By means of its law of 19 December 2014, Luxembourg adopted since 2015 a legal framework regarding transfer pricing, which reflected the provisions of article 9 of the Organisation for Economic Co-operation and Development ("OECD") Model Tax Convention related to the arm's length principle, and introduced transfer pricing documentation requirements.
In the context of the OECD's project regarding base erosion and profit shifting ("BEPS"), Luxembourg now further aligns its transfer pricing legislation with some of the provisions laid down in the 2015 final report on Actions 8-10 of the OECD BEPS project (the "OECD Report") and amending the section D of Chapter I of the OECD transfer pricing guidelines for multinational enterprises and tax administrations (2010) (the "OECD Transfer Pricing Guidelines").
In this respect, the Law introduces a new article 56bis into the Luxembourg income tax law ("Article 56bis") which extends the scope of the arm's length principle and provides a legal framework in view of determining the arm's length character of a transaction, which contains four key principles:
1. General scope
Article 56bis highlights that companies have to determine an arm's length price for all transactions between related parties. In line with the OECD Transfer Pricing Guidelines, the new article however specifies that the mere fact that a transaction between related parties may not be concluded between unrelated parties does not necessarily mean that this transaction has not the characteristics of an arm’s length arrangement. Considering the variety of innovative and flexible instruments in Luxembourg, this clarification is welcomed and should avoid that Luxembourg tax authorities challenge certain well established practices within the Luxembourg market only because they are not concluded between unrelated parties.
2. Importance of the comparability analysis approach
The Law emphasises the key role of the comparability analysis in the determination of the arm's length character of a transaction. In this respect, a comparison between the conditions in a transaction between related parties and the conditions that would have been made had the parties been independent, needs to be undertaken; to consider in addition the comparison as significant, the economic characteristics of the transactions analysed need to be sufficiently comparable. According to the new Article 56bis, the comparability analysis is based on two pillars:
- the identification of the commercial or financial relations between affiliated enterprises and the relevant economic conditions and circumstances attached to those relations so that the transaction between related parties is accurately delineated; and
- a comparison of the relevant economic conditions and circumstances of an accurately delineated transaction between related parties with the relevant economic conditions and circumstances of comparable transactions between independent parties.
The relevant economic conditions and circumstances to be determined for the comparability include the following:
- the contractual terms of the transaction;
- the functions performed by each of the parties to the transaction, taking into account assets used and risks assumed and managed;
- the characteristics of the asset transferred, the services provided or the agreement concluded;
- the economic circumstances of the parties and of the market in which the parties operate; and
- the business strategies pursued by the parties.
3. Use of the most appropriate transfer pricing method.
According to the Law, the determination of appropriate transfer pricing method (e.g. comparable uncontrolled price, resale price or cost plus method) has to be made based on the identified conditions and circumstances mentioned above and must be consistent with the nature of the transaction precisely delineated. The taxpayer should thus always use the most appropriate transfer pricing method accepted in the OECD guidelines that allows to obtain the closet arm’s length price.
4. Introduction of an anti-avoidance rule
Finally, the Law introduces anti-avoidance measures which allow the Luxembourg tax authorities to disregard, for transfer pricing purposes, transactions which include one or more elements that do not have valid commercial rationality and have a significant impact on the determination of the arm's length price.
The OECD Report provides in relation to this anti-avoidance rule that a tax administration should not disregard an actual transaction or substitute other transactions for it, except in exceptional circumstances. According to the OECD Report, "a transaction may be disregarded or replaced by an alternative transaction where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the option realistically available to each of them at the time of entering into the transaction". The OECD Report illustrates two situations for non-recognition of a transaction considered as commercial irrational and thus unrealistic to be performed by unrelated parties: first, a transaction between related parties regarding a highly risky activity for which there is no active market (e.g. insurance in area subject to frequent flooding); second, in the absence of any reliable means to determine whether a payment reflects the appropriate evaluation of rights or assets transferred. Despite the recommendation of the Council of State (Conseil d'Etat), the reference to the "exceptional circumstances" has not been introduced in the Law, which thus slightly deviates from, and goes beyond, the provisions of OECD Report. We can only regret the absence of such reference considering that, as highlighted by the OECD Report, the non-recognition of a given transaction may lead to double taxation and should thus be limited really to exceptional circumstances only.
Despite the absence of such reference to "exceptional circumstances" in the Law, it is in fact far from being certain to infer therefrom that the Luxembourg tax authorities will in the end apply this provision more broadly as generally, the Luxembourg tax authorities follow the guidelines provided by the OECD.