Luxembourg is the second largest investment fund centre in the world.
Moreover, not only headquarters of important commercial and industrial
groups migrate to Luxembourg, and are keen to develop business directly
from the country, but also start-ups that benefit from a tax efficient
regime related to intellectual property (IP) and R&D incentives.
In this respect, the cross-border intra-group transactions reach a
level that is surprising compared with the size of the country. This
surprise is, however, not the only one that Luxembourg can offer to an
international group. The accelerated compliance to the transfer pricing
rules stated by the OECD and the EU is impressive in light of the status
of the country. Two years ago, except for very general provisions in
the law, no transfer pricing rule existed to regulate and set a fair
price on intra-group cross-border transactions carried out through
Luxembourg.
In mid-2012, what is the status of transfer pricing regulations and
practices in Luxembourg? How do the Luxembourg tax authorities develop
in light of both the non-written rules of a demanding financing market
but also the pressure and requirements of the OECD and EU? In a
nutshell, is Luxembourg still the attractive investment location it used
to be?
Intermediary financing activities: The approach of the market
On January 28 2011, the head of the Luxembourg direct tax authorities
published a circular addressed to Luxembourg entities performing
intermediary financing activities as their principal activity, circular
L.I.R. n°164/2 (the Circular). The objective of this Circular was
obvious; evidence that Luxembourg was following the international trend
with the introduction of transfer pricing rules covering intra-group
financial structures, which represent an important contributor to the
Luxembourg economy. More than one year after publication of the
Circular, the practice is now more or less harmonised in the Luxembourg
market and the approach of the tax authorities has matured.
Before detailing the present administrative practice, it is
worthwhile recalling two important characteristics of the Luxembourg
transfer pricing approach.
First, while a majority of foreign tax authorities concentrate on the
terms and conditions of the inter-company loans, including the interest
rate that is applied on such loans to avoid a non-arm's-length
reduction of the taxable basis of the tested company, the Luxembourg tax
authorities focus on the level of margin that is realised by the
Luxembourg company, i.e. the difference between the interest received
and the interest paid, working on the assumption that the arm's-length
character of the interest received has been justified in a transfer
pricing analysis abroad.
Second, the Circular requires that the taxpayers willing to obtain a
written approval on the arm's-length character of the remuneration of
their intermediary financing activity need to respect various criteria
that evidence a certain level of organisational and economic substance
(leading the taxpayers to be considered as having a real presence in
Luxembourg in the sense of the Circular). The economic substance is
ensured by the introduction of risk in the intermediary financing
transaction that needs to be covered by appropriate equity (retained
earnings and profits/losses of the year are excluded from the definition
of equity ). This risk needs to be at least 1% of the principal amount
of the debt receivable(s) of the Luxembourg company or €2 million ($2.5
million).
The Luxembourg transfer pricing practice is based on these two
specifications and has evolved over the past few months with one main
objective: it is of utmost importance to use internationally recognised
methods – be they OECD or economic methods – to gain and maintain
credibility on the new transfer pricing rules.
The margin is generally determined in two components:
- An annual fee remunerating the company for its loan management
functions mainly consisting of inter-company financing and on-lending,
administering the loans, receiving and paying interest according to the
relevant loan agreements in place, monitoring repayments of principal,
bookkeeping, administrative services to fulfil for example legal and tax
requirements. This annual fee is generally expressed as a function of
the loan(s) managed (in basis points applied on the principal amount of
the loan(s)) and is supposed to cover at least the operational expenses
of the company in relation to its intermediary financing activity.
- A remuneration of the risks assumed by the company. The operational
risk consisting for example of inadequate internal processes is
generally considered as low in light of the activity of the company.
Foreign exchange risks may occur but are in most cases either avoided
through matching terms of the loans (in particular the currency) or
various forms of hedges. The credit risk is the risk that is generally
supported by the company. To the extent possible, the credit risk is
limited to the minimum required by the Circular, in that 1% of the
financing volume or €2 million, in order to limit the remuneration of
the company and, as a consequence, its annual tax charge.
- Since the risks are covered by equity, the market is slightly
evolving towards the application of the capital asset pricing model to
determine the expected return on the equity at risk in the company so
the latter can obtain a reward adequate to the risks it bears. This
expected return is then referenced to the loan(s) made and also
expressed in basis points of the principal amount of the loan(s).
Both components are then added to obtain a global margin deemed to
remunerate the functions performed, assets used and risks borne by the
tested company. This margin can be adjusted, if necessary, based on the
OECD Transfer Pricing Guidelines and depending on the functions, risks
and assets used for the tested transaction.
