Luxembourg is a small country in the heart of Europe. Despite its size, it is one of the key global hubs in the funds, banking, capital markets and insurance sectors, as well as being a primary location for intra-group financing and treasury related activities.
The fundamental changes to the international tax landscape arising from the BEPS initiative spearheaded by the OECD has seen transfer pricing (TP) move into the spotlight across most jurisdictions, including Luxembourg. The aim of the BEPS initiative was trifold:
- To align taxation with the economic activity that produces such profits more closely;
- To increase the level of transparency for tax authorities to better direct their audit activities; and
- To increase the coherence of international tax frameworks moving from the historic focus of double taxation avoidance to the avoidance of low or non-taxation.
This is in addition to other factors such as Brexit (with the subsequent transfer of activities into Europe and question of a potential exit tax, as well as an ongoing focus on tax competition in Europe), and a trend towards regulated structures in the alternative asset management sector, which have all raised the level of attention around tax and TP.
In this article, the authors take a closer look at recent key trends in the TP landscape in Luxembourg and its impact on the financial services sector, given its importance to the Luxembourg market.
Luxembourg's TP landscape
In December 2016, Luxembourg amended its tax code by explicitly including the arm's-length principle in its income tax law. Since then, we have seen additional guidance in the form of a circular on the TP aspects of intra-group financing activities.
In addition, we have seen more dedicated resources from Luxembourg tax authorities, especially focusing on TP audits as part of its 'division revisions'.
Regulators [in Luxembourg] have started focusing more on TP probing existing policies, agreements and documentation as an indicator of proper management of regulated entities
In 2018, the Luxembourg tax authorities started a campaign, sending out requests (outside the context of formal tax audits) to a range of financial institutions and asset managers requesting evidence of their arm's-length adherence (i.e. in form of policies, agreements and documentation), and of their intra-group transactions and/or dealings that involve Luxembourg.
The focus of this campaign was likely to identify the level of readiness of the financial services sector with respect to the upcoming challenges, obtain clarity on what could be referred as the governance structure with respect to tax, and the involvement of Luxembourg in the relevant tax related organisation and processes.
We have also seen that the regulators/supervisors (such as the Commission de Surveillance du Secteur Financier in Luxembourg, and pan-European regulators/supervisors such as the European Banking Authority or European Securities and Markets Authority), have started focusing more on TP, probing existing policies, agreements and documentation as an indicator of proper management of regulated entities.
These are only few of the indicators illustrating a clear trend in focus on TP.
TP in the financial services sector
There is a lot of discussion about the future of TP in the financial services sector. Some of the key themes triggered by the BEPS initiative specifically relate to the defensibility of existing TP approaches, mainly specific to the asset management sector covering so-called one-sided approaches.
As part of a one-sided approach, a captive management company (ManCo) would typically remunerate related parties for the performance of delegated functions. In this context, only the transaction(s) and/or dealing(s) between the ManCo and its foreign related parties (or branches) performing the delegated functions would be tested, while any residual income that is being retained by the ManCo would not be further examined vis-à-vis the functions performed, risks borne or the delegation model applied by the ManCo.
However, under a two-sided model, both the remuneration retained by the regulated ManCo, as well the remuneration paid for by the provision of delegated functions would be tested. This would reflect the spirit of the OECD BEPS initiative by allocating profits along the value chain based on economic activity and value creation.
Other key impacts of the BEPS initiative relate to the revised thresholds for the recognition of permanent establishments (PEs), how to reconcile different notions regarding the allocation of risks from an economic and regulatory point of view, as well as the rise of intangibles in the financial services sector.
The question of TP treatment of intangibles is becoming more relevant given the large-scale investments into back, middle and front office related software applications/platforms in the industry, and a broader notion of intangibles under the BEPS initiative. The latter has led to challenges in the recognition of intangibles in the financial services sector as well as what could be considered constituting an arm's-length remuneration.
Already today, various tax authorities have started to scrutinise more closely transactions in the financial services sector, and as they are gaining more experience, it is expected to further increase their focus on the sector in the future. The tax controversy challenge is likely one of the two key challenges facing TP and the financial services sector and Luxembourg in the future.
Tax controversy challenge
There are a number of reasons why tax controversy is the first challenge for the financial services sector in Luxembourg.
On one hand, many tax authorities still lack the relevant experience and technical expertise in the financial services sector. As a result, certain tax authorities have relied on rather formalistic criteria (i.e. whether reasonable efforts were made to document the arm's-length nature of transactions, the non-documentation of certain transactions, the non-recognition of a PE, or the lack of sufficient cooperation under audit) as basis for their assessments invoking, for example, presumptive taxation. Other tax authorities in the past decided to focus on less complex transactions, such as the provision of intra-group services instead.
The question of TP treatment of intangibles is becoming more relevant given the large-scale investments into back, middle and front office related software applications/platforms in the industry
On the other hand, it should not be a surprise that financial regulation often influences the set-up of operating models in the financial sector. Common examples include the use of regulated ManCos for the fund production (under a cross-border delegation/distribution model), centralised booking models for global trading in banking (to encourage the efficient use of regulated capital), and underwriting with a regulated insurance carrier across different jurisdictions using a framework of passporting.
The common denominator is their reliance on centralised operating models, where one regulated entity (e.g. in Luxembourg) engages with a number of related (or unrelated) parties across a range of jurisdictions based on a delegation model. The result is that Luxembourg is the legal counterparty for most of these related party transactions or dealings and – in case of tax controversies – would need to reconcile the outcome of any foreign-triggered tax assessments. Given that the amounts at stake are often quite material, the large number of jurisdictions involved and that any potential double or multiple taxation cases need to be resolved with Luxembourg shows the importance of the tax controversy challenge.
