Contributed By Baker McKenzie
Luxembourg's transfer pricing legislation complies with the arm's-length principle that is applicable between associated enterprises carrying out commercial and financial transactions, as set forth in the OECD's Transfer Pricing Guidelines and as provided for by Articles 56, 56-bis and 164 of the Luxembourg Income Tax Law (LITL), as well as paragraph 171 of the General Tax Law (Abgabenordnung, or AO).
In addition, the Luxembourg Tax Authorities (LTA) have issued certain circular letters and internal notes regarding transfer pricing.
Reference to the transfer pricing rules can also be found in various recent Luxembourg laws, such as the Anti-Tax Avoidance Law of 21 December 2018 (eg, interest deduction limitation rules and CFC rules) or the Law of 25 March 2020 implementing the sixth amendment to the automatic exchange of information in the field of taxation directive for intermediaries known as DAC6 (eg, transfer pricing hallmarks).
The Law of 19 December 2014 amended Article 56 of the LITL to clarify Luxembourg tax legislation on transfer pricing. The existing provision was replaced with wording very similar to the first paragraph of Article 9 of the OECD Model Tax Convention dealing with profit adjustments between associated enterprises. Accordingly, if (i) an enterprise participates directly or indirectly in the management, control or capital of another enterprise; or (ii) if the same persons participate directly or indirectly in the management, control or capital of two enterprises, and in either case, the two enterprises are, within their commercial or financial relations, bound by conditions agreed or imposed that differ from those that would be made between independent enterprises, the profits of these enterprises are determined and taxed on the basis of the conditions agreed upon between independent enterprises.
Article 56-bis of the LITL specifies that transactions are deemed sufficiently comparable when no material difference exists between the transactions that could, methodologically, have a significant influence on the pricing, or when reasonably reliable adjustments may eliminate any impact on the pricing. In this case, the basis for such comparability adjustments has to be shown to be in compliance with the OECD Transfer Pricing Guidelines.
Article 164(3) of the LITL requalifies, as hidden profit distribution, any advantage that a shareholder, member or other interested party receives directly or indirectly from a company or an association that they would normally not have received in the absence of their status as an interested party.
In addition, a new provision under the current paragraph 171 of the AO has been enacted, according to which information and documentation obligations regarding the burden of proof of taxpayers toward the LTA are applicable for transfer pricing purposes.
Finally, the LTA have issued the following guidelines and internal notes with respect to transfer pricing.
Alignment with OECD Transfer Pricing Guidelines
In general, Luxembourg transfer pricing practice is fully aligned with the 2017 OECD Transfer Pricing Guidelines and the OECD report on "Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10" (OECD FT Report), which was released on 11 February 2020. The OECD FT Report is a significant step by the OECD toward providing comprehensive guidance on financial transactions.
The term "associated/related parties" is defined in Article 56 of the LITL. Two entities are deemed to be related parties if:
Apart from Article 56-bis of the LITL, which makes a direct reference to the use of transfer pricing methods described within the 2017 OECD Transfer Pricing Guidelines, there is no specific guidance in regard to acceptable transfer pricing methods.
Indeed, the LTA rely on the methods depicted in the OECD Transfer Pricing Guidelines to determine whether the arm’s-length principle has been observed in a particular case.
Luxembourg taxpayers retain the freedom to apply other methods than those described in the 2017 OECD Transfer Pricing Guidelines to establish prices in line with the arm's-length principle.
There is no hierarchy of methods. In practice, the LTA rely on the methods provided in the 2017 OECD Transfer Pricing Guidelines to determine whether the arm's-length principle has been observed in a particular case. However, taxpayers are allowed to apply methods not described in the 2017 OECD Transfer Pricing Guidelines to establish prices in line with the arm's-length principle. As mentioned in 3.2 Unspecified Methods, these other methods should not be applied instead of the OECD-recognised methods where the OECD-recognised methods are more appropriate to the facts and circumstances of the case.
However these other methods should not be applied instead of the OECD-recognised methods where the OECD-recognised methods are more appropriate to the facts and circumstances of the case.
In line with transfer pricing international standards, the LTA expect that economic analyses are based on market-based outcomes and show the use of ranges or statistical measures.
Comparability adjustments may be performed if required to improve the reliability of the comparables. Nevertheless, such adjustments should meet internationally accepted standards to safeguard the validity of the comparability analysis performed.
There is no particular transfer pricing guidance with respect to intangibles. In general, the LTA follow the OECD Transfer Pricing Guidelines, which provide a balanced definition of intangibles. Final Reports on Actions 8–10 of the BEPS Action Plan describe an intangible as "something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities." The CUP method or the TPSM are commonly used when assessing the value of an intangible.