This methodology is particularly followed in cases of companies
performing a standard intermediary financing activity in the sense that
their functions are limited to loan support and management, as detailed
above. If the functions are more extensive, for example, some cash
pooling activities or pure treasury activities that would for example
involve sales, trading, monitoring and management of risks, this general
scheme cannot be applied as such and more specific and tailor-made
transfer pricing studies will generally be required to take into account
a different functional and risk profile.
Intermediary financing activities: The approach of the Luxembourg tax authorities
The tax authorities have adopted a very formal approach in the review
of the compliance of Luxembourg resident companies performing
intra-group financing activities.
The real presence in Luxembourg of these companies is scrutinised
when they have asked for an advance pricing agreement on their margin.
With regard to the organisational substance, the most important
criteria that is systematically reviewed by the tax authorities is the
majority of board members that must be Luxembourg residents or must earn
at least 50% of their worldwide, taxable income in Luxembourg.
With regard to the economic substance, consisting in credit risk
assumed by the Luxembourg company and covered by equity, the approach
taken by the tax authorities is formal. The international groups
incorporating a company in Luxembourg to carry out intermediary
financing activities are generally able to minimise the credit risk
supported in Luxembourg to the minimum required by the Circular, in that
1% of the principal amount of the loan receivable(s) with a cap at €2
million. Thus, they are able to minimise the tax charge supported by the
Luxembourg company while respecting the condition set forth by the
Circular. In this respect, the preferred structuring of the Luxembourg
tax authorities is the following:
- The company introduces a specific limited recourse clause in its
loan payable agreement that limits its credit risk to the sums it
receives on its loan receivable and 1% of its financing volume with a €2
million cap or it concludes an agreement with a related or
non-related-party with a similar limitation of liability language.
Guarantees or derivative instruments such as credit default swaps can
also be envisaged even if they are less common in these kind of
intra-group structures. They are however clearly considered in the cases
where the Luxembourg company receives an external loan, or issues bonds
on the market for which it is hard to modify the terms and conditions,
for various reasons, of the debt instrument that has already been issued
or to transfer the credit risk to the creditor of the Luxembourg
company.
- If the company does not already have sufficient equity (that can be
invested in any asset of the company provided that the latter has a fair
market value of at least 1% of the loan receivable(s) of the company or
€2 million), it is obligated to increase its equity, preferably its
share capital or share premium, even though other non-distributable
reserves can be considered.
In cases where the risks of the company cannot be limited to the
minimum required by the Circular, the tax authorities refuse the
taxpayer's assumption that its risk is effectively the minimum of 1% of
its financing volume or €2 million. The latter needs to assess its
actual risk (for example, through the credit rating of its borrowers)
and determine an appropriate equity to cover such a risk. In this
respect, a computation based on the principles established by Basel II
can be envisaged, taking into account the four main risks the company
faces, being the operational risk, the credit risk, the foreign exchange
risk and the counterparty risk, and evaluating the level of equity that
is needed to support these risks. A value-at-risk approach, built on
the probability of default and the loss given default, can also be
considered to evaluate possible losses in case of default of the
borrowers of the Luxembourg company, leading to the default of the
company itself on its intermediary financing activity.
Even though this process may seem quite heavy, it appears that it
strengthens the Luxembourg intra-group financing structures since,
though minimal, some risks that were not assumed at all in the past are
now borne by Luxembourg companies which, in addition, increase their
equity to be able to support the consequences of the materialisation of
this risk. This reinforcement of the Luxembourg structure can explain,
to a certain extent, why it is so important for the Luxembourg tax
authorities that Luxembourg companies respect the economic substance
criterion of the Circular.
Surprisingly, even though the Circular requires that organisation and
economic substance be in place in Luxembourg only if a company would
like to confirm that its margins respect the arm's-length principle in
an advance pricing agreement, the tax authorities seem to expect that
all companies falling in the scope of the Circular respect the criteria
set by such Circular. In such cases where no advance pricing agreements
are requested by the taxpayers, the tax authorities will check upon
assessment of the corporate tax return whether the conditions set by the
Circular are respected. Consequences of non-compliance could, among
others, be the communication to foreign tax authorities that the company
under review has no real presence in Luxembourg, in that it is not the
beneficial owner of the interest it receives or the adjustment of the
taxable basis of the company upon assessment of its corporate tax
return.
It is clear that this expectation is linked to the fact that it is
essential for the Luxembourg tax authorities to highlight that the
intermediary financing structures implemented in Luxembourg respect
international standards and that, as such, Luxembourg is and remains a
worldwide, significant and truthful investment location.
