Adjustments Luxembourg Transfer Pricing Rules
On 27 December 2016, the Luxembourg administration for direct taxes published a Cicular on group financing activities. The Circular more or less clarifies and/or emphasizes that the effective management of Luxembourg group financing companies should take place in Luxembourg and certain risk requirements need to be satisfied.
12 Dec. '17
Patrick T.F. Schrievers
On 27 December 2016, the Luxembourg administration for direct taxes published a Circular (no. L.I.R. n° 56/1 – 56bis/1) on group financing activities. The Circular is brought about by the codification of the arm’s length principle in the Income Tax Act (ITA) and seems to be inspired on the OECD Action plans 8 – 10 in the context of base erosion and profit shifting. It more or less clarifies and / or emphasizes that the effective management of Luxembourg group financing companies should take place in Luxembourg and that Luxembourg group financing companies need to satisfy certain economic risk requirements, meaning that such companies must assume genuine business risks and must have enough capital in place to cover these risks. The Circular also focusses on strengthened documentation guidelines to establishing and support the arm’s length remuneration (which meets international transparency standards). It will apply immediately for any new requests made for advance pricing agreements and existing advance pricing agreements will no longer bind the Luxembourg tax authorities as from 1 January 2017. Details of the Circular are summarized below.
Definition of group financing activities & related companies
Intra-group financing transactions are defined as activities consisting of among others the granting of loans to related companies, which may be refinanced by financial means, and instruments such as public issues, private borrowing, cash advances or bank loans. A related company exists (and to summarize) if an enterprise participates, directly or indirectly, in the management, control or capital of another enterprise. In either instance, the two enterprises are within their commercial or financial relations subject to conditions made or imposed which differ from those which would be made between independent enterprises. Hence, the (taxable) remuneration should be based on the arm’s length principle taken into consideration functions performed and risks assumed.
Previous legislation / Circular
Until recently (i.e. December 31, 2016) Luxembourg based group financing companies needed to satisfy several minimum operational and economic risk requirements involving the bearing of real risk and an appropriate level of equity with regard to the functions performed. Typically, as compared to the old ruling practice in The Netherlands a safe harbor minimum equity was considered to be the lower of EUR 2 million or 1% of the amounts lent. Via contractual agreements this limited risk / exposure was documented in loan agreements (e.g. limited recourse clauses / guarantee provisions).
New Circular: application of the arm’s length principle to intra-group financing activities
For the comparability of the activities, the following points must be investigated:
- the identification of the commercial or financial relations between companies and the determination of economic conditions and circumstances relating to these relationships to determine the specifics of the transactions concerned; and
- the comparison of economically significant conditions and circumstances of the related transactions with those of comparable transactions between independent enterprises.
For the determination of the exact features of a financing transaction, based on a case by case approach the characteristics of the transaction, including its terms, the functions performed, the assets used and the risks incurred by the related companies must be determined, i.e. a functional analysis. This functional analysis focuses on the company strategy and the risks taken and the rights and obligations of the companies for the exercise of their functions. Relevant functions include: the transaction, for which the following aspects are relevant, the marketing of the transaction (customer identification, product proposal, etc.), the negotiation (setting of contract terms, assessment of risks related to the granting of a credit, etc.), the identification of the refinancing structure related to the financing, the monitoring of the compliance with contractual commitments prior to the conclusion of the transaction (value of guarantees, analysis of solvency, etc.), the management and administration as well as the monitoring of credit risk (review of guarantees and risks related to a transaction) and refinancing activities and management. As a corollary to the Action Plans 8 – 10 in the context of base erosion and profit shifting Luxembourg group financing companies must assume genuine business risks and must have enough capital in place to cover these risks. Contractual arrangements that do not match the functional analyses can be ignored.
New Circular: minimum operational substance requirements
For the determination whether a finance company has substance in Luxembourg, the following factors are taken into account: the majority of the members of the board of directors is established in Luxembourg, the directors or managers authorized to engage the group finance company are either residents, or nonresidents carrying out a professional activity in Luxembourg, legal persons participating in the board of management must have their registered office or central management in Luxembourg, having qualified personnel at the disposal in Luxembourg, key management decisions must be taken in Luxembourg, at least once a year general shareholdings must be held and the company may not be resident of another state. This basically follows the requirements necessary to satisfy the old Circular.
Arm’s length compensation
The Circular also provides for safe harbors in case of a group financing company that have a pure intermediary activity. In that case transactions will be considered arm’s length if they support an after tax return of at least 2% of the finance activity. We would expect that in such a case a standard commission fee would also apply (based on a functional analyses). In addition financing and treasury companies may wish to adopt an after tax return of (at least) 10% (similar to that of a regulated financial undertaking). We expect however that the majority of companies may wish to establish a functional analyses and a proper benchmark using internationally applied databases.
MNEs that use Luxembourg group financing companies need to assess the impact of the changed international tax environment for these companies. As from 1 January 2017 these companies need to assume genuine business risks and must have enough capital in place to cover these risks. Contractual arrangements that do not match the functional analyses can be ignored. To the extent companies want to file for an APA or if companies want to leave things as they are (including insufficient operational substance or risk appreciation), they should be aware that there are transparency rules that may trigger exchange of information with relevant treaty partners or EU Member States. Until recently the base erosion and profit shifting debate has focused on intellectual property, effectively dismantling the Luxembourg preferential IP regime. Observing recent discussions within the OECD we expect that group financing activities will be scrutinized as well.
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