However, since transactions involving intangibles are usually very specific, the CUP method is not suitable in many cases. In such cases, the comparability analysis performed should be supplemented by a case-by-case valuation analysis of the intangible to support the arm's-length character of the analysed transaction.
There are no special rules regarding hard-to-value intangibles in Luxembourg.
The LTA do recognise cost sharing/cost contribution arrangements. Nevertheless, there is no specific guidance and general rules apply to such arrangements.
There are no legal provisions in domestic legislation prohibiting year-end adjustments performed by taxpayers due to outcome testing for the purposes of the preparation of the yearly tax return and compliance with the arm's-length principle. Any request for correction after filing tax returns must be communicated in writing to the competent tax office within three months of the taxpayer sending the declaration.
Luxembourg has an extensive network of double tax treaties, mainly based on the OECD Model Tax Convention on Income and Capital, in order to mitigate the risks of double taxation for businesses. Given their very nature, tax treaties are constantly negotiated and updated to the latest international standards.
On 13 March 2009, Luxembourg endorsed the international standard of exchange of information upon request, embodied in Article 26-5 of the OECD Model Tax Convention.
Moreover, Luxembourg has been promoting the introduction of the automatic exchange of information for tax purposes as a global standard and has implemented the automatic exchange of information based on European Council Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation, as amended.
Except for companies engaged in intra-group financing transactions, there is no formal advance pricing agreement (APA) procedure before the LTA.
Intra-group Financing Transactions
With respect to the APA procedure for intra-group financing transactions, Circular LIR No 56/1 – 56-bis/1 explicitly requires that, based on the facts and circumstances relevant to each specific case, each APA request filed to the direct tax administration following the provisions of paragraph 29a of the AO, should at least contain the following information and documents:
The taxpayer must submit a transfer pricing study, along with the advance tax clearance letter (an advance tax clearance letter without a transfer pricing study would not be approved by the LTA).
Furthermore, the tax authorities may give their view on non-financing intra-group prices/margins used by taxpayers upon request (on a case-by-case basis).
Agreements could be obtained from the tax authorities where the parties agree up front on the level of the compensation to be realised on a given intra-group transaction (eg, intellectual property structuring), provided the transaction reflects the substance and economic reality under arm's-length terms.
The programme is administered by the LTA (Administration des Contributions Directes).
There is no co-ordination between the APA process and mutual agreement procedures (MAPs). However, in practice, the economic division of the Ministry of Foreign Affairs, responsible for the MAP, and the LTA, responsible for the APA, could co-operate when required.
There are no limits on which taxpayers or transactions are eligible for an APA.
The LTA require that the transactions covered in the APA have not taken place before the APA application.
An amount between EUR3,000–10,000 can be charged for APAs, to be paid at submission.
The validity of the APA is limited to five years in accordance with paragraph 29a of the AO.
An APA cannot have retroactive effect.
Transfer Pricing Documentation
There is no mandatory requirement to file the transfer pricing documentation with the annual tax returns, but the tax authorities may request, at any time, that the taxpayer disclose it in accordance with paragraph 171 of the AO.
The transfer pricing documentation should comply with Article 56 bis of the LITL, which refers to the arm's-length principle and the OECD Transfer Pricing Guidelines and should be updated if any change occurs.
Burden of Proof in Controlled Transactors
Paragraph 171 of the AO operates a reversal of the burden of proof, whereby the taxpayers must prove that the pricing of their controlled transaction is at arm's length. This is an exception to the general principle, according to which the burden of proof regarding the facts that trigger a tax liability lies with the tax authorities, while the proof of facts that releases the taxpayer from such a tax liability or reduces the tax liability lies with the taxpayer.
In the case of late payments or missing payments of tax due, the LTA may impose monthly 0.6% late interest on the tax due by the taxpayer.
In the event of late filing or if the filing deadline of the tax returns is missed, the taxpayer may be subject to a penalty of up to 10% of the tax due, as well as a tax fine of up to EUR25,000.
In the event of the voluntary filing of incomplete or incorrect tax returns, or if filing of the tax returns is missed, the taxpayer may be subject to a tax penalty for an amount between 5% and 25% of the eluded tax or tax unduly reimbursed.
The tax authorities may also impose a penalty ranging between at least 10% (minimum) and, at the maximum, half of the amount of the eluded tax (or of the unduly reimbursed tax) in the case of a proven simple tax fraud.
