The Luxembourg tax authorities (“LTA”) have released circular L.I.R. 56/1 - 56bis/1 of 27 December 2016 on the tax treatment of Luxembourg-resident companies that carry out intra-group financing activities (“Circular”), which replaces the two related 2011 circulars (Cicular L.I.R. n°164/2 of 28 January 2011 and Circular L.I.R. n°164/2bis of 8 April 2011) with effect from 1 January 2017.
The Circular aims to be more consistent with the OECD transfer pricing guidelines that were initially introduced into domestic legislation with article 56 of the Luxembourg income tax law (“LITL”) referring to the arm’s length principle together with the said 2011 circulars.
The Circular notably refers to the newly adopted article 56bis which provides a legal framework for the comparability analysis performed by a financing company to determine arm’s length pricing. Article 56bis LITL was introduced by the Luxembourg law of 23 December 2016 on the 2017 budget, which applies as from 1 January 2017, and transposes into Luxembourg law actions 8-9-10 of the OECD BEPS report, aimed at aligning the transfer pricing outcomes with value creation.
The Circular also focuses on certain substance obligations, and removes the equity at risk rule (1% of the principal amount of the loans or EUR 2 million), which will now have to be determined on the basis of the comparability analysis, as evidenced in a transfer pricing study.
Most importantly, the Circular states that existing advance pricing agreements (“APAs”) are no longer binding on the LTA as from 1 January 2017. Luxembourg companies intending to secure their transfer pricing policy after this date will need to apply for a new APA.
Under the Circular, an intra-group financing activity involves a Luxembourg-resident company granting interest-bearing loans or advances to related enterprises, refinanced by financial means and instruments such as public debt issuance, private loans, advances or bank loans.
The Circular also states that where a transaction between related parties does not have a commercial rationale (i.e. if independent parties would not have entered into the transaction), the said transaction may be disregarded along with the related tax implications.
However, it is important to note that not falling within the scope of the Circular for a Luxembourg company does not mean the company has no obligation to comply with any arm’s length price.
New guidelines on the application of the arm’s length principle to intra-group financing transactions
The Circular provides guidelines regarding the requirements an intra-group financing company must perform to determine arm’s length prices. This notably includes a comparability, a functional and a risk analysis.
The comparability analysis is based on two main elements:
1. First, the identification of the commercial or financial relations between associated enterprises and the determination of the conditions and relevant economic circumstances associated with these relations so that the controlled transaction is precisely delineated.
In this respect, the Circular states that the role and conduct of the related parties is critical. Consequently, economic reality prevails over the contractual terms of the agreement.
2. Secondly, the comparison of the conditions and the relevant economic circumstances of the precisely delineated controlled transaction with comparable transactions between independent parties.
The Circular provides further details in this respect and states that the said relevant economic circumstances of a financing transaction are necessarily closely linked to commercial relations existing between the associated enterprises and the economic strategies they implement.
The functional analysis aims to identify the relevant economic activities, responsibilities and functions, assets used or provided and the risks borne by the parties related to a financing transaction. These functions notably include the creation and management of a financing transaction.
The Circular reiterates the importance of intra-group financing companies having the financial capacity to assume and manage the risks they face in the same way financial institutions would in an open market.
Financing companies should be able to assume and manage such risks to the extent they have sufficient substance in Luxembourg. The effective capabilities of such companies must be evidenced (e.g. qualified employees to manage and control the transactions).
Required amount of equity
As mentioned above, the Circular removes the former equity at risk rule and imposes the performance of a comprehensive risk analysis in order to determine the adequate level of equity.
In order to determine the arm's length price, a controlled transaction must be compared with an uncontrolled transaction. In the case of a situation comparable with financial institutions governed by European Regulation (EU) N°567/2013 of 26 June 2013 on prudential requirements for credit institutions and investments, the LTA appear to consider that a return on equity for an intra-group financing company amounting to 10% after tax would be acceptable (such a rate being subject to regular revisions by the LTA based on market changes).
Under certain conditions and as a simplified measure, the LTA appear to consider that a return on equity for a company pursuing a purely intermediary intra-group financing activity amounting to 2% on the financed assets after tax would be acceptable (such a rate being also subject to regular revisions by the LTA based on market changes). To the extent this simplified measure applies, the transaction will be subject to the exchange of information.
The Circular emphasises the substance requirements of the company. It imposes a higher level of related expertise from the managers of any entity engaged in intra-group financing, in order to evidence that they have adequate decision-making and risk-monitoring capabilities.
Content of the APA request
Any APA request should include the following (cumulative) information (non-exhaustive list):
- the precise name of the requestor and the entities or branches involved in the transactions or arrangements which are covered by the request;
- a detailed description of all intra-group financing transactions relating to the company and the legal arrangements referred to in the request;
- the qualifications of the employees and the description of their duties;
- the other country/countries concerned in the transactions or arrangements;
- a presentation of the legal structure of the group as well as information on the beneficial owner of the equity of the requestor;
- the fiscal years set out in the request;
- a transfer pricing study in accordance with the principles set out under the Circular and as recommended by the OECD (the Circular indicates the main information to provide in this respect);
- a statement that information required to assess the facts is complete and in line with the facts.
The implementation of the Circular requires revisiting current transfer pricing policies and documents of Luxembourg financing entities in order to adapt to the new principles and obligations embedded in this new set of rules.