In the past few years, the Luxembourg tax authorities (LTA) have shown a growing interest in the examination of transfer pricing (TP) aspects of transactions carried out by multinational groups. This has resulted in a significant increase in the number of TP cases brought before Luxembourg administrative tribunals. Therefore, judges provided further guidance on the interpretation of the Luxembourg TP provisions set forth under Articles 56, 56bis and 164 of the Luxembourg Income Tax Law (LITL), as well as under paragraph 171 of the General Tax Law (GTL), which closely follow the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines (OECD TPG).
The recent development of TP case law demonstrates that the LTA challenge the economic reality of a taxpayer's transactions on a case-by-case basis, often relying on the absence of proper TP documentation. However, the LTA's powers are limited, as they must prove that the infringement exists and that the judges have ensured the proof is sufficient and appropriate.
The arm's length principle under the spotlight
The arm's length principle is enshrined under Article 56 of the LITL, which provides that profits of enterprises that are bound by conditions that differ from those between independent enterprises will be determined in accordance with the conditions that prevail between independent enterprises and will be taxed accordingly. In a recent case law1, the tribunal had to assess whether the arm's length principle had been violated as argued by the LTA. For that purpose, the tribunal had to determine whether there was a link between the taxpayer that paid the interest on a loan and the company that received it, even if the company that received it was different from the company that granted the loan (but part of the same group as the company that received the interest). Relying on the contractual documents concluded between the taxpayer and the other group of companies, as well as on the absence of proof brought by the LTA, the tribunal ruled that the taxpayer complied with the arm's length principle to the extent that it and the other companies were unrelated parties. At the same time, in another case law2, the tribunal endorsed the LTA's position, refusing to recognize the value adjustment a taxpayer made to the funds it granted to its subsidiary on the grounds that a third party would not lend funds to another company without being remunerated for this service and without getting any guarantees to ensure the repayment of these funds.
Therefore, the judges confirmed that the appreciation of the arm's length principle requires to verify whether there is a special relationship (e.g., transactions performed by companies within the same group) between the companies involved in the operations performed.
The TP method
Article 56bis LITL provides for the fundamental principles to be observed when performing a TP analysis. This focuses on the methodology to be adopted for the application of the arm's length principle under Article 56 LITL3. Accordingly, the Luxembourg taxpayer must justify that the price of its controlled transactions complies with the arm's length principle and, for this purpose, it must conduct a comparability analysis documented by a TP study.
The LTA often refer to the OECD TPG to interpret the TP provisions. In a case law of 23 September 20224, the LTA refused to deduct a notional interest on an interest free loan (IFL) on the grounds that the taxpayer did not apply the method set forth under the OECD TPG. According to the OECD TPG, the traditional transaction-based methods, such as the comparable uncontrolled price method (CUP), are more appropriate than methods based on profit transactions. However, the tribunal did not take a position on the adequacy of the method used to determine the notional interest as they ruled on another ground, requalifying the interest-free loan as equity.
Further, in a case law dated 2 December 20225, the LTA considered using the discounted cash-flow method to evaluate intangible assets (intellectual property rights) as abusive. However, as the tribunal ruled that the taxpayer was not the economic owner of the intellectual property rights, the question relating to the adequacy of the TP method used was not decided by the tribunal.
Even if there is no Luxembourg provision detailing the TP method that the taxpayer should apply, choice the taxpayer's seems to be closely scrutinized by the LTA, which rely on the OECD TPG to justify their position.
TP documentation requirements
In Luxembourg, paragraph 171 of the GTL requires that, upon request, taxpayers have to provide evidence of the accuracy of their tax return and provide clarifications, including the relevant documentation. This includes TP documentation in the case of transactions between associated enterprises. Clarifications have been brought in that respect by Bill of Law 8186 of 28 March 2023 (please read our alert dated 5 April 2023 on the topic), including one paragraph on TP documentation requirements (i.e., all documents that taxpayers are obliged to prepare to evidence that their related-party transactions were performed under arm's length conditions and at arm's length prices) for transactions between associated enterprises. The scope, exact content and magnitude will be provided through a grand ducal decree and should be in line with the international standards provided in the OECD BEPS Action 13 report.
Several court decisions confirmed that the LTA expects to receive consistent and appropriate TP documentation6.
