This article summarises the key points arising from the Luxembourg tax administration's Transfer Pricing Circular, which sets new standards for the tax treatment of companies carrying out intra-group financing transactions.
On 27 December 2016, the Luxembourg tax administration released Circular L.I.R. n° 56/1 - 56bis/1 (the Transfer Pricing or "TP" Circular) setting new standards for the tax treatment of companies carrying out intra-group financing transactions.
The recently adopted Luxembourg 2017 budget law of 23 December 2016 (the Budget Law) provides for enhanced transfer pricing rules (with an explicit reference to the arm's length principle and Organisation for Economic Co-operation and Development (OECD) transfer pricing guidelines).
Article 56bis of the Luxembourg Income Tax Law, as amended (ITL) introduces new definitions (eg "transaction", "comparable" "open market transaction", "arm’s length price" etc) in very similar terms to those in the OECD Transfer Pricing Guidelines.
Article 56bis of ITL then deals with "principles" and "methodology". In particular, it explicitly includes the obligation to use, for corporate income tax purposes, an "arm’s length price".
In addition, Article 56bis of ITL provides guidance with respect to the required "comparability" analysis, again in line with the OECD Transfer Pricing Guidelines.
Furthermore, the Budget Law includes a disposition that could be used as a transfer pricing general anti-abuse rule consisting of the "non-recognition" of a transaction which does not have valid economic reasons, with an impact in the determination of the "arm’s length price".
In this context, the Luxembourg tax administration released a new TP Circular which repeals the Circulars 164/2 of January 2011 and 164/2/bis of 08 April 2011 as from 1 January 2017.
Key points of the new TP Circular
Intra-group financing transactions are defined as activities which consist in granting loans or cash advances to related parties remunerated by interest and are refinanced by means of financial instruments such as public offering, private loans, cash advances or bank loans.
Any intra-group transaction should be scrutinized from a transfer pricing perspective in order to determine if the agreed remuneration is at arm’s length. This should be done through a comparability analysis (see below).
Section 171 of the Luxembourg general tax law, as amended (Abgabenordnung or “AO”) provides that the general obligation for tax payers to be able to justify the data included in their tax returns is extended to transactions between associated enterprises.
The Comparability analysis includes two items:
- the identification of the commercial or financial relations between the associated enterprises and the determination of the conditions and economic significant circumstances in connection with those relations in order accurately to delimit the controlled transaction, and
- the comparison of the conditions and the economic significant circumstances of the controlled transaction accurately delimited with those of comparable transactions between independent enterprises.
In the context of the determination of the arm’s length remuneration of the controlled transaction, the description of the role of each entity party to the controlled transactions as well as the commercial or financial relationship are essential.
The features of the transaction, including the functions carried out, the assets used as well as the risk borne by the associated enterprises must be determined.
It is unimportant whether or not the transaction has been formalised in writing. The behaviour of the parties to the transaction is the relevant criteria in the context of the identification and precise delimitation of the controlled transaction. The actual conduct of the parties is the factor which must be taken into account in the exercise of the delimitation of the transaction actually carried out.
A functional analysis involves the identification of activities, responsibilities and economically significant functions, assets used or provided and risks borne by the parties of the transactions. The functions performed within the granting of loans advances to related enterprises is, in substance, comparable to the functions performed by independent financial institutions subject to the supervision by the Luxembourg financial regulator.
Without being exhaustive, the following functions may be exercised:
- creating the transaction, or
- managing the transaction.
Identification of the functions performed and the assets used is required in order to identify the risks related to the financing transaction.
Risk analysis in the financing activity
Before granting a loan, a financial institution should analyse its risk exposure. In this context, the capacity to manage the risk and the capacity to that said risk are the pertinent economic features which must be identified to delimit accurately the controlled transaction.