Licensing activities and transfer of IP rights
The financing industry is clearly the leading industry in the
Luxembourg market and this mainly explains why the first transfer
pricing circular tackled intermediary financing transactions. However,
Luxembourg is also a prime location for IP structuring, in particular
since January 1 2008 and the effective implementation of the IP regime
providing for the exemption of 80% of royalty income and capital gains
derived from a large range of IP rights (article 50 bis of the
Luxembourg income tax law).
Under the IP regime, any transfer of IP should be done at fair market
value in order to benefit from the exemption and, thus, from a low
effective tax rate. Even though there is no specific documentation rule,
the Luxembourg taxpayers are globally following the trend whereby the
arm's-length character of more and more transactions is sustained in a
transfer pricing study, in particular when it comes to significant,
valuable transfer of IPs. In this respect, the Luxembourg approach does
not differ from the methods that are used abroad in countries that have
mature transfer pricing regulations.
Market, costs and income approaches are generally considered as the
most appropriate to evaluate an IP since the traditional and
transactional methods provided by the OECD guidelines are not reliable
in light of all factors that need to be taken into account for the
valuation of IPs that can be complex.
In practice, income approaches are always chosen in Luxembourg where
the fair value of the IP under review is computed based on the estimated
future benefits that could be derived over its remaining useful life.
In particular, two methods are often used:
- The multiple-period excess earning method that isolates the cash
flows attributable to a specific asset from the cash flows attributable
to the other contributory assets of the company in cases where a group
of assets jointly generate a cash flow stream. Charges are made for
intangible assets and working capital and all cash flows generated are
discounted to present value at the valuation date with a discount rate
that is determined for each asset, based on the weighted average cost of
capital and taking into account the various risks associated with the
cash flows of the relevant asset.
- The relief-from-royalty method is also often applied to value
patents and trademarks and this method clearly has an impact on the
development of the transfer pricing documentation of royalty flows in
Luxembourg. Indeed, this method is based on the notion that an acquirer
could have obtained similar rights through licensing instead of buying
the IP. Thus, the savings of the acquirer by buying rather than
licensing IP rights are represented by the avoided, tax-adjusted royalty
payments, knowing that the royalty rate is in principle based on rates
paid under licensing agreements of similar IP rights.
Therefore, the awareness of documenting not only the value of an IP
upon its transfer but also the arm's-length character of the royalties
received under licensing agreements increases among Luxembourg taxpayers
that are, to a certain extent, anticipating the future developments of a
more extensive transfer pricing regulation that could be published in
the next few years.
Thus, the practice is evolving: on the one hand led by taxpayers that
are used to documenting their intra-group transactions abroad and, on
the other hand by the Luxembourg tax authorities that require, for
certain significant taxpayers, to obtain transfer pricing documentation
before agreeing on the application of the IP regime for certain IP
rights.
In this respect, again, the tax authorities adopt a quite formal
approach in their review of the transfer pricing documentation that is
presented by taxpayers. They focus much more on the comparables that
have been chosen, the level of similarity with the tested asset, the
point in the range that is chosen by the taxpayer and the reasons why it
is considered as the most appropriate, rather than on the choice of the
method that is applied. This can probably be explained by the fact the
transfer pricing knowledge, and competencies of the Luxembourg tax
authorities, is still maturing and developing. What matters is that they
do not diverge from their constant objective: keep dialogue with
taxpayers to allow a transparent implementation of transactions on the
Luxembourg market.
Other developments
The easy access to European customers, the stable business
environment, the effectiveness of the taxation regime and the
multi-lingual workforce have an increasing impact on the choice of
Luxembourg as an attractive place not only for holding, financing and
licensing activities but also for any activities linked to commerce,
industry or the location of global headquarters.
The tangible consequence of this attractiveness is the involvement of
Luxembourg in the frame of worldwide business restructurings. Driven by
the attractive IP regime, some international groups set up a central
company in Luxembourg and transfer their global IP rights to the latter.
Upon restructuring the supply chain management of an international
group, Luxembourg is chosen to incorporate a company that acts as a
principal for contract-manufacturers or toll-manufacturers, limited-risk
distributors, commissionaires or agents that are located abroad. The
increasing importance of headquarters leads to the provision of
management, support or technical services from Luxembourg to foreign
companies.
In the context of business restructurings or implementation of
significant cross-border transactions, the taxpayers naturally document
that their transactions are at arm's-length, particularly to respect
foreign transfer pricing documentation rules and to avoid foreign tax
authorities challenging the restructuring of their group. This has a
positive impact on the Luxembourg transfer pricing practice. Indeed,
taxpayers are used to transparency with the Luxembourg tax authorities.
