if redemption premiums on

convertible bonds are considered as borrowing costs for the issuer,

the premiums should also be considered as

“interest-equivalent” for the lender.

Any income realised following the subsequent sale of the shares

or new equity received in exchange for the conversion of the debt

will, however, almost always be considered as non-interest income

(i.e. “bad income” for the purposes of the IDLR). In

these situations, the exact sequence of transactions will therefore

be extremely important to understand and monitor to determine the

applicable tax treatment and whether or not a portion of the

interest charges will be non-deductible for tax purposes.

Asset managers which finance discounted or convertible debt with

profit participating instruments or other loan instruments (e.g.

debt funds) may therefore need to review their current structure

setup to identify potential tax exposures and take the necessary

steps, if needed, to prevent potential “trades of a

lifetime” from turning sour once an unexpected tax burden

ruins the party.

And… oh yes, for Luxembourg individual investors, short-term

capital gains (less than 6 months), as well as short-selling gains,

are considered speculative and therefore subject to individual

taxation at the maximum tax rate.

The content of this article is intended to provide a general

guide to the subject matter. Specialist advice should be sought

about your specific circumstances.