On 27 December 2016, the Luxembourg tax authorities published a new Circular (Circular L.I.R. 56/1 - 56bis/1) reshaping the rules for Luxembourg companies engaged in intra-group financing activities. Whilst the existing substance and arm's length requirements remain largely similar to those set forth in previous circulars, the new rules aim at being even more in line with OECD guidelines by removing the artificial 1% equity at risk requirement to implement a genuine equity test. Most Luxembourg companies engaged in intra-group financing will therefore have to re-assess their level of equity and financing structures will have to be adjusted before the end of 2017.
Luxembourg intra-group financing rules were based on article 56 of the Luxembourg income tax law (stating the general arm's length principle) together with two specific circulars issued in 2011. These circulars were applicable to Luxembourg companies whose principal activity consists of intra-group financing transactions. An intra-group financing transaction was defined as the granting of loans to related entities financed out of (related or third party) debt. The definition of related entities for this purpose includes any direct or indirect participation in the management, control or capital of another company.
The 2011 circulars introduced formal rules to obtain advance pricing agreements which were only available for financing companies which had a certain level of substance (directors/managers and equity at risk) and proper transfer pricing documentation supporting the pricing of their financing activities. As a rule of thumb, a minimum equity at risk of 1% of the amounts lent (capped at €2 million) was required.
The new Circular
Whilst the scope remains the same, the requirements are now adjusted to strengthen the beneficial ownership position of financing companies in line with OECD principles.
1. Transfer pricing requirements and risk analysis
The new Circular still requires a financing company to determine its remuneration on the basis of OECD transfer pricing guidelines. The financing company is required to substantiate its remuneration on the basis of a transfer pricing analysis which should contain a functional analysis taking into account the functions performed, assets used and risks assumed in relation to the financing activities and an economical analysis of data on comparable transactions.
In this respect, the following points should be noted:
- The financing company must have a sufficient amount of equity in relation to its functions (taking into account assets used and risks assumed). In this regard, a case-by-case analysis will now have to be performed in order to assess the level of equity which is appropriate for the financing company.
- This equity needs to actually be called upon if the risk in relation to the financing activities materialises. This will generally not be the case if the back-to-back loan terms and conditions provide for a non-recourse or limited recourse clause. These clauses will therefore have to be ignored for the purpose of determining the arm's length remuneration of the financing company.
- When determining the arm's length remuneration of the financing company, the Circular states that this equity at risk shall be remunerated at a rate of 10% after tax. This percentage will be regularly updated by the tax authorities based on market evolutions.
- Whilst banking institutions should remain the main comparable, the Circular confirms that functional differences can be significant and therefore impact the result of the benchmarking.
2. Substance requirements
- Luxembourg directors/managers: the majority of the members of the board, directors or managers having the power to bind the company, must be Luxembourg residents. Alternatively, these persons can also be non-residents carrying out a professional activity in Luxembourg if they are taxed in Luxembourg on at least 50% of their income from those activities. A company acting as board member must have its registered office and central administration in Luxembourg.
- Luxembourg employees: the financing company must have the appropriate resources to control the financing activities. Functions which do not have a significant impact on risk management can however be outsourced to external providers.
- Key decisions: key decisions regarding the company have to be made in Luxembourg and at least one shareholders meeting per year has to take place there. More specifically as regards the financing activities, the financing company should be able to demonstrate that it has the capabilities to take the decision to enter into financing. In case some functions are outsourced as regards the financing (which would result in a reduction of the remuneration), the company must have the capabilities to monitor the outsourcing.
- Dual resident: the company cannot be considered as tax-resident in another country.
3. Simplified rule
When a financing company acts as a pure intermediary and meets the substance requirements described above, the company will be deemed to carry out arm's length transactions if the company reports a return on its financing activities of 2% after tax. This percentage will also be regularly updated by the tax authorities based on market evolutions.
In order to benefit from this simplified rule, a specific application will have to be made by the company in its tax returns.
Opting for this simplified rule may however weaken the beneficial ownership position of the financing company and the Luxembourg tax authorities may (on demand or spontaneously) exchange this information with foreign tax authorities.
Timing and actions to be taken
Whilst the new Circular is immediately applicable and existing advance pricing agreements will be cancelled as from 1 January 2017, we understand that pre-existing structure will have till the end of 2017 to be adjusted.