What would a GME or AMC short squeeze mean for a Luxembourg investor?


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.

 Antoine Dupuis
Antoine Dupuis, Partner - International & Corporate Tax

Posted on 04/02/2021