On 27 December 2016, the Luxembourg direct tax authorities issued new guidelines by way of Circular LIR n° 56/1 – 56bis/1 (the Circular) regarding the tax treatment applicable to Luxembourg companies carrying out intra-group financing transactions. The Circular details the application of the arm’s length principle to such transactions. It abrogates and replaces the previously applicable circulars of 2011 (LIR n° 164/2 and 164/2bis) as per 1 January 2017.
The arm’s length principle was so far mainly laid down in article 56 of the Luxembourg income tax law (LIR) and, for intra-group financing companies, in the 2011 circulars. With effect as of 1 January 2017, a new article 56bis LIR lays down the basic principles that a transfer pricing analysis must comply with, in line with the OECD Transfer Pricing Guidelines and actions 8-10 of the BEPS Action Plan. The purpose of the Circular is to clarify the Luxembourg tax authorities’ interpretation of articles 56 and 56bis LIR as regards intra-group financing activities. According to the Circular, intra-group financing activities comprise all interest bearing lending to related companies, funded with financial instruments in- or outside the group.
The guiding principles in the Circular are that intra-group financing companies need to have the financial capacity to assume risks and the ability to control and manage such risks. With respect to the financial capacity, the previous circular generally considered a minimum amount of equity at risk equal to the lower of either 1% of the intra-group financing amount or EUR 2 million to be adequate. The Circular, however, states that the appropriate amount of equity at risk should be determined on a case by case basis. Intra-group financing companies that can be compared to regulated financial undertakings will be considered to have sufficient equity if they meet the solvability requirements as set out in EU Regulation 575/2013 on prudential requirements for credit institutions and investment firms. If the functional analysis reveals important differences with a regulated financial undertaking, a different methodology should be used for the computation of the equity at risk. On the control and management of risk, the Circular refers to adequate people functions. The specific substance requirements are broadly similar to those required by the previous circular: key decisions being taken in Luxembourg; having qualified personnel adapted to the needs of the control of the transactions carried out; having a majority of Luxembourg resident board members; holding at least one annual shareholder meeting in Luxembourg; and not being tax resident in another jurisdiction. In addition, the Circular requires that personnel should have the understanding of risk management in relation to the transactions carried out.
The Circular also provides for safe harbours in certain circumstances:
An after-tax return on equity of 10% may reflect an arm's length compensation for financing and treasury functions for companies with a functional profile similar to that of a regulated financial undertaking. This percentage will be regularly reviewed and updated by the Luxembourg direct tax authorities; and
for intra-group financing companies performing a pure intermediary activity, transactions will be considered to respect the arm's length principle if a minimum after-tax return of 2% on the amount of the financing activity is reported. Intra-group financing companies will have the possibility to deviate from this simplification measure on the basis of a transfer pricing report. The Circular, however, does not define pure intermediary activities.
Finally, the Circular states that all rulings and other individual administrative decisions “in relation to the arm’s length principle” will no longer be binding on the Luxembourg tax authorities as from 1 January 2017 for tax years starting after 2016. Whereas the Circular addresses intra-group financing companies, the above statement is worded without restriction in scope. It is therefore unclear whether this targets more than just transfer pricing rulings obtained by intra-group financing companies.
Going forward, Luxembourg intra-group financing companies must reassess the appropriate amount of equity at risk and verify if the allocation of risks is in line with substance, especially in relation to significant people functions. Taxpayers wishing to have certainty on transfer pricing continue to have the possibility to file an advance pricing agreement request with the Luxembourg direct tax authorities. The Circular lists information that must be included in a request for an advance pricing agreement by an intra-group financing company, which includes the qualification and functions of relevant employees, the countries affected by the financing transactions, information on the parties involved in the controlled transaction and a detailed transfer pricing analysis.