In a case law dated 22 November 20227, the LTA requalified the distribution made by the taxpayer to its shareholder as a hidden dividend distribution, relying notably on the fact that the TP documentation was not sufficient. Based on the LTA's arguments, an acceptable TP study should (i) be performed by an independent expert and not in-house without any mention of the person who performed the analysis' name, (ii) not be limited to a simple computation but rather rely on an appropriate and recognized TP method, and (iii) be performed objectively and impartially. The tribunal endorsed the LTA's decision to requalify the distribution into a hidden dividend distribution without explicitly taking a position on the arguments they provided to define TP documentation. Indeed, the tribunal ruled that the LTA pointed out a set of circumstances that make such distribution more likely than not and that have not been clarified nor documented by the taxpayer.
The judgment also confirms that unofficial discussions and meetings with the LTA without any official and formal confirmation — for instance, through an advance pricing agreement (APA) — do not constitute sufficient proof to justify the taxpayer's position.
Therefore, it is objectively reasonable to argue that a TP report realized by an external adviser seems to be the secure way for a Luxembourg taxpayer to support and justify the economic reality of its transaction and mitigate challenges from the LTA on the arm's length nature of the transaction.
Requalification into a hidden dividend distribution
Article 164 (3) LITL provides that hidden dividend distributions arise when a shareholder directly or indirectly receives advantages from a company that a third party would not have received. The advantage is further classified as dividend income,8 which is generally subject to a 15% Luxembourg withholding tax.9
According to a constant case law, hidden dividend distribution provisions should apply when the following conditions are met:
- A decrease (or increase) of a company's net equity that meets the following conditions:
In support of the above, in a recent case law,10 the tribunal confirmed that the qualification of a shareholder within the meaning of Article 164 (3) LITL also covers the beneficial owner of the company granting the advantage, even though the said beneficial owner does not directly hold shares in that company. With respect to the economic justification of the advantage granted to the beneficial owner, the tribunal ruled that the TP documentation was not detailed enough to prove the reality of the functions performed and risks supported by the beneficial owner. However, for clarity, the tribunal recently rejected the qualification of a hidden dividend distribution on the grounds that the participating link cannot result from the fact that a taxpayer's managers are the same as the company indirectly providing services to the taxpayer in relation to the sale of a building.11
Burden of proof
According to the combined reading of the provisions and confirmed by a constant jurisprudence, the burden of proof of the existence of the hidden dividend distribution is placed on the LTA. In a case law dated 27 July 2022,12 the court endorsed the first tribunal's position, explaining that the sole existence of an interested third party is not in itself sufficient to prove that a hidden dividend distribution exists. The LTA should evidence a clear financial imbalance between the beneficiary and the taxpayer. Considering that the LTA failed to demonstrate such advantage, the court ruled in favor of the taxpayer. Additionally, the court ruled that the LTA could not reduce the interest rate charged on the loan from 8% to 3% on the grounds that it was more in line with market conditions, without justifying the decrease with a concrete analysis of comparable situations or the specific characteristics of the loan.
Similarly, in a case law dated 30 March 2023, the LTA did not provide sufficient proof that a special link existed between two companies, which would result from the fact that they have the same beneficial owner.13
Based on the above, it is fair to say that Luxembourg case law on tax-TP matters has exponentially developed in the last two years. This confirms the LTA's increasing scrutiny of TP matters, even though the tribunal set some limits on the LTA's powers by requiring proof of their allegations (i.e., burden of proof on the LTA). This overview of the latest TP case law also shows the LTA's dynamic approach through their audit interpretation to closely follow the OECD developments in TP matters.
The various cases illustrate the high level of complexity for each taxpayer involved in intragroup operations, which require significant technical knowledge in that field, far from the grouping or black-and-white thinking approach.
1Administrative tribunal, case law dated 27 January 2023 (42432).
2Administrative tribunal, case law dated 30 March 2023 (47414).
3Administrative tribunal, case law dated 30 March 2023 (47414).
4Administrative tribunal, case law dated 23 September 2022 (44902).
5Administrative tribunal, case law dated 2 December 2022 (44239).
6Administrative tribunal, case law dated 22 October 2018 (40348); Administrative tribunal, case law dated 7 January 2019 (40251); Administrative tribunal, case law dated 10 May 2021 (43559); Administrative tribunal, case law dated 13 January 2021 (42435) appealed; Administrative court, case law dated 23 December 2021 (45696C).
7Administrative tribunal, case law dated 22 November 2022 (43535).
8In accordance with Article 97(1), No. 1 of the LITL.
9Administrative tribunal, case law dated 30 March 2023 (45984).
10Administrative tribunal, case law dated 22 November 2022 (43535) and CA, 27 July 2022 (46801C).
11Administrative tribunal, case law dated 30 March 2023 (45984).
12Administrative court, case law dated 27 July 2022 (46801C).
13Administrative tribunal, case law dated 30 March 2023 (45984).