In aggravated tax fraud cases, the penalty can range between EUR25,000 and six times the amount eluded (or unduly reimbursed) together with imprisonment for one month to three years.
In case of tax swindling (or tax evasion), the penalty can range between EUR25,000 and ten times the amount eluded (or unduly reimbursed) together with imprisonment for one month to five years.
Fines are payable within one month from the notification. In practice, the risk of litigation and penalties is quite remote. The tax authorities may reassess or adjust the taxable result of the company to align it with the arm's-length principle, but no specific penalties are likely to be imposed. Nevertheless, administrative penalties may be applicable in order to enforce the taxpayer's delivery of general documentation on transactions in the course of the tax assessment.
With respect to the country-by-country report (CbCR), it must be accurate, completed and filed annually within 12 months after the fiscal year-end of the multinational group; otherwise, penalties of up to EUR250,000 may be imposed.
There is no specific transfer pricing documentation requirement for a master file and a local file. In practice, however, the LTA expect the prepared transfer pricing documentation to follow the framework suggested in the 2017 OECD Transfer Pricing Guidelines. The CbCR follows a specific reporting format, which is fully aligned with the standards set by the 2017 OECD Transfer Pricing Guidelines.
Luxembourg transfer pricing rules are strictly aligned with the 2017 OECD Transfer Pricing Guidelines.
Luxembourg transfer pricing rules respect the arm's-length principle.
Luxembourg has expressed its willingness to be fully compliant with the new international framework, in particular with the 2017 OECD Transfer Pricing Guidelines, the base erosion and profit shifting (BEPS) project, as well as with the OECD's and the EU's exchange of information requirements. Therefore, some of the most important recent changes in Luxembourg tax legislation address transfer pricing and tax transparency matters.
Action 5 of the OECD/G20 BEPS Project had a considerable impact on the Luxembourg tax environment as it led to the abolition of the existing Luxembourg IP regime (as of 1 July 2016, with a grandfathering period of five years). The Luxembourg Parliament (Chambre des députés) adopted a law on 22 March 2018 introducing a new Luxembourg IP regime. The content of the law is based on the modified nexus approach and thus reflects the content of the BEPS Action 5 report released by the OECD in 2015.
Furthermore, OECD Action 5 also dealt with the automatic exchange of information of advance cross-border rulings and APAs. Therefore, Luxembourg adopted a law on 23 July 2016 broadening the scope of the automatic exchange of information to advance tax clearances and APAs. This law completed the Grand Ducal Regulation of 23 December 2014, implementing a dedicated procedure for advance tax clearances and APA requests, subject to fees and application reviews by the tax ruling commission as of 1 January 2015.
Actions 8, 9, 10 and 13 of the OECD/G20 BEPS Project have encouraged the Luxembourg tax authorities to proceed toward the formalisation of transfer pricing requirements in the Luxembourg tax legislation. Luxembourg has also implemented CbCR requirements in line with related OECD guidance and EU-related directives.
The Arm's-Length Principle
The guidance for applying the arm's-length principle set out in Actions 8, 9 and 10 is reflected in the Luxembourg transfer pricing legislation through the introduction of the new Circular and the new Article 56-bis of the LITL. As mentioned, the guidance is aimed at ensuring that the methods to be used for the determination of the appropriate arm's-length compensation take into account the OECD comparability factors and are coherent with the nature of the accurately delineated transactions.
Related-Party Transactions and the Multilateral Instrument
Actions 2, 4 and 6 of the OECD/G20 BEPS project are of particular importance, since they affect the main related-party transactions occurring in Luxembourg. In fact, Luxembourg has adopted the revised EU Parent Subsidiary Directive, restricting intra-EU use of hybrids effective as of 2016, and the EU Anti-Tax Avoidance Directive (ATAD I), which entered into force on 1 January 2019. The amended Anti-Tax Avoidance Directive (ATAD II) introduced by the law of 23 December 2019 and applicable as from 1 January 2020 (except for the reverse hybrid mismatches, applicable as from FY 2022) has broaden the scope of application of the directive with respect to the limitation of the use of hybrid mismatches to non-EU countries. Finally, in order to be fully compliant with all four key areas of an effective dispute resolution mechanism under the Action 14 Minimum Standard, Luxembourg needs to amend and update a certain number of its tax treaties. In that respect, Luxembourg signed the Multilateral Instrument in order to implement all the related tax treaty provisions included in the BEPS Action Plan (Actions 2, 6, 7 and 14), potentially covering all of its tax treaties. Luxembourg did not make any reservations to the modifications related to the article on the mutual agreement procedure and opted for the introduction of a mandatory and binding arbitration provision in tax treaties through the Multilateral Instrument. The law implementing the Multilateral Instrument provisions was adopted on 7 March 2019.
The LTA has recently published Circular LG – Conv. D.I. No 60 of 11 March 2021, which updates and replaces Circular LG – Conv. D.I. No 60 of 28 August 2017 regarding guidance on the implementation of mutual agreement procedures (MAPs) under bilateral tax treaties concluded by Luxembourg. The scope of guidance provided in the new circular is in line with the previous circular, including guidance in relation to the MAP request, the relevant competent authority, the deadlines, the phases of the MAP and arbitration.
In practice, explicit guarantees where one entity bears the risk of another entity's operations, are allowed, provided the arrangement is properly documented and has valid underlying economic and commercial reasons (eg, the new 2020 OECD Transfer Pricing Guidelines on financial transactions apply on financial and performance guarantees).
The UN Practical Manual on Transfer Pricing does not have any impact on transfer pricing practice or enforcement in Luxembourg.
As market reference, it is considered that companies carrying out intra-group financing transactions comply with the arm's-length principle if their remuneration corresponds to a return on equity equal to 10% after taxes. The LTA reserve the right to update this percentage based on a market analysis.
In addition, where specific conditions are met, Circular L.I.R. 56/1-56bis/1 includes a simplification measure for companies with a pure intra-group intermediary financing activity. For simplification purposes, transactions will be considered to be in line with the arm's-length principle if, in relation to the controlled transactions analysed, the company generates a minimum return (considering the assets financed) of 2% after tax. The LTA reserve the right to update this percentage based on a market analysis.
There are no specific rules governing savings that arise from operating in Luxembourg.
Luxembourg does not have any notable unique rules or practices applicable in the transfer pricing context.
Luxembourg does not require co-ordination between transfer pricing and customs valuations.
In Luxembourg, litigation on transfer pricing issues is dealt with by the administrative courts. However, taxpayers that wish to object to their tax assessment must first lodge a complaint in writing with the head of the direct tax administration within three months from the receipt of the tax assessment notice. The head of the tax administration is then obliged to review the tax assessment from both a formal and factual perspective.
The decision of the head of the administration for direct taxes may be challenged before the administrative tribunal within three months. In the event that the head of the administration for direct taxes does not respond within six months from the filing of the claim, the taxpayer is allowed to directly seize the administrative tribunal. In such a case, no delay of foreclosure applies. The administrative tribunal performs a material examination of the whole case, although it does not re-examine the global situation of the taxpayer.
The judgment of the administrative tribunal is subject to an appeal before the administrative court within 40 days from the notification of the judgment. The administrative court re-examines the judgment of the administrative tribunal, taking into account both the factual and legal background. The administrative court is the highest and final judicial power in tax matters. No further revision is possible.
The judicial precedent on transfer pricing is moderate.
Excessive Loan Interest and the Validity of Ex Post Transfer Pricing Studies
On 22 October 2018, Decision No 40348 of the Administrative Tribunal was released, ruling in favour of the LTA on an issue pertaining to interest rate application.
The tax authorities considered the interest rate on the loan taken by a company from its shareholder to be an undue advantage within the meaning of Article 164(3) of the LITL, on the basis that the difference between the rate provided for under the loan agreement and the rate fixed by the tax office would be requalified as a hidden distribution of profits. The interest rate set at 12% by the taxpayer was indeed not consistent with the transfer pricing report (A report) conducted by the company itself at the time of the financing. The study suggested a rate range between 3.21% and 7.88%. The report, issued ex post in 2017 (B study) on the request of the company and establishing a rate between 9.95% and 19.61% to justify the rate of 12% applied in 2011 and 2012, was not accepted by the tax authorities.
The administrative tribunal recalled that hidden distributions of profits under Article 164(3) of the LITL exist if a partner or a shareholder receives benefits directly or indirectly from a corporation, which results for the company in the use of income without an efficient counterpart and which the partner or shareholder could not have obtained in the absence of this link. The situation is that of a cautious and prudent manager who would not have granted a similar benefit to a third party.
The administrative tribunal found that the rates fixed by the tax authorities (1.87% in 2011 and 0.82% in 2012, increased by a risk premium of 1.7% to amount to a final rate of 3.57% in 2011 and 2.52% in 2012) were supported by the transfer pricing report provided by the taxpayer for 2011 (A study). In the absence of evidence submitted by the taxpayer (such as the production of a transfer pricing report for the 2012 rate) for the 2012 tax assessment, the tribunal considered that a manager, even a moderately diligent and conscientious one, would not have entered into a loan agreement with a 12% interest rate with no counterpart.
In its decision No 42043C dated 17 July 2019, the court confirmed the first judgment and stated that the B study could not be applied to the case at hand to the extent the variables used by this study are likely to correspond to a situation involving important economic operations, but not those of a company with a single shareholder whose sole activity resides in the holding of real estate. The court concluded that this B study did not provide enough elements to reverse the conclusion of a hidden profit distribution in this case.
The decision, although not trailblazing, provided valuable insight into the potential acceptance and validity of ex post transfer pricing studies, as well as the accepted interest rates by the tax authorities.
On 7 January 2019, decision No 40251 of the administrative tribunal was released, ruling in favour of the LTA on an issue involving the fiscal treatment of granted debt waivers to the taxpayer's subsidiaries as hidden distribution and the deductibility of depreciation of shares in the same subsidiaries by the same taxpayer.
Initially, the tax authorities qualified the debt waivers granted to the subsidiaries as hidden profit distributions, which was reiterated by the administrative tribunal. The tribunal grounded its reasoning on the economic criteria (wirtschaftliche Betrachtungsweise) enshrined in Article 11 of the Tax Adaptation Law (Steueranpassungsgesetz) combined with the arm's-length principle, which led to the conclusion that the debt waiver granted by the taxpayer did not correspond to appropriate behaviour likely to be justified by economic considerations. Further to Article 164(3) of the LITL "there is hidden profit distribution, especially if a partner, member or interested person receives directly or indirectly advantages from a company or an association from which they would not normally have benefitted if they had not this quality."
The general term "especially" (notamment in French) has been chosen by the legislature to allow the tax authorities, as well as the courts and tribunals, to ground their decisions on a case-by-case basis and take into account the difficulties for an exhaustive remuneration. Consequently, the administrative tribunal explained that the advantage granted by the taxpayer to its subsidiaries as direct beneficiaries was granted, without any relevant evidence regarding the real use of the amount paid, by the taxpayer to its subsidiaries as real beneficiaries of the financial advantage.
Secondly, the administrative tribunal considered that the second condition set in Article 164(3) of the LITL should be verified to establish whether the two shareholders (individuals), through the subsidiaries, benefited directly or indirectly from an advantage that would not have been granted in a transaction between unrelated parties.
The administrative tribunal stated that granting financing to the subsidiaries and then renouncing its reimbursement could not be considered as prudent management behaviour and should be analysed as an advantage in the meaning of Article 164(3) of the LITL. The administrative tribunal recognised that a company is free to invest in risky assets and, if the investment turns out to be unsuccessful, granting a subsequent debt waiver by itself does not constitute a hidden profit distribution. Nevertheless, the taxpayer should be able to justify the reasons for granting a debt waiver. The administrative tribunal did not accept the explanation provided by the taxpayer that the investment in start-ups has not resulted in profits.
The administrative tribunal also confirmed the non-deductibility of depreciation of shares requested by the taxpayer, on the grounds that the taxpayer did not provide sufficient proof and reasoning to challenge the tax authorities' position.
Registering Losses as Hidden Profit Distribution
In case No 42326C of 31 July 2019, the court rejected the position of the tax administration with respect to hidden profit distribution. A Luxembourg company investing in start-ups involved in the areas of telephony, media and computer applications was financing them through advances made by the shareholders. Since the business did not turn out to be successful, the shareholders decided to stop the activity, take the loss and amortise the book value of the subsidiaries in question. The tax administration, however, treated these transactions from the perspective of hidden profit distribution in order to:
The tribunal confirmed the decision of the tax office.
The court, meanwhile, reformed the judgment and the decision of the tax administration on the grounds that the explanations and documentary evidence provided by the appellant were such as to justify the economic reality of the transactions at issue. Therefore, a hidden profit distribution should not be based on the mere appearance of the unusual nature of transactions without being further substantiated by sufficiently concrete facts.
Transfer Pricing Audits in a Context of Automatic Exchange of Information
In case 45072 dated 16 December 2020, the Belgian tax authorities sent an information request to the Luxembourg tax authorities further to the tax audit of a Belgian company carrying out business activities in and through Luxembourg. Indeed, the Belgian tax authorities explained that the investigation carried out revealed various inconsistencies on the transfer pricing policy of the Belgian company and especially in the remuneration of the Belgian company compared to the functions and risks supported. Additionally, the Belgian tax authorities gathered evidence that fictitious invoices have been established by