Luxembourg’s sharpened tax rules for intra-group financing
On December 27 2016, the Luxembourg Tax Authorities (LTA) published a circular, L.I.R. no 56/1 – 56bis/1 (Circular) designed to position the seminal principles of the OCED TP Guidelines (i.e. the arm’s-length principle, comparability and substance over form) as the framework of reference when establishing the capital structures and the remunerations of financing vehicles in Luxembourg. With an effective date of January 1 2017, the Circular has left virtually no time for taxpayers to adjust to this new paradigm while many questions regarding the scope, implementation and implications remain unanswered.
By Loek de Preter, transfer pricing leader, and Christophe Hillion, partner, PwC Luxembourg
There are three categories of requirements, that (i) the majority of the key decision makers need to be tax residents of Luxembourg, (ii) the company needs to employ personnel able to manage and control the transactions and, (iii) the company is not a resident of another state. In addition, evidence that board members are involved in transactions’ flows must be demonstrated (i.e., merely signing off a financing structure will not suffice). To date, the substance requirements stipulated in the Circular imply, among other things, that the totality of the board members of Luxembourgish companies performing financing activities within the scope of the Circular need to be physically present in Luxembourg when key financing decisions are made. Such requirements, especially when imposed on companies with limited financing operations, could place an inordinate administrative and logistical burden on taxpayers, which, to the extent possible, should be avoided (refer to the OECD TP Guidelines, § 4.98 that states that the complexity connected to the application of the arm’s length principle “may be disproportionate to the size of the corporation or its level of controlled transactions”).
In that respect, having the possibility to delegate boards’ signing authorities under very specific guidelines should be further explored to alleviate concerns vis-à-vis substance requirements. Finally, a failure to meet the Circular’s substance requirements might trigger an exchange of information procedure with the tax authorities of the foreign counterparties to the transactions under scrutiny. They may see this as a start to challenge the beneficial ownership status of the Luxembourgish entity.
Equity at risk and its remuneration
With respect to the determination of levels of equity at risk and their remunerations, the LTA has expressed preferences for the application of an expected loss model approach, which weighs the probability of default of an instrument by its expected recovery rate, (because of its intuitiveness of implementation) and industry specific benchmarks respectively. When a Luxembourgish financing company engages in the extension of many instruments to multiple related parties, the application of the expected loss model would then be run on a portfolio approach basis, adding layers of complexity. However, for entities akin to regulated financing and treasury entities, a “safe harbour rule” applying a 10% return on equity as of the time of publication of the Circular may be considered.
Armed with this guidance, taxpayers might, however, still end up in a position where reconciling the results of the expected loss model with the actual functions, risks and substances of their Luxembourgish entities will be necessary. A value chain analysis of the group to which the Luxembourgish entity belongs could be construed as a solution, albeit a time consuming one. Likewise, relying on industry data for the return on equity determination might lead to unreliable results as such data will most likely suffer from comparability issues. Potential solutions, although perceived as sub-optimal by the LTA at this time, range from adjusting the comparable data to relying on theoretical pricing models.
Taxpayers with Luxembourgish financing structures must review those structures and assess their levels of audit readiness in light of the standards set by the Circular. In-depth functional and economic analyses of those structures adequately documented along with the active involvement of boards will be critical to meet the LTA’s expectations. What’s more, such analyses and documentations would prove very useful in the context of a state aid and/or deemed dividend distribution challenges related to these Luxembourgish financing structures.
Loek de Preter