On 27 December 2016, the Luxembourg tax authorities released a new circular (the Circular) on the tax treatment of intra-group financing activities. The Circular follows the introduction of the new article 56bis of the Income Tax Law (ITL) on the application of the arm's length principle.
The Circular provides guidance on the practical application of these principles to intra-group financing activities, ensuring consistency with recent Luxembourg legislative developments and all international transfer pricing standards.
The Circular cancels and replaces circular 164/2 of 28 January 2011 and circular 164/2bis of 8 April 2011 and becomes applicable as from 1 January 2017.
Scope of the Circular
The scope of the rules applicable to intra-group financing activities remains the same as under the old rules. The Circular applies to entities that are engaged in intra-group financing transactions. The term "intra-group financing transaction" is to be interpreted very broadly and includes any activity involving the granting of loans (or advancing of funds) to associated enterprises. How these loans are financed is irrelevant (for example, intra-group loans, bank loans, public issuances, etc.).
While the former circulars referred to cross-border financing transactions between associated enterprises, the new circular refers to any financing transaction between related enterprises, meaning that the remuneration of financing transactions between Luxembourg companies also has to be in line with the guidelines provided in the Circular. This change is in line with the Luxembourg transfer pricing rules, as amended in 2015 (article 56 ITL).
Determination of the arm's length price
The new article 56bis ITL emphasises the concept of the comparability analysis through the replication of some of the guidance provided in the OECD TP Guidelines. A comparability analysis is critical for the application of the arm's length principle and a cornerstone of any transfer pricing analysis.
While the comparability analysis was already an integral part of transfer pricing analysis, under the new regime there will be additional emphasis on the comparability analysis in transfer pricing documentation.
The Circular further expands on how to perform a comparability analysis in case of intra-group financing transactions.
The contractual terms are always the starting point when analysing a controlled transaction. In accordance with OECD transfer pricing guidance, the Circular states that when the behaviour of the parties deviates from the contractual terms, the actual behaviour is to be considered (i.e. substance over form approach). However, in case of financing activities such deviation from the contractual terms should be very exceptional.
As under the previous regime, a functional analysis has to be performed in order to identify the activities and economically significant functions performed by the parties (taking into account assets used and risks assumed), in relation to the controlled transaction.
Risk analysis and capital at risk
One of the key changes under the new transfer pricing regime is the requirement to determine the capital at risk on a case-by-case basis. In contrast, under the former regime, the so-called equity-at-risk requirement was deemed to be met when the equity (at risk) of the company amounted to at least 1% of the outstanding loan(s) or EUR 2 million.
Notably, a financing company must be financed with sufficient equity to cover the risk in case it materialises. The capital at risk has to be remunerated at arm's length and may either be used to finance the loan portfolio or other assets.
More precisely, the new Circular provides that:
- If the comparability analysis shows that the financing company has a profile comparable to entities governed by EU regulation 575/2013 on prudential requirements for credit institutions and investment firms (banks, etc.), and if its own funds are in line with the solvency criteria provided by this regulation, the financing company is considered as having a level of own funds which is sufficient to bear the financial consequences in case of risk realisation.
- If the comparability analysis shows that the financing company has a profile which differs significantly (in the assets used and the risks assumed) from the one of entities governed by EU regulation 575/2013 on prudential requirements for credit institutions and investment firms (banks, etc.), then other methods (in particular by performing a credit risk analysis) have to be applied in order to determine the amount of own funds required to assume the risks.
To control the risks, the financing company should possess the power to decide whether or not to enter into the risk bearing financing transaction and take the decisions to handle the related risks.
Abolishing the previous equity-at-risk requirement is positive for several reasons. First, it improves the beneficial ownership position of Luxembourg financing companies (bearing contractually all the risks in relation to the financing activities). Second, it removes the only arbitrary element of the Luxembourg transfer pricing regime for financing companies. Third, under the previous transfer pricing regime, it was in some cases difficult to contractually limit the risk of the financing company through limited recourse clauses, guarantees, etc. (for example, when bonds are issued on the market and the funds are used to finance the operations of the group). These issues will disappear under the new regime.
Substance of the financing company
The Luxembourg financing company has to maintain a real presence in Luxembourg. For this purpose, as under the former circulars, the majority of the managers/directors should be (professionally) resident in Luxembourg.
