On 27 December, 2016 the Luxembourg Tax Authorities issued the new Circular LIR n°56/1-56bis/1 on the tax treatment of entities engaged in intra-group financing activities.
The new circular LIR n°56/1-56bis/1 (New Circular) responds to the introduction of the amended transfer pricing provisions into Luxembourg Income Tax Law (LIR) on 23 December, 2016 by means of Article 56bis, with the intention of clarifying the arm’s length principle as previously provided by the law.
Since 1 January 2017, the New Circular has replaced Circulars LIR n°164/2 and LIR n° 164/2 which were issued in 2011 to provide guidance on intra-group financing activities.
The New Circular provides practical guidelines on the application of the arm’s length principle to intra-group financing transactions and sets out the twofold comparability analysis to be performed.
Twofold Comparability Analysis
The twofold comparability analysis consists of:
Identifying the business or financial relations between related entities and thus determining the economically significant conditions and circumstances attached to such relations.
Comparing the economically significant conditions and circumstances of controlled transactions with transactions between non-related entities.
According to the New Circular, in order to perform intra-group financing activities, the following requirements must still be met:
Description of the role and function of the entities involved in transactions, the transactions’ characteristics and purpose, the assets used and the supported risks.
A minimum level of local presence/substance in Luxembourg.
The transactions’ specific economically significant risks must, however, be assessed and the level of equity determined on a case-by-case basis by using credit analysis methods. Consequently, the previous rule, which stated that equity at risk equalled at least 1% of the value of its loan receivables, capped at €2,000,000, is no longer applicable. An amount of equity that complies with the solvability rules of the European Parliament Regulation n° 575/2013 on prudential requirements for credit institutions and investment firms will be considered sufficient to cover the risk of a company engaging in intra-group financing activities.
In addition to the existing substance requirements, the New Circular states that companies must have qualified personnel to control the performed transactions. Companies may, however, outsource functions that do not have a significant incidence on the control of risks.
The process to identify the potential comparable transactions must be transparent, systematic and verifiable and all available data must be used for that purpose.
For companies that have financing activities similar to those of regulated entities (i.e. entities subject to EU Regulation n° 575/2013), a return on the equity at risk of 10% after tax is considered arm's length remuneration of the financing company. This percentage will be regularly updated by the tax authorities based on a relevant market analysis.
Intermediate financing companies with sufficient substance will be considered, for the purpose of simplification, as having arm's length transactions, if they report a minimal return of 2% after tax on their financed assets. This percentage will also be regularly updated by the tax authorities based on relevant market analysis.
Finally, the New Circular provides that from 1 January 2017 and for the following tax years, the advance pricing agreement taken before the introduction of article 56bis LIR no longer binds the Luxembourg tax authorities. Therefore, taxpayers must comply with the New Circular in 2017 and may introduce a new request for filing an advance pricing agreement, if necessary.
Companies currently engaged in intra-group financing transactions should review their transfer pricing documentation and be prepared to potentially increase their equity at risk and taxable margin. Additional guidelines and solutions should be available in accordance with the future practice of the Luxembourg Tax Authorities.