The primary function of these CFC rules is to deter taxpayers from shifting profits to foreign low-taxed controlled entities or permanent establishments. Under the CFC rules, a Luxembourg corporate taxpayer may be subject to corporate income tax on its share of the CFC’s undistributed income. The circular introduces additional compliance (transfer pricing) requirements in Luxembourg for resident taxpayers with CFCs: annually, a functional analysis involving the significant functions in relation to the assets and the revenue of the CFC must be made available (upon request) to the LTA. The circular also contains a number of clarifications on how to determine whether there is a CFC and on abuse of law considerations.
Control and effective tax rate tests
For an entity to be considered as a CFC, the Luxembourg taxpayer must hold, directly or indirectly, more than 50% of the voting rights or profit entitlement in, or capital of the entity (the Control Test). In respect of a permanent establishment, the Control Test will normally be satisfied. In addition, an effective tax rate or ETR Test applies, pursuant to which the entity or permanent establishment is a CFC when it incurs an effective tax rate on its profits that is less than half of the Luxembourg corporate income tax (8.5% as per the rate applicable in 2019 and 2020) it would have paid in Luxembourg on its profits.
With respect to the Control Test, the circular mentions that it requires looking at economic reality, rather than legal appearances. The circular further takes the view that the threshold can be exceeded simultaneously in the hands of several taxpayers when the various types of participation are not aligned, e.g., when there is a split between voting rights and profit entitlement.
Also, the Control Test takes into account participations in the foreign entity held by enterprises “associated” to the Luxembourg taxpayer. Associated enterprises are entities with which the Luxembourg taxpayer has a direct or indirect link of at least 25% by virtue of a (downward or upward) participation in terms of voting rights, capital ownership or profit rights. The circular stipulates that any association existing at a given moment during the tax year is to be taken into account, regardless of the duration of this association.
With respect to the ETR Test, the circular notably mentions that the assessment of the foreign tax position should include the tax rate, the tax base including all other tax rules susceptible of impacting the effective tax on the subsidiary’s revenue and should cover all income (not just the income in the scope of the CFC rules).
When the Control Test and the ETR Test are met, the entity or permanent establishment is a CFC.
CFC income inclusion
The CFC rules grant taxing rights to Luxembourg on the taxpayer’s share of the CFC’s non-distributed income arising from a non-genuine arrangement. In addition, the CFC’s income may be taxed in Luxembourg only to the extent it is generated through assets and risks linked to “significant people functions” carried out by the Luxembourg taxpayer. The latter requirement is to be assessed on the basis of the arm’s length principle. Expenses economically linked to this income are deductible. The net negative income of the CFC in a given year should not be included, but losses of the CFC may be carried forward and used to offset future net positive income of the CFC.
The circular also does not contain much clarification in respect of the application of the “non-genuine arrangement” concept.
When the controlling taxpayer of the CFC changes in a particular year, the circular takes the view that the net income inclusion should be made pro rata to the size of the participation held and to the holding period thereof. In addition, when a taxpayer owns unequal percentages of different participation rights (the example of a 70% entitlement to voting and a 60% entitlement to profit rights is given), it argues that the highest percentage would be relevant for the income inclusion (i.e., the LTA would seek in this example to take 70% of the CFC’s net income into account).
Burden of proof
According to the circular, taxpayers must upon request provide evidence of the CFC’s foreign taxation and its payment. In addition, the taxpayer must prepare an analysis each year of the functions and risks of the CFC in relation to its income and assets. This analysis is to be made available to the LTA upon request.
These documentation requirements are not stipulated as such in the law.
Exceptions and abuse of law
The CFC rules contain exemptions for CFCs with a low (commercial or book) profit and CFCs with a low profit margin. The circular contains some practical guidance for the interpretation of these exemptions. Notably, it states that any restructuring aimed at enabling the CFC to fall within the above exemptions, without any underlying valid commercial reasons reflecting economic reality, may constitute abuse in the sense of the Luxembourg general anti-abuse rule.
Similar comments are made with respect to restructurings aimed at reducing a taxpayer’s control over, or participation in, a CFC, or a taxpayer’s association with another entity.
This could be viewed as reflecting an intention of the Luxembourg tax authorities to put abuse of law on the radar in the context of the CFC rules.
The Luxembourg CFC rules were enacted as part of the implementation of the EU Directive 2016/1164 on anti-tax avoidance (ATAD). This directive allows for a type of CFC rules (which Luxembourg intended to adopt when implementing the ATAD) targeting the non-distributed income of a CFC arising from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage. An arrangement is under ATAD non-genuine to the extent that the CFC would not own the assets or would not have undertaken the risks which generate its income if it were not controlled by a company where the significant people functions (relevant to those assets and risks) are carried out and are instrumental in generating the controlled company's income. It remains to be seen whether the circular is entirely compatible with the ATAD in this respect. Luxembourg taxpayers should carefully consider and monitor whether their structure involves a CFC that could fall under this circular and in particular its intended extra transfer pricing documentation obligation.