In addition, the company should have personnel whose qualifications should be such as to allow them to control the transactions performed by the company. Nevertheless, the company may still outsource or delegate some of the functions to the extent that these functions are supervised by the managers/directors of the company and have no significant impact on the control of the risk.
The Luxembourg company should hold its annual shareholder meeting in Luxembourg at the registered seat of the company. Finally, as before, the company should not be considered as tax resident in another jurisdiction.
Comparable transactions between unrelated enterprises
In order to determine the arm's length remuneration on financing activities, reference has to be made to the remuneration applied in practice in a comparable activity sector.
In the case where the financing company has a profile comparable to the one of entities falling under the scope of EU regulation 575/2013 on prudential requirements for credit institutions and investment firms (banks, etc.), a return after tax on own funds of 10% (to be revised by the Luxembourg tax authorities as the practice evolves) is considered as a level of return commonly seen in practice currently and thus considered as an arm's length remuneration. Nonetheless, even under these circumstances it will be possible to determine an arm's length return for this specific case (which may be lower than 10% return on the equity).
Lack of valid commercial rationality
In the same way as mentioned in the new article 56bis ITL, the Circular includes some language on circumstances in which a transaction may be disregarded due to a lack of valid commercial rationality and because a third party would not have entered into a specific transaction. However, this guidance should only concern very exceptional cases.
Measure of simplification for financing companies acting as an intermediary
In the case where a Luxembourg financing company falling within the scope of the Circular acts only as an intermediary, given that the risks are very limited in this case, it is assumed that the remuneration realised by the Company is at arm's length if the company realises a minimum return of 2% after tax on its financed assets.
However, companies merely involved in the on-lending of funds will still have the possibility to benchmark a lower return in a transfer pricing study. Given the relatively high return required under the simplified regime (2% return on the assets corresponding to a 200 bps margin), it should make sense for most taxpayers to produce transfer pricing documentation in these cases.
This percentage will be revised on a regular basis by the Luxembourg tax authorities. In order to benefit from this simplified measure, a formal request has to be filed with the tax return. Should a company opt for this system, a procedure of exchange of information will be launched (based on the Luxembourg rules on administrative cooperation or in accordance with double tax treaties).
Advance Pricing Agreement (APA)
The procedure for obtaining an APA remains unchanged. However, the content of the transfer pricing study needs to be much more detailed, including a description of the qualifications and functions of the employees of the financing company.
However, when a transfer pricing analysis is properly done, an APA does not add much additional comfort and creates unnecessary costs (for the preparation of the APA and the filing costs levied by the Luxembourg tax authorities of EUR 10,000). Therefore, we frequently recommend that our clients not file APAs.
Given that the new guidelines become effective as from 1 January 2017, APAs which have been granted in accordance with the former circulars will be no longer valid as from 1 January 2017.
However, it is expected that transfer pricing studies prepared under the old regime will not be challenged for a reasonable amount of time in order to give taxpayers the possibility to smoothly adapt to the new requirements (to the extent the financing activity is still consistent with the underlying fact pattern in the transfer pricing study).
Conclusion and recommendations
The new Circular is positive for Luxembourg as it will make Luxembourg financing structures even more robust and strengthen the beneficial ownership position of Luxembourg financing companies, which is key in the current international tax environment.
The new transfer pricing regime adheres to the arm's length principle and OECD transfer pricing guidance and, therefore, makes the new transfer pricing regime immune to challenges from the EU Commission or foreign tax authorities. The Circular is another step towards more and more substantial transfer pricing documentation requirements in Luxembourg. However, this will not necessarily change anything about the outcome of the transfer pricing analysis.
Transfer pricing documentation has become a key element in tax risk management in an environment that relies increasingly less on tax rulings. In the current international tax landscape of heightened transparency and scrutiny, companies would be wise to take it one step further and integrate the documentation of transfer prices in their wider tax strategy, using it as a means to reflect the business rationale behind their corporate structure and intra-group transactions.
Since the new rules will become applicable as from 2017, companies performing financing and on-lending activities in Luxembourg should review their transfer pricing policy and related transfer pricing documentation to make sure that these are in line with the new requirements.
Originally published 29 December 2016
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.