a. new legal provision
Luxembourg seized the opportunity of the 2017 budget law adopted on 23 December 2016 to introduce a new Article 56bis in the income tax law (“ITL”), the provisions of which are directly inspired by the revision of the OECD Transfer Pricing Guidelines (the “OECD Guidelines”) published in Actions 8-10 of the final reports of the OECD BEPS project.
This new article sets out the principles and the methodology to be applied as from 1 January 2017 by related entities carrying out intra-group transactions (i.e. so called “controlled transactions”), when determining the at arm’s length prices of such controlled transactions within the meaning of article 9 of the OECD Model Convention.
Based on the OECD Guidelines, article 56bis ITL states that the core principle to determine an at arm’s length remuneration for controlled transactions between related parties consists of a comparability analysis, which relies on the two following pillars:
i. analysing the commercial or financial relations between related parties and determining the economic conditions and economically significant circumstances attached to these relations in order to precisely delimit the controlled transaction; and
ii. comparing the conditions and economically significant circumstances of the controlled transaction, in a precise manner, with a comparable uncontrolled transaction.
The introduction of this new article seems to be a mere confirmation by Luxembourg that it adheres to the at arm’s length principle as laid down in the OECD guidelines, which are already followed by the administrative practice and the Courts of Luxembourg, was it not that it also prompted the Luxembourg Tax Authorities (“LTA”) to revisit its circular on intra-group financing.
b. Adoption of a new transfer pricing circular for intra-group financing activity
Hence, further to the introduction of new Article 56bis in the Luxembourg ITL, the LTA issued a new administrative circular L.I.R. n°56/1 – 56bis/1 on 27 December 2016 (the “Circular”) prepared in cooperation with the DG Competition of the European Commission. The Circular has to be read and understood against the background of the Fiat Finance State aid case, in which the previous circulars on intra-group financing are at the heart of the dispute.
The Circular, which has entered into force as from 1 January 2017, sets out a new approach purportedly in line with the newly introduced transfer pricing provision of Article 56bis ITL in the specific context of intra-group financing activity.
The Circular repeals and replaces the two previous circulars pertaining to intra-group financing activities, namely, circular L.I.R. n°164/2 dated 28 January 2011 and circular L.I.R. n°164/2bis dated 8 April 2011.
Key changes introduced by the Circular are the following.
i. Determination of the equity at risk
The previous rule regarding the determination of the amount of equity at risk that a Luxembourg company should carry when engaging in intra-group financing activities, consisting in the lesser amount of either 1% on the amount on lent or a maximum of EUR 2 million, is abandoned. This rule was one of the points on which the European Commission was the most critical. Indeed, one should admit that the lump-sum approach to the equity at risk was difficult to maintain in light of the OECD guidelines;
Now, as an example, the Circular provides that companies with a risk profile similar to the one of entities that are subject to Regulation EU 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms (i.e. EU implementation of the so-called Basel III Agreement – “Regulated Financing Entity”) and that comply with the equity requirements
of said regulation, are deemed to have sufficient equity at risk;
For companies with another risk profile (notably regarding assets used and functions performed), the equity at risk will need to be determined on a case by case basis, through other methodologies, including by means of a credit risk analysis based on balance sheet and market data, as well as other risk factors that are relevant in the context of a financing activity.
ii. Determination of an arm’s length remuneration
Since the comparability analysis is the core concept of the new legal provisions, when determining the at arm’s length remunerations one should precisely compare the controlled transaction with uncontrolled transactions entered into on the free market in the relevant sector of activity. Such is done on the basis of an identification of the significant economic elements of the transaction as well as on the basis of a functional analysis and risk analysis.
The Circular seems to distinguish two main base cases.
- Intra-group finance companies
If the finance company has a profile similar to a Regulated Financing Entity (e.g. banks, credit institutions etc) besides having equity at risk in line with the Basel III Agreement, it could be deemed to earn an at arm’s length remuneration if its return is equal to 10% (after tax) of its equity. This rule seems to apply mainly to so-called “intra-group banks” of multinational groups developing similar activities as a bank, such as treasury management, cash-pooling, and long-and short-term financing.
