March 23 2012

Transfer pricing rules for intra-group financing transactions

Arendt & Medernach | Corporate Tax - Luxembourg

Thierry Lesage, Alain Goebel

Introduction
First circular
Second circular


Introduction

Luxembourg has traditionally been a hub for intra-group financing transactions. In 2011 new transfer pricing guidelines, which are in line with the Organisation for Economic Cooperation and Development (OECD) standards, were introduced in order to clarify administrative practice and further strengthen Luxembourg's position in this respect.

The transfer pricing rules for intra-group financing transactions were introduced by way of two circulars issued by the tax authorities:

  • Circular LIR (164/2), issued on January 28 2011, introduced transfer pricing guidelines for the determination of the arm's-length character of intra-group financing transactions. This circular also governs the prior clearance thereof through advance transfer pricing agreements. The rules are based on Article 9 of the OECD Model Convention on Income and Capital and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
  • Circular LIR (164/2 bis), issued on April 8 2011, clarifies the entry into force of the new guidelines.

First circular

The first circular covers the scope of the new rules, the determination of the arm's-length price and the conditions under which an advance transfer pricing agreement may be established.

Scope
Transfer pricing rules apply to any entity that is principally engaged in intra-group financing transactions. In order to determine what is considered as principal activity, activities related to the holding of participations are disregarded. 'Intra-group financing transactions' are defined as the granting of loans or the advancing of funds to affiliated enterprises and their refinancing through financial instruments (eg, public issuances, private borrowings, advances or bank loans). Two enterprises are considered to be affiliated if one of them participates directly or indirectly in the management, control or capital of the other, or if the same persons participate directly or indirectly in the management, control or capital of the two enterprises.

Determination of the arm's-length price
The functions assumed by companies engaged in intra-group financing transactions are comparable to those assumed by independent financial institutions. Hence, the determination of the arm's-length price should follow the remuneration charged by these institutions for comparable credits (ie, it should be based on an individual risk analysis and take into account related costs). The risk analysis usually includes a review of the borrower's annual accounts, guarantees, duration of the loan, relevant industry and the terms and conditions of the loan. Related costs include the base costs of the financing and supplements (eg, costs incurred by solvency requirements, credit risk, handling costs or foreign exchange costs). Remuneration is generally fixed in relation to either the amounts borrowed or the fair market value of the assets under management.

Accordingly, companies engaged in intra-group financing transactions should undertake a prior risk analysis and consider any other relevant factors that may influence the determination of the transfer price.

In addition, the company must have an appropriate amount of equity (share capital/premium) in order to be able to assume the risks involved.

Conditions for advance transfer pricing agreement requests
The tax authorities will provide binding information on an advance transfer pricing agreement request only to a company that has a genuine presence in Luxembourg and assumes the risks related to the financing transaction.

Substance requirements
A genuine presence requires the fulfilment of the following conditions:

  • The majority of the board members, directors or managers having power to bind the company must be Luxembourg residents, or non-residents which pursue a professional activity (ie, a business, agricultural/forest, independent or salaried activity) in Luxembourg and who are taxable in Luxembourg for at least 50%. In case a company is part of the management board, it must have its statutory seat and central administration in Luxembourg.
  • Board members, directors or managers which are either Luxembourg residents or non-residents that realise at least 50% of the above-mentioned profits in Luxembourg (in case of individuals), or have their statutory seat and central administration in Luxembourg (in case of companies), must possess appropriate professional knowledge to exercise their functions. They must further have at least the capacity to engage the company's liability and ensure the proper execution of all transactions. The company must have qualified personnel (either its own employees or external staff) capable of executing and registering the transactions performed. The company must ultimately guarantee the supervision of the work executed by the staff.
  • Key decisions regarding the management of the company must be taken in Luxembourg. Companies that are required by corporate law to hold shareholders' meetings must hold at least one annual meeting at the place indicated in the articles of incorporation.
  • The company must maintain at least one bank account in its own name with a Luxembourg bank or a Luxembourg branch of a foreign bank.
  • At the time that the request for a binding advance tax confirmation is filed with the tax authorities, the company must have complied with all legal requirements regarding the filing of tax returns.
  • The company must not be considered a tax resident of another state.
  • The company's equity must be appropriate to its activity (taking into account the assets managed and the risks assumed).

Capitalisation
A company is considered to have assumed the risks of the financing transaction if the amount of its equity corresponds to at least 1% of the nominal amount of the loan(s) granted or €2 million.

The company should further be able to demonstrate that it is obliged to use its equity on the realisation of the risks of the transaction.

Content
Depending on the facts and circumstances of each case, the advance transfer pricing request must further include at least the following:

  • the precise designation of the requesting taxpayer (name, residence and, as the case may be, file number);
  • a detailed description of the transactions, arrangements or legal acts concerned by the request and the taxpayer's legal motivation;
  • the designation of the other states involved;
  • the presentation of the legal structure of the group, including information on the beneficial owner;
  • the designation of the fiscal years concerned;
  • a transfer pricing analysis complying with OECD standards, including in particular a complete description of the methodology used, as well as detailed information on that methodology (eg, the identification of the comparables and results);
  • a general description of the market situation;
  • an analysis of all other relevant tax issues raised by the methodology used; and
  • confirmation that the facts disclosed are complete and accurate.

Validity
The duration of the validity of the confirmation granted by the tax authorities depends on each individual case, but may not exceed five years. Once this five-year period has expired, the tax authorities may, on the request of the taxpayer, grant a new confirmation for a maximum period of five years.

According to the principle of good faith, the confirmation has a binding effect on the tax authorities, unless:

  • the situation or the operations described are incomplete or inaccurate;
  • the essential elements of the operations differ from the request; or
  • the confirmation does not comply with international law.

The confirmation is ineffective if the legal provisions on which it is based change or if the essential characteristics of the transaction are modified.

Second circular

The second circular clarifies the entry into force of the above-mentioned rules. It states that as from January 1 2012, the tax authorities are no longer bound by advance transfer pricing agreements obtained before January 28 2011 in relation to intra-group financing transactions which would otherwise fall within the scope of the first circular.

For each individual intra-group financing transaction, the practical impact of the second circular depends on the facts. In cases where the essential characteristics of a financing transaction have not been modified since the initial advance transfer pricing agreement was issued, the (implicit or explicit) transfer pricing analysis performed at the time when it was implemented, and therefore its arm's-length character, will not be altered by the fact that the transaction is no longer covered by an advance transfer pricing agreement. Consequently, the tax authorities are unlikely to deviate from the remuneration confirmed in the initial advance transfer pricing agreement once it has expired.

Taxpayers benefiting from an advance transfer pricing agreement which, under the second circular, expired on January 1 2012 may wish to check whether the remuneration confirmed in this initial advance transfer pricing agreement is satisfactorily substantiated. This will generally be the case when a transfer pricing analysis was available with the original advance transfer pricing agreement. If this is not the case, a transfer pricing study can be conducted on the basis of data available on the date of the transaction. With satisfactory transfer pricing documentation, even in the absence of a new advance transfer pricing agreement, taxpayers may expect to continue being assessed on the same basis after 2011.

Equally, taxpayers wishing to continue benefiting from an advance transfer pricing agreement for an existing structure may prefer to submit a new request and comply with the conditions set forth in the first circular – most notably, having the minimum required equity at risk (the lower of 1% of the financing volume or €2 million), a majority of local directors and a transfer pricing report substantiating the arm's-length remuneration.

For further information on this topic please contact Thierry Lesage or Alain Goebel at Arendt & Medernach by telephone (+352 40 787 81), fax (+352 40 780 4) or email ([email protected] or [email protected]).