New regulations have moved the country forward regarding international standards for both financial activities and transfer pricing, while new measures for VAT-free zones and highly skilled workers are also being introduced, explains Santiago Fernandez of KPMG.
New transfer pricing documentation rules for intermediary financing transactions
The Luxembourg intermediary financing market has recently adapted to new transfer pricing rules which have significantly changed the documentation requirements for intra-group financing transactions structured through Luxembourg. Indeed, specific documentation requirements have been introduced into Luxembourg law with the consecutive publication by the tax authorities of two circulars (164/2 of January 28 2011 and 164/2bis of April 8 2011) highlighting the necessity to justify the arm's-length character of the remuneration of intra-group financing transactions, be they newly structured via Luxembourg, or implemented before January 28 2011 but still active for the years to come.
The transfer pricing circulars specifically apply to entities principally performing intra-group financing activities in Luxembourg. Companies, but also branches and any permanent establishment recognised in Luxembourg, are concerned. Even though no territoriality rule is mentioned, it becomes clear after some months of practice that the fiscal personality (rather than the legal personality) matters. Thus, any entity considered as a Luxembourg tax resident should conform to the new rules.
Moreover, only entities principally performing financing activities should comply with the documentation rules. Therefore, the holding activity – which generally goes hand-in-hand with the financing activity in Luxembourg – has to be ignored.
The objective of the publication of the circulars is absolutely not to increase litigation between the taxpayers and the tax administration.
References to international principles
The first circular establishes a comparison between credit institutions and companies performing intermediary financing activities and considers that the arm's-length price remunerating the functions performed by such companies should be based on the remuneration asked by these institutions for comparable credit operations.
Moreover, the circular introduces a new requirement for Luxembourg companies since the latter has to assume a risk and have adequate equity to cover this risk.
This equity allocation can easily be linked to the Basel II agreements where banks are required to put capital aside to guard against the risks (mainly operational and financial) they usually face in order to ensure that they have capital reserves appropriate to the risks they are exposed to when lending funds.
It is considered in the circular that the companies entering into intra-group financing activities need to assume a risk of at least 1% of the financing volume (i.e. for €100 million of funds lent by a Luxembourg company to an associated enterprise and refinanced by debt, only €1 million must be put at risk and covered by capital) or €2 million. However, if it can be evidenced that the company assumes more than this 1% or €2 million risk, capital should be increased according to the risk assumed.
The first circular makes an explicit reference to article 9 of the OECD Model Tax Convention for the definition of the arm's-length principle that must be respected when implementing intra-group transactions.
Moreover, as defined in the OECD Transfer Pricing Guidelines (the TP Guidelines), two enterprises are considered as associated enterprises in the sense of the circulars if "one of the enterprises 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 both enterprises".
The TP Guidelines are also mentioned with respect to the process to be followed in order to justify that a price or a margin is at arm's-length.
First, the importance of the functional analysis is underlined since the first circular requires the analysis of the functions performed by the company under review (taking into account the assets owned and the risks assumed) in light of the activities and responsibilities assumed by the company that may have an economic importance and of an in-depth analysis of the structure and organisation of the group to which the associated enterprises belong.
Moreover, the circular puts an emphasis on the comparability analysis and requires the assessment of the characteristics of the property or services transferred, the functions performed by the parties (taking into account assets used and risks assumed), the contractual terms, the economic circumstances of the parties, and the business strategies pursued by the parties. This comparability analysis should be the basis of the search for comparables and the determination of the arm's-length nature of the remuneration of the company performing intermediary financing activities.
In this respect, it has to be noted that the Luxembourg tax authorities are focusing at this stage on the margin which is earned by the Luxembourg company performing the financing activity rather than on the level of interest rates on the loans. This can be partly explained by the fact that Luxembourg companies often lend funds to enterprises resident in countries with mature transfer pricing regulations. In this respect, the arm's-length nature of the interest borne by the loan receivable (at the level of the Luxembourg company) has generally been tested in the country of residence of the borrower. Thus, assuming that the interest receivable is at arm's-length, then reviewing the arm's-length character of the margin realised by the Luxembourg company leads to the simple conclusion that the interest payable is also at arm's-length.
Specific requirements of the circulars
The Luxembourg tax authorities should agree to enter into an advance pricing agreement with a taxpayer if the latter has a real presence in Luxembourg during the period in which the transaction is maintained at the level of the Luxembourg company under review. The real presence is analysed in light of these criteria:
- The majority of the board members with the power to engage the company should be Luxembourg resident or, if non-resident, should be taxable for at least 50% of their income in Luxembourg. Moreover, they must have the professional knowledge to carry out their duties and should manage the company from Luxembourg and not abroad.
- The entity requiring binding information must have a bank account in a Luxembourg-resident bank or in a Luxembourg branch of a non-Luxembourg resident bank.
- The entity must be compliant with all its filing obligations in terms of corporate income tax returns.
- The entity must not be considered as tax-resident in a foreign country.
- As detailed above, the entities must assume a risk of at least 1% of their financing volume or €2 million and equity should be adequate to the risk assumed. In this respect, equity has to be understood as share capital, share premium and any other reserve that would not be freely distributable.