- Finance companies acting as intermediary
In case the finance company does not have a profile of an intra-group bank, but rather intervenes as an “agent” in a financing transaction, i.e. sources funds to on-lend such funds to affiliated companies, the Circular considers that at an arm’s length remuneration should equal a return of 2% (after tax) on the assets financed (i.e. the on-loan).
However, this determination of the at arm’s length remuneration, whether for intra-group finance companies or finance companies acting as intermediary, does not apply if a transfer pricing report is produced, in accordance with the OECD Guidelines and the provisions of the Circular, which determines a different return.
Hence, although the above percentages, which are quite high under current market circumstances, are presented by the Circular as so-called safe harbour rules, to be applied in the absence of a transfer pricing report, they may in our opinion be seen rather as a sanction.
Interesting to note is that companies that do not wish to conduct a proper transfer pricing analysis and therefore wish to apply the above lump-sum determination should opt explicitly for this possibility in their yearly tax return. By doing so, the transaction will automatically be subject to an exchange of information under the different relevant exchange of information instruments entered into by Luxembourg. This approach taken by the Circular tends, in our opinion, to confirm the deterrent effect of the lump-sum percentages and the reliance on those.
From a practical point of view, the Circular clearly aims at incentivising taxpayers to conduct an appropriate transfer pricing study in order to determine the at arm’s length remuneration of a mere agent activity, especially in situations where the financing structure implies the involvement of numerous entities. We expect that mere agent entities should produce proper transfer pricing reporting to demonstrate that a remuneration of less than 2% after taxes of the financed assets is at arm’s length.
It is worth noticing that the lump-sum percentages of 10% and 2% are net, after tax, margins, which in itself do not seem in conformity with the at arm’s length principle. It is therefore questionable whether this approach is in conformity with the new article 56bis ITL and will be upheld by the Luxembourg Courts. Indeed, there is a large variety of intermediary profiles, ranging from pure pass-through agents (which are purportedly not beneficial owner of the income) to genuine finance transactions, that the Circular does not seem to distinguish in its approach.
Finally, in the context of the comparability study, the Circular seems to put a certain emphasis on the fact that, when analysing the controlled transaction, non-genuine arrangements or transactions lacking economic substance, which would not be found in a third-party relationship, should be disregarded for purposes of determining the at arm’s length remuneration. Although not mentioned by the Circular, this could mean that the tax administration will disregard certain commonly used clauses in finance transactions, such as the limited recourse clauses, for the determination of the at arm’s length
remuneration.
iii. Substance requirements
The substance requirements imposed by the Circular are broadly the same as those set out in the two previous circulars on intra-group financing. However, the Circular now particularly insists on the fact that Luxembourg companies carrying out intra-group financing activities should have a genuine presence in Luxembourg meaning the capacity to enter into and manage the risk of the transaction via (i) their board, the majority of whom should consist of Luxembourg resident or professionally resident managers and (ii) duly qualified employees to control the transactions, although it accepts that functions which are not significant for the control of the risks can be outsourced.
iv. Advance pricing agreements (“APA”) and non-binding effect of existing APA
The Circular confirms that it is still possible for taxpayers who wish to obtain certainty as to the validity of their transfer pricing documentations to ask for advance pricing agreements. However, the requirements in terms of documentation are now more stringent and more complete than they were under the previous regime. This probably will lead to a further increase of the costs of filing an APA.
Finally, the Circular states that, as from January 2017, any APA issued prior to the issue date of the Circular that is not in line with its provisions are no longer valid or binding the LTA, for fiscal years after 2016.
This position, although not surprising, may be questionable. Indeed, according to the law of 19 December 2014, advance tax agreements bind the LTA for a period of 5 years unless there is a change in factual circumstances or if there is a change in the law which is incompatible with the agreement. The question is therefore whether article 56bis ITL introduced a change in the law which is incompatible with the APA granted in the past. As stated above, in our opinion, article 56bis ITL does not necessarily introduce new rules, but is merely a codification or confirmation of the application of the OECD Guidelines in the Luxembourg ITL, which were already applied before the introduction of the new article 56bis ITL.
This being said, we would nevertheless advise taxpayers to review their transfer pricing documentation in light of the rules of the new Circular rather than to rely on a previously obtained APAs.