Thus, they are keen to present their global transfer pricing
documentation to the tax authorities in order to secure their taxation
in Luxembourg for example in an advance pricing agreement.
One of the consequences of these restructurings is that more and more
Luxembourg companies are involved in cross-border transactions that are
subject to scrutiny from foreign tax authorities. The latter may
challenge the transfer prices that have been set, leading therefore to
double taxation. In this respect, Luxembourg is experiencing more and
more requests from taxpayers to apply the EU Arbitration Convention
(90/436/CEE) or the mutual agreement procedure provided for by the
treaties concluded by Luxembourg with 64 foreign countries to avoid
double taxation. In case the taxpayer agrees with the adjustment
suggested abroad, the Luxembourg tax authorities may generally accept a
corresponding adjustment in their own tax assessments. It is only in
case the taxpayer disagrees that they enter into a more formal procedure
whereby the taxpayer is invited to provide its arguments against the
adjustment made by the foreign tax authorities.
These cases concern (at this stage generally) the financial business
but are expanding to commercial and industrial international groups.
As for the banking industry, cases related to the allocation of
profits to a foreign permanent establishment regularly arise. While, for
the funds that are constituted in Luxembourg, cases arise more
regarding general partners of funds set up in Luxembourg that have to
recognise an appropriate remuneration in relation to decision making
processes that are conducted by the general partner and any advisory and
other management activities that are performed on a regular basis.
The Luxembourg tax authorities provide almost only for unilateral
advance pricing agreements. These new developments may trigger new
practices with, for example, the conclusion of bilateral advance pricing
agreements that would avoid long-lasting and costly procedures in case
of disagreement – after agreement – between countries.
A business oriented approach
At first sight, the increasing importance in Luxembourg of transfer
pricing can appear as being a disadvantage for the country as a prime
location for international transactions. However, after a closer look at
the transfer pricing regulation and administrative practice, one can
easily conclude that Luxembourg still has a business oriented approach
that is necessary for the development of the country, while proving at
the same time that they are compliant with the basic transfer pricing
rules stated by the OECD and the EU. This business approach is
reinforced by the fact that in addition, taxpayers are also driving the
transfer pricing approaches since they are often willing to present
transfer pricing documentation to the tax authorities in order to secure
their structures and tax charge in Luxembourg, even though this
documentation is not formally required yet. This open practice is
probably the first step toward a more formal transfer pricing
legislation that would allow hamonisation of the market.
| Biography |
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Philippe Neefs
KPMG
Tel: +352 22 51 51 5531
Fax: +352 46 52 27
Cell: +352 621 87 5527
Email:philippe.neefs@kpmg.lu
Philippe Neefs has been partner with KPMG Tax Luxembourg since 2007.
He is in charge of Commercial & Industrial clients, and specialises
in the Luxembourg tax aspects of interposing Luxembourg vehicles to
structure holdings, IP and finance structures in various European and
non-European countries.
Neefs's professional experience includes cross-border tax planning
(holding, financing, intellectual property structures, private equity,
real estate structures, and distribution channels), merger and
acquisitions. He is a member of the International Corporate Tax, the
Merger & Acquisition and the Global Information Communication and
Entertainment tax networks of KPMG. He is, moreover, developing a
transfer pricing department as transfer pricing leader at KPMG
Luxembourg and is a member of the Global Transfer Pricing Services
network of KPMG.
Neefs has carried out some very important restructuring and merger
projects for US and continental European investors and multinationals
(also for some pharmaceutical groups). He has advised on both direct and
indirect taxation issues and has experienced several transfer pricing
studies mainly focused on industry and commerce but also on financial
services activities.
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| Biography |
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Sophie Boulanger
KPMG
Tel: +352 22 51 51 5423
Fax: +352 46 52 27
Cell: +352 621 87 5527
Email: Sophie.boulanger@kpmg.lu
Sophie Boulanger is a manager with KPMG Tax Luxembourg and has worked
for the firm since 2006. She mainly works for commercial and industrial
clients, and specialises in the Luxembourg tax and transfer pricing
aspects of interposing Luxembourg vehicles to structure holdings, IP and
finance structures in various European and non-European countries.
Boulanger's professional experience includes cross-border tax
planning (holding, financing, intellectual property structures, private
equity, real estate structures, and distribution channels) and merger
& acquisitions. She also participated in the creation of the
transfer pricing practice with KPMG Luxembourg.
Boulanger has worked on important restructuring and merger projects
for US and continental European investors and multinationals. She
advises on direct taxation issues and has undertaken several transfer
pricing studies mainly focused on industry and commerce but also on
financial services activities.
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