A safe harbour clause for the equity level is provided when the comparability analysis evidences that an intra-group financing entity has a comparable profile to those of entities subject to the Capital Requirements Regulation (Regulation EU No. 575/2013 of 26 June 2013 modifying Regulation EU No. 648/2012).
When the considered entity carrying an this intra-group activity has an amount of equity conforming to the solvency criteria mentioned in the above regulation, its net equity will be deemed to be sufficient to bear the financial consequences should the risk materialise.
If the analysis of comparability proves significant differences with the functional profile (assets used and functions exercised) and the entities subject to the mentioned solvency criteria, it is necessary to determine the level of equity necessary to bear the risks on the basis of methods used by recognised professionals in the field of determination of credit risk.
According to the TP Circular, an intra-group financing entity controls the risk if it has the decision capacity to execute the transaction and has the capacity to monitor the transaction. Outsourcing of these functions is possible to the extent that the considered company determines the objective, monitors the service provider and has the capacity to amend or terminate the contract with the service provider.
Any such company must therefore have a presence in Luxembourg in order to meet the risk control requirement. This would be deemed to be the case if the company meets, in particular, the following conditions:
- The majority of the members of the board of directors or managers having the ability to bind the group finance company are either residents, or non-residents undertaking a professional activity in Luxembourg, under the relevant Luxembourg tax law definition. Where a legal person is a member of the board, it must have its registered office and its central administration in Luxembourg.
- The company must have qualified staff adapted to the needs of the control of the transactions. The company may outsource functions that do not have a significant impact on risk control. Key decisions concerning the management of the company should be taken in Luxembourg
- For companies which provide for the convening of a general meeting (GM) of shareholders, at least one GM per year must be held at the place indicated in the articles of association.
- The company shall not be deemed to be a tax resident of another State.
The comparability analysis process must be transparent, systematic and verifiable.
Safe harbour clause for the return on equity
The TP Circular also provides for a safe harbour clause regarding return on equity. In the case of enterprises performing functions similar to those carried out by regulated financing and treasury enterprises (ie. the one subject to the Capital Requirements Regulation (Regulation EU No. 575/2013 of 26 June 2013 modifying Regulation EU No. 648/2012)), a percentage return on equity of 10% after tax may reflect an arm's length remuneration.
When necessary, comparability adjustments can be made according to internationally recognised standards.
Transactions with no commercial rationale
In the context of the comparability analysis and of the precise delimitation of one or several controlled transactions, these transactions may not appear on the open market and may in fact have no commercial rationale - hence, independent parties would not have agreed to conclude these transactions under the same conditions. Such transaction(s) and the principle tax consequences thereof must be ignored to ensure compliance with the arm's length principle.
Finally, a simplifying measure exists for intra-group financing companies with sufficient substance (ie, the one described above to be considered to control the risk) carrying out a purely intermediary activity of granting of loans or advances of funds to related companies refinanced by loans and advances from related undertakings. Such transactions would be deemed to comply with the arm’s length principle where the analysed company has at least 2% return after tax with respect to the financed assets.
To benefit from this measure, the company must communicate its intention to the Luxembourg tax administration in its corporate tax returns.
A deviation from such minimum margin is acceptable in exceptional cases when justified by a transfer pricing analysis.
Taxpayers who opt for the scheme set out above would be subject to the exchange of information.
Content of an Advance Pricing Agreement
The TP Circular specifies that a request for an Advance Pricing Agreement must include a transfer pricing report. This report must include several items, but, in particular, the description of the computation of the equity allocation required to bear the risks, the full list of comparables, the accurate delimitation of the transactions under analysis and a forecast of profit and loss accounts for the years covered by the Advance Pricing Agreement.
Decisions of the Luxembourg direct tax authorities prior to the entry into force of article 56bis ITL
Any individual administrative decision relating to the arm's length principle on the basis of the rules applicable before the entry into force of Article 56bis ITL is no longer binding for the Luxembourg tax administration as from 01 January 2017.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.