Given the heavy reliance on centralised operating models in the financial services sector, it is important for both taxpayers and tax authorities to address potential tax risks upfront to avoid an increase in the number of tax audits, and any subsequent controversies that may arise.
Advanced pricing agreements
One of the new dispute prevention tools that is available in Luxembourg are bilateral and multilateral advanced pricing agreements (APAs).
In the past, taxpayers in Luxembourg typically relied on unilateral arrangements (mainly rulings) with the local tax authorities to obtain certainty on the tax treatment of their respective transactions or dealings. Due to a range of factors (including the mandatory exchange of rulings) and the increased uncertainty triggered by the BEPS initiative, there has been a decrease in the number of rulings across many jurisdictions. As such, this has left taxpayers, particularly in Luxembourg, with some uncertainty regarding their TP position.
A new option for dispute prevention that has emerged recently in Luxembourg relates to bilateral and multilateral APAs where the first cases ever are currently being negotiated in the financial services sector. Both APAs are available on the basis of mutual agreement procedures (MAP) contained in Article 25 of the respective double taxation agreement.
Unlike other jurisdictions where there is no formal/dedicated APA program in Luxembourg, the Luxembourg tax authorities issued Circular LG–Conv DI 60 in August 2017, providing additional guidance related to MAPs specific to TP, which can also be applied for bi-/multi-lateral APAs.
Tax governance challenge
Tax governance is the second key challenge for the financial services sector and Luxembourg.
We already outlined that one of the common denominators of the operating models across today's financial services sector is that these often rely on a centralised operating model, where one regulated entity engages with a number of related (or unrelated) parties across a range of jurisdictions.
Given the heavy reliance on centralised operating models in the financial services sector, it is important…to address potential tax risks upfront to avoid an increase in the number of tax audits
Jurisdictions such as Luxembourg, which serve as the counterparty to a range of group internal transactions and jurisdictions (often covering hundreds of transactions and dozens of jurisdictions that all link back to Luxembourg as counterparty), could have an impact on the regulatory position of regulated entities in Luxembourg covering aspects such as financial stability, reputation, capitalisation and liquidity.
As such, there is a genuine interest by regulators and supervisors on tax/TP to ensure that the interaction between the tax and regulatory dimension is properly considered.
Taxpayers will need to respond to the controversy and governance challenge by considering the following:
- Are key regulated entities (especially those under centralised operating models involving Luxembourg) sufficiently integrated from a tax governance perspective, particularly with respect to setting TP prices, their implementation/documentation, and managing potential tax audits/controversies?
- Are TP policies defendable in light of BEPS and recent changes in the financial services sector;
- Do TP policies exist, and are they consistently implemented/monitored;
- Does TP documentation exist, and is it aligned with the messaging of the regulatory position;
- How are tax audits managed to avoid potential inconsistencies in the overall TP model; and
- Is management aware of the different options available for dispute prevention and dispute resolution ranging from domestic appeals, MAPs and/or APAs, especially considering the new option of bilateral and multilateral APAs in Luxembourg?
It can be seen that the BEPS initiative has had a major impact on the defensibility of certain existing TP approaches, especially in the financial sector.
In addition to tax authorities, an increasing number of regulators/supervisors are also probing TP as an indicator of proper management of regulated entities, so the topic is not only relevant for tax professionals, but also for other stakeholders outside the tax function.
Tax controversy management has to begin well before the start of any tax audit. It begins with defensible TP policies that are aligned with the new reality under BEPS, and continues to their proper implementation, monitoring and documentation of tax audits.
Given the heavy reliance on centralised operating models in today's financial services sector, it is essential for both taxpayers and tax authorities to address potential tax risks upfront to avoid an increase in the number of tax audits and subsequent controversies that will be challenging to mitigate in the future.
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Partner, Transfer Pricing
T: +352 45145 3313
Ralf Heussner is a partner with Deloitte Luxembourg. He specialises in the financial services sector and is part of Deloitte's global financial services transfer pricing (TP) leadership. Ralf has worked for many of the key players in the asset management industry (ranging from traditional to private equity, real estate, and hedge funds), and the banking and insurance sectors during his prior tenure in Frankfurt, Hong Kong, and Tokyo. Over the last 17 years, Ralf gained extensive experience advising clients on a range of TP challenges, valuations, international tax, and value chain alignments.
Ralf's experience covers TP planning and policy setting, risk reviews, operationalisation, documentation, restructurings, and dispute resolution engagements. He has worked on more than 30 advance pricing agreements and numerous high profile controversies on both the local and competent authority levels with the authorities in China, the EU, Japan, the US, and other key jurisdictions.
Ralf is a frequent speaker at tax seminars, has participated in government consultation projects about tax reform, and has contributed to thought leadership on TP issues.
Director, Transfer Pricing
T: +352 45145 2504
Enrique Marchesi-Herce is a director with Deloitte Luxembourg. He specialises in advising multinational enterprises in terms of designing and implementing their transfer pricing (TP) policies and assisting with documentation. With more than 11 years of experience, Enrique has led a wide array of complex TP projects including IP valuation, value chain alignment, global documentation and other tax planning projects.
He has worked on multiple advance pricing agreements for multinationals in the automotive and financial services industries, and participated to complex tax audit disputes (negotiation, mediation and litigation), notably assisting a leading telecom group in the defense of its TP position in Spain.
Recently, Enrique has focused on the financial services sector, advising a wide range of clients such as private equity, management companies, funds, banks, and asset management firms. He has assisted key players in complex tax matters including TP planning, negotiations with local tax authorities, assessment of the BEPS-impact on existing structures, and alignment of TP policies from a tax and regulatory perspective.
As a TP specialist, Enrique regularly presents at tax seminars and contributes to Deloitte's publications.