The Luxembourg direct administration published Circular L.I.R. n° 56/1 – 56bis/1 applicable to companies carrying out intra-group financing transactions (the Circular) on 27 December 2016. The Circular has replaced two existing circulars published in 2011 (the 2011 Circulars) and follows the introduction of the new article 56 bis of the Luxembourg income tax law on the application of the arm’s length principle.
The revamping of the Circular has been made in coordination with the European Commission and enables Luxembourg to adapt its legal framework to take into account the latest international and European tax developments. Other Member States will most likely need to adjust their internal legislation in the same manner within the coming months. The key points of the Circular are summarized below.
Luxembourg companies involved in new financing activities will have to comply with the rules set out in the Circular as from the implementation of the financing transaction in 2017.
Luxembourg companies already involved in intra-group financing transactions will have until 31 December 2017 to comply with the new rules of the Circular including the performance of a transfer pricing study to determine the appropriate amount of equity. As applicable, the equity of the relevant company will have to be increased and remunerated for transfer pricing purposes as from 1 January 2017.
Scope of the Circular
The scope of the Circular is the same as the 2011 Circulars. It covers entities carrying out intra-group financing transactions and refers to activities consisting of the granting of loan or cash advances remunerated by interest to related companies, whether financed internally or externally through instruments such as public or private debt issuances, cash advances or bank loans.
Application of the arm's length principle to intra-group financing transactions
The application of the arm’s length principle to intra-group financing transactions has to be in line with the comparability analysis included in paragraph 4 of the article 56 bis LIR and should therefore consist of two main elements:
Identification of commercial and financial relations between associated enterprises, and determination of economically material conditions and circumstances in order to delineate the controlled transaction;
Comparison of the controlled transaction with comparable transactions between independent enterprises and determination of the arm’s length remuneration.
The Circular further describes the analysis to be performed and the general principles applicable: (i) the economic reality of the transaction should prevail over the terms of the agreement, (ii) a functional analysis has to be carried out to identify the functions and responsibilities that are important in the context of the intra-group financing activities, and (iii) an analysis of the capacity to manage and to assume the risks in relation to its intra-group financing activities (and notably the existence of guarantees) has to be made.
Determination of the level of equity
The Circular has removed the possibility included in the 2011 Circulars to cap the equity at risk at 1% of the principal amount of the debt investments or EUR 2 million. In practice, this implies that the adequate level of equity for a given Luxembourg financing company will have to be determined on the basis of the comparability analysis envisaged above and substantiated by way of a transfer pricing study.
The Circular further provides that (i) if Luxembourg companies have a similar functional profile to the entities regulated under the EU Regulation n° 575/2013 of 26 June 2013 on prudential requirements for credit establishments and investments firms, and (ii) such companies have an amount of equity complying with the solvency requirements under this regulation, it is considered that these companies have enough capital to support the risks assumed. Furthermore, the Luxembourg tax administration indicates that it is considered that these companies comply with the arm’s length principle if their remuneration corresponds to a return on equity equal to 10% after taxes. The Luxembourg tax administration has reserved its right to regularly update this percentage based on a market analysis.
Simplification measures for pure intermediary entities
The Circular also provides for a simplified regime for financing companies exercising a pure intermediary financing activity. This regime would apply to companies with limited functions and risks, notwithstanding the number, amount, nature and other characteristics of the loans and cash advances that have been granted.
These companies will be considered to comply with the arm's length principle if a minimum after-tax return of 2% on the amount of the debt assets financed by way of debt is reported. The Luxembourg tax administration has reserved its right to regularly update this percentage based on a market analysis. Alternatively, the companies have the possibility to deviate from this simplification measure on the basis of a transfer pricing report. In addition, the Circular states that companies benefiting from the simplified regime will remain subject to the exchange of information with foreign tax authorities under applicable laws.
In light of the relatively high level of the return required under the simplified regime, it would probably be more beneficial for the taxpayers in most cases to prepare a proper transfer pricing analysis.
In order to be able to control the risks linked to its financing activity, the relevant Luxembourg company has to have a genuine presence in Luxembourg. More specifically, it should have the decision-making capabilities to execute the financing transaction and to monitor the risks i.e., to have qualified employees. For that purpose, outsourcing will only be possible to the extent that the company can determine the objectives of the external service provider, has the ability to monitor its performance and to amend or terminate the contractual relationship.
Furthermore, the Circular provides for a list of basic substance requirements which encompass notably that key decisions must be taken in Luxembourg, the fact that the majority of the board members must be Luxembourg residents and that the finance company must not be considered as a tax resident of another country.
Advance pricing agreements
The existing advance pricing agreements are no longer binding on the Luxembourg administration from 1 January 2017. No grandfathering period has been granted.
The procedure to obtain an advance pricing agreement remains unchanged. However, it should be noted that the Circular sets out a more detailed list of information requirements in the case where the taxpayer intends to obtain an advance pricing agreement from the Luxembourg tax administration (e.g., qualifications of the employees and a description of their functions, financial projections for the years covered by the advance pricing agreement, list of comparables including those which have been rejected and the reason for their rejection…).