The practice has confirmed over the last few months that it is not required to invest the capital at risk in the loan receivables towards group companies.
Validity and penalties
The advance pricing agreements are valid for a five-year period as from the date of the agreement provided that the facts and circumstances described to the Luxembourg tax authorities do not change. Moreover, if these facts and circumstances can be evidenced as unchanged at the end of this five-year period, the agreement may be renewed for a new five-year period with updated comparables.
The publication of these two circulars enables Luxembourg to reach a new step regarding the international standards both for financial activities and transfer pricing.
More specifically, these transfer pricing documentation rules are reinforcing the strength of the intermediary financing structures implemented in Luxembourg. In an economic and financial world which requires more and more transparency, these provisions are relatively well accepted by investors in Luxembourg even though it cannot be denied that it increases their administrative burden. As investors are generally used to similar documentation rules abroad, they adapt quickly to this new environment.
The next step for this adaptation process to the international regulatory environment may be the documentation requirement of other intra-group transactions well developed in Luxembourg such as service fees or profit allocations. The future will tell.
Minimum flat tax
Luxembourg has introduced an annual minimum flat tax of €1,500 for certain corporate entities with effect from January 1 2011.
The new minimum flat tax applies to corporate entities subject to these conditions:
- The entity must be subject to corporate income tax in Luxembourg,
- Activities of the entity must not require an approval of a minister or a supervisory authority, and
- The total financial fixed assets, transferable securities, cash at bank, cash in postal cheque accounts, cheques and cash in hand of the entity must exceed 90% of its total assets.
Where several Luxembourg companies form a fiscal unity, the minimum flat tax applies once at the level of the integrating parent company (or the Luxembourg permanent establishment) heading the fiscal unity.
The minimum flat tax is subject to a 5% solidarity surcharge. Where the flat tax applies, the aggregate corporate tax liability amounts to €1,575. National legislation in respect of the investment tax credit, withholding tax and net wealth tax credits remains applicable in the context of the minimum flat tax.
The minimum flat tax is aimed at Luxembourg's large population of holding companies, as they are generally subject to a limited tax burden (if any) due to the receipt of tax-exempt income. It is interesting to note that, when assessing whether holding companies have a sufficient level of substance, some jurisdictions require the holding company to actually pay income tax. The new minimum flat tax allows a company to meet this actual income tax test. Therefore, it is a helpful tool in further supporting substance of Luxembourg (holding) companies.
Luxembourg Chamber of Commerce fees
At the end of 2010 a new legislation was adopted for SOPARFIs (Sociétés de Participations
Financières, principally holding companies) classified as such by the Luxembourg Central Statistics Office (STATEC), to be subject to a fixed Chamber of Commerce subscription fee of €350, instead of the general fee of 0.2% applying on the taxable income without taking into consideration the losses brought forward. This is a substantial improvement, compared with the old regime. Adequate classification as a SOPARFI is, however, critical.
Double tax and bilateral investment protection treaties
Luxembourg continues to expand its double tax treaty network and now benefits from almost 65 double tax treaties. In 2011, five new double tax treaties entered into force with Armenia, Bahrain, Liechtenstein, Monaco and Qatar. Some 20 other treaties are still in negotiation or pending ratification.
Luxembourg also has more than 90 bilateral investment protection treaties. This is especially important, as investors wish to have economic and legal protection when investing in any foreign country. The volatility of the economic policy of individual countries (and risks of nationalisation) is tempered by this type of agreement.
Luxembourg is soon to introduce new VAT provisions for the setting up of VAT-free zones, with the aim to support the development of Luxembourg as a prime logistics platform by introducing a favorable fiscal framework easing the cross-border flow of goods.
Luxembourg benefits from favorable rules regarding the import of goods. While some countries in the EU would ask an importer of goods to prepay VAT at the point of time the goods are imported from a country outside the EU into the respective country within the EU, Luxembourg does not require such VAT prepayment where goods are imported into Luxembourg. In contrast to several other jurisdictions, the only condition to be met in order to get such VAT deferral in Luxembourg is to be VAT-registered in Luxembourg.
The new VAT provisions maintain this advantageous deferral and grant additional benefits:
- to service providers rendering certain services with respect to goods retained in VAT-free zones; and
- to intermediate buyers of imported goods that are retained in the VAT-free zones.
These new rules are yet another element testifying to Luxembourg's competitive advantage that international groups should consider when looking for a tax efficient base for their logistics and supply chain operations. Luxembourg's prime geographical location and renowned workforce, R&D subsidies, domestic investment tax credits/incentives and income/profits tax planning opportunities place Luxembourg as an undisputed platform for business for international groups willing to do business in Europe.
Highly skilled workers
As from January 1 2011, specific tax provisions apply for highly skilled workers who settle in Luxembourg after December 31 2010 (tax circular L.I.R. n° 95/2 of December 31 2010). These provisions aim to exempt, subject to several conditions, the elements of the highly skilled workers' remuneration linked to their assignment in Luxembourg (for example, relocation, travel and childcare expenses, etc).
The aim is to attract highly skilled workers with specific skills and knowledge who represent a key advantage for companies located in Luxembourg.
Santiago Fernandez (email@example.com), Tax, KPMG in Luxembourg