Tax Alert Luxembourg - Changes in tax treatment of intra-group financing transactions

Effective as of 1 January 2017 a new article has been introduced to the already existing statutory transfer pricing framework in Luxembourg. Until that date a general provision confirmed as a general principle of Luxembourg tax law the applicability of the arm's length principle ("ALP"). Further guidance on ALP and the basic principles that must be observed in a transfer pricing analysis (in specific the comparability analysis) is now also included in the socalled new article 56bis. This new provision in effect implements several revised OECD Transfer Pricing Guidelines in Luxembourg.

Interpretation Luxembourg Tax Authorities

Parallel with this change in law, the Luxembourg tax authorities ("LTA") have issued on 27 December 2016 a Circular Letter ("Circulaire") expressing their normative interpretation of article 56bis and the application of the ALP in case of taxpayers that are engaged in intra-group financing transactions.

The Circulaire also states that the previous interpretation of LTA as laid down in earlier communications in 2011 no longer applies as of 1 January 2017, i.e no grandfathering is allowed.

Any advance pricing agreements entered into by the LTA with respect to the applicability of the ALP will no longer be binding upon the LTA as from 1 January 2017 for tax years starting after 2016. Although the Circulaire addresses taxpayers engaged in intra-group financing companies, this remark is drafted without restriction in scope. It is therefore unclear whether this also expands to other tax rulings obtained by taxpayers.

The scope of the Circulaire is broader than under the old rules that only applied to taxpayers mainly engaged in intra-group financing transactions. According to the Circulaire, intra-group financing transactions comprise all interest bearing lending to related companies, funded with financial instruments in- or outside the group. In order to determine where a taxpayers falls in scope of the Circulaire holding activities have to be disregarded.

The main objectives of the Circulaire are to ensure that taxpayers involved in intra-group financing transactions possess (i) the financial capacity to assume risks and (ii) the ability to control such risks in Luxembourg. In other words, LTA emphasizes on equity at risk and substance. This approach is consistent with international tax policy developments initiated by OECD and the EU.

Equity at risk

In the new approach the safe harbour under the old rules with respect to the minimum equity (at risk) being equal to the lower of EUR 2,000,000 or 1% of the lendings no longer applies. Each taxpayer should individually determine its appropriate amount of equity at risk. Such amount then should be fully available to absorb materialized risks. Contractual arrangements (such as a limited recourse provision or a group guarantee) have to be ignored when determining the ALP remuneration.

Substance

On the control and management of risk, the Circular refers to adequate people functions. The specific substance requirements are broadly similar to those required under the old rules:

• key decisions of the members of the board of directors are to taken in Luxembourg;
• at least one shareholder meeting per annum is to be held in Luxembourg;
• the majority of the members of the board of directors, directors or managers who have the authority to bind the taxpayer are tax residents of Luxembourg or non-residents of Luxembourg with a professional activity that is subject to tax in Luxembourg. Where a legal person is a board member, it must have its statutory seat and central administration in Luxembourg;
• having qualified personnel (employed by the taxpayer or a Luxembourg resident group company) to control the transactions. Such personnel should have the understanding of risk management in relation to the transactions carried out. Outsourcing of supporting risk control activities is allowed as long as the taxpayer has the capacity to manage and monitor the outsourcing;
• the taxpayer can not be considered resident of another State

Safe harbours

The Circulaire explicitly provides for a safe harbour with respect to the equity level and minimum return on equity for taxpayers having a functional profile similar to that of a regulated financial undertaking. The equity level should be such that the taxpayer meets the solvability requirements as set out in EU Regulation 575/2013 on prudential requirements for credit institutions and investment firms. The minimum return on equity should be 10% after tax. This percentage will be regularly reviewed and updated by the LTA based on relevant market analysis.

Another safe harbour is availabe for a taxpayer that performs a pure intermediary financing activity, where a minimum after tax return of 2% of the total amount of the assets financed. Disclosure in the tax return is required when a taxpayer applies lastmentioned safe harbour results in an exchange of information by the LTA.

Exchange of information

Under Luxembourg law a comprehensive legal framework exists that provides for (automatic) exchange of information between competent authorities. This framework is largely in line with internationally accepted principles. It is expected that when a taxpayer that falls in the scope of the Circulaire does not meet the substance and/or equity at risk requirements, the LTA will exchange information with the relevant States.

Conclusion

The Circulaire expresses the view of the LTA with respect to the applicability of the ALP and 56bis in case of intra-group financing transactions performed by Luxembourg taxpayers as from 2017. Many questions remain unanswered in the Circulaire and also different interpretations thereof are possible. It is expected that in the course of 2017 based on discussions with LTA further interpretative guidance will become available.

At this stage it is recommended for any Luxembourg taxpayer that is involved in intra-group financing transactions to review the possible implications of the changed Luxembourg environment and discuss next steps.