In our article in last year’s edition we presented the consequences of the new Article 56bis of the Luxembourg Income Tax Law (LITL), as well as of the new Luxembourg Transfer Pricing Circular of December 27, 2016 (the Circular), both effective from January 1, 2017. Both documents provide additional guidance on the application of the arm’s length principle, and transpose OECD/G20 Base Erosion and Profit Shifting (BEPS) Actions 8-10.
While Article 56bis of the LITL describes the contents of the comparability analysis, the Circular clarifies the transfer pricing rules applicable to intra-group financing activities and, in particular, the requirements of organisational and economic substance in Luxembourg.
In terms of organisational substance, in order to be able to control the transactions and risks, the financing company should have a real presence in Luxembourg, i.e. not only office, telephone and computer, but qualified personnel (either a qualified, possibly part-time, employee or a qualified board member) with a good understanding of the transactions, such as having a background in finance, treasury and audit.
Regarding economic substance, in order to have the financial capacity to assume the risks, an analysis to determine the necessary equity to cover the assumed risks needs to be carried out on a case-by-case basis by using widely accepted methodologies. The level of equity at risk depends on the functional profile of the respective company.
Generally, to determine the minimum level of equity at risk, an expected loss (EL) framework is applied stating the minimum equity a company should maintain. During 2017 and 2018 so far, most companies in Luxembourg have adapted to these new requirements, in view of which they have updated their transfer pricing documentation to be in line with the Circular.
In the framework of the law on non-public country-by-country reporting (CbCR) of December 27, 2016, transposing EU Directive 2016/881 of May 25, 2016 into domestic law and reflecting OECD/G20 BEPS Action 13, a project of grand-ducal regulation was published on June 15, 2018 including a list of the countries who have signed the Multilateral Competent Authority Agreement (MCAA) on exchanges of information regarding CbCR for 2016 and 2017 with Luxembourg.
Notably, China does still not exchange information with Luxembourg. However, we expect China to sign the MCAA for exchanges of information in the coming months.
According to the CbCR legislation in place, constituent Luxembourg entities must either file the CbC report with the LTA or inform the LTA about the other country in which they have filed it in order to enable the LTA to exchange information.
As the first CbC reports and/or notifications had to be filed in 2017 for the financial year 2016, most Luxembourg companies have filed the CbC reports or notifications themselves, though some have engaged their advisers to do so.
Following the repeal of Article 50bis of the LITL, regarding the intellectual property (IP) box regime as being non-compliant with BEPS Action 5, the law introducing a new Article 50ter of the LITL was published in 2018, with effect from financial year 2018. The new law encompasses the nexus approach introduced by BEPS Action 5, connecting the benefit of the income tax exemption with the R&D costs incurred while taking into account the concept of DEMPE (i.e. development, enhancement, maintenance, protection and exploitation) functions introduced by BEPS Action 8.
The LTA added, to Form 500 of the tax returns for fiscal year 2017, new transfer pricing disclosure requirements to improve the tracking of intra-group transactions in which Luxembourg taxpayers are engaged. The latter have to indicate whether they are involved in intra-group transactions and whether they have chosen the simplification measure for intermediary, intra-group financing activities. In cases where taxpayers are involved in such intra-group transactions and have not chosen the simplification measure, the LTA may request the respective transfer pricing documentation.
More recently, following the publication of the EU Anti-Tax Avoidance Directive (ATAD 1) on July 12, 2016, which EU Member States must transpose – at least most of the provisions – into their domestic laws by December 31, 2018, the Luxembourg Government submitted on June 19, 2018 a draft bill (n°7318), previously approved by the Government council on June 15, 2018, to the Luxembourg parliament that would implement ATAD 1 as Luxembourg domestic law. Among other measures, the draft law introduces a new Article 164ter into the LITL, providing for new controlled foreign company (CFC) rules in line with Articles 7 and 8 of ATAD 1.
In this respect, Luxembourg has opted for option B, as foreseen by Article 7 (2) (b) of ATAD 1, consisting of taxing non-distributed income of CFCs arising from so-called “non-genuine arrangements”, which have been put in place for the essential purpose of obtaining a tax advantage.
Based on the draft new Article 168ter, an arrangement or series of arrangements should be regarded as non-genuine to the extent that the CFC would not own the assets or would not have undertaken the risks which generate all, or part of, its income if it were not controlled by a Luxembourg company whose significant people functions (SPFs) linked to those assets and risks are carried out and play an essential role in generating the controlled company’s income.
The draft new Article 168ter of the LITL specifies that the allocation of profit to the controlling company should be made according to the arm’s length principle enshrined in Article 56 of the LITL. In this respect, the exact relationship between the new Article 168ter and Article 56 still needs to be further clarified during the legislative process.
All these developments highlight the increasing focus on transfer pricing in Luxembourg. Therefore, in order to be prepared for potential tax enquiries from the LTA, we strongly recommend to seek guidance and to consider preparing appropriate transfer pricing documentation to stay on the safe side.
Philippe Neefs is a partner and Luxembourg transfer pricing leader at KPMG Luxembourg.