Luxembourg levels the playing field for intra-group activities

Circulaire LIR 56/1 – 56bis/1, applicable from January 1 2017, introduces the arm’s-length principle based on Actions 8-10 of the OECD’s BEPS Project, taking into account the latest international and European tax developments and provides guidance on the TP framework. It focuses on the importance of applying the arm’s-length principle and offers substantial guidance on how to conduct such analysis in line with the OECD’s guidelines. Failure to comply with this obligation may give rise to adjustments to the taxpayer’s taxable income.

The circular applies to Luxembourg companies performing intra-group financing transactions, but does not include holding activities. It does, however, emphasise that intra-group financing companies need to have the capacity to assume and manage risks.

Raymond Krawczykowski, head of tax at Deloitte in Luxembourg, said that this was good news for Luxembourg’s taxpayers. “It is an extremely positive development for Luxembourg, both in terms of attraction and retention of headquarters and treasury centres as well as in terms of building a financial centre,” Krawczykowski said. “Benefits is a pragmatic, sustainable and OECD-rules proof platform for their developments in this new challenging tax environment.”

The circular was published after a new article was introduced into the Luxembourg Income Tax Law (LITL). It replaces Circulaires 164/2 of January 28 2011 and 164/2bis of April 8 2011.

Philippe Neefs, a partner and head of private equity at KPMG in Luxembourg, said the new circular is part of the government’s willingness to have a level playing field for intra-group activities. “By documenting such intra-group financing activity as being part of the global value chain of a multinational enterprise, this will also give more comfort for having such intra-group activity carried out from Luxembourg,” Neefs said.

The scope of application and the definitions of the new circular are similar to the old circulars. It defines intra-group financing activities as all interest bearing lending to related companies, irrespective of how the funding is financed (i.e. intra-group loan, bank funding, etc.).

However, it makes some amendments to the way equity at risk is defined, provides guidance on the application of arm’s-length principle to intra-group financial transactions, explains changes to advance pricing agreements (APAs), and provides, for the first time, safe harbour margins.

The circular amends the guidance on equity at risk. The old circulars said that the equity at risk must be assessed further to the functions, assets and risks assumed, but considered a minimum amount of €2 million ($2.1 million) or 1% of the equity at risk to be adequate. The new guidance states that the appropriate amount of equity at risk should be determined on a case-by-case basis.

Neefs said that intra-group financing entities will have to perform an analysis to determine the necessary capital at risk that corresponds to its functional profile, using the widely accepted methodologies in this area. “The new circular prescribes some substance requirements, not critically different than in the past, in order to be able to control those risks,” Neefs said.

“One important point is that transactions can be disregarded if those cannot be observed between independent parties and if no commercial rationale can be identified. However, it does not mean that transactions that cannot be observed between independent parties have automatically no commercial rationale” Neefs added.

“The increase in the equity at risk should provide more substance to Luxembourg structures and should decrease the potential beneficial ownership disputes in foreign jurisdictions,” said Eduardo Trancho, tax adviser at Van Campen Liem in Luxembourg.

The circular also sets out the necessary criteria to compare a controlled intra-group financial transaction to a transaction realised in an open market under the same conditions to ensure that the transaction meets the arm’s-length principle. The circular states that the comparability analysis consists of two elements:

1.       Identifying commercial or financial relations between the associated enterprises and determining economic conditions and circumstances that relate to these relations in order to delineate the controlled transaction; and

2.       Comparing the economically significant conditions and circumstances of the controlled transaction accurately with comparable transactions between independent enterprises.

The new guidance explains that APAs issued before January 1 2017 should no longer be binding from the 2016 fiscal year. However, the new circular affirms the possibility of applying for new APAs. It also outlines what information must be included in a request for an APA by an intra-group financing company. This includes employee information, countries affected by the financing transactions, information on the parties involved and a TP analysis.

Companies engaged in intra-group financing activities must report an arm’s-length margin, which must be assessed further to the functions, assets and risks assumed.

The circular does, however, provide two safe harbours:

1.       An after-tax safe harbour margin of 10%, which must be assessed on the equity at risk; and

2.       An after-tax safe harbour margin of 2%, which must be assessed on the financing granted to related parties.

“The safe harbours provide high legal certainty to investors while giving rise to a manageable tax liability,” said Trancho. “These should be regularly updated by the Luxembourg tax authorities in order to reflect market changes.”