Arm's length principle and tax treatment of companies engaged in intra-group financing transactions

The law of 23 December 2016 on the budget 2017(1) introduced into the Luxembourg income tax law dated 4 December 1967 (as amended) (hereafter ‘ITL’) a new article 56 bis related to transfer pricing and, in particular, the technique to be used and the methodology to be adopted for the application of the arm's length principle.

Additionally, the Director of the Luxembourg income tax authorities has published on 27 December 2016 a new Circular Letter LIR n°56/1 – 56bis/1 on the tax treatment of companies engaged in intra-group financing transactions, which replaces the previous Circular Letters LIR n°164/2 dated 28 January 2011 and LIR n°164/2bis dated 8 April 2011.

Transfer pricing refers to the price for which an undertaking transfers assets or renders services to another undertaking.

Actions 8-10 of the BEPS Action Plan regarding base erosion and profit shifting aim to bring the price determined between related parties in line with the case where the parties were independent under comparable circumstances in respect to comparable transactions.

According to article 56 bis ITL, the Luxembourg taxpayer must justify that the price of his controlled transactions is the arm’s length price and for this purpose, he must conduct a ‘comparability analysis’ documented by a transfer pricing study.

An intra-group financing transaction is defined as any activity involved in the granting of loans or advances remunerated by interest to related enterprises financed by financial instruments such as the public issuance of debt, related party loans, advances or bank loans.

In line with article 56 bis ITL, a group finance company must ensure that the price of the intra-group financing corresponds to the arm’s length price in accordance with a ‘comparability analysis’.

The key elements are as follows:

  1. The group finance company must assume the credit risk necessitating that it have the financial capacity to manage the risk and bear the financial consequences if the risk were to materialise. Previously, the assumption of risk was deemed satisfied when the amount of the equity at risk of the group finance company corresponded to at least 1% of the nominal amount of the financing or two million euros. Henceforth, the new Circular Letter mentions that the amount of equity at risk must be adequate and determined on a case-by-case basis by using the credit analysis methods developed by recognised professionals.
  2. The group finance company must control the credit risk necessitating that it has decision-making capacity to enter into financing. In this regard, the conditions related to professional qualifications of the managers of the group finance company as well as its substance with respect to a real presence in Luxembourg are strengthened.
  3. The group finance company must receive a consideration equal to the arm’s length price, indicating that ‘in general, in an open market, the acceptance of an increasing risk generates a higher remuneration(2). Additionally, the Circular Letter sets up two specific ‘statuses’ related to (i) the group finance companies which perform similar functions to those performed by regulated financing and treasure companies as defined in the CRR(3) and (ii) the group finance companies involved in back-to-back intra-group financing, namely, when the group finance company grants loans or advances to related entities which are financed by loans or advances granted by other related entities, an activity that is now qualified as a ‘purely intermediary financing activity’.

As article 56 bis LIR came into effect on 1 January 2017, the new standards will be applicable from the 2017 tax year.

In terms of documentation, the Circular Letter requires that as of 1 January 2017, in the presence of an intra-group financing transaction, a transfer pricing study is established in compliance with the principles set out by the OECD in the area of transfer pricing and that it must contain a detailed list of minimum aspects (e.g., a description of the calculation of the capital required and a necessity to assume the risks, the complete list of the comparable researched or the matrix of potential comparable not taken into consideration as well as the reason why these comparable were not taken into account).

Even if there is no mention in the Circular Letter, it is acceptable to consider that such a transfer pricing study is not required when the amounts at stake are small with reference to the principle of proportionality contained in the OECD guidelines.

Considering that the existing transfer pricing studies should, in large majority, be revised with respect to material or formal aspects, the Circular Letter mentions that any advance ruling issued before article 56bis LIR came into effect (i.e., before 1 January 2017) will no longer bind the income tax authorities as of 1 January 2017 for the tax years after 2016 and will require that a new request be filed for the group finance companies interested in the delivery of a new administrative decision pursuant to the new applicable rules.

1. Loi du 23 décembre 2016 concernant le budget des recettes et des dépenses de l’Etat pour l’exercice 2017, Mémorial A, n°276, 27 décembre 2016, p. 5323.

2. Free translation of the Circular Letter.

3. Règlement (UE) n°575/2013 du Parlement européen et du Conseil du 26 juin 2013 concernant les exigences prudentielles applicables aux établissements de crédit et aux entreprises d'investissement et modifiant le règlement (UE) n°648/2012, J.O.U.E., 26 juillet 2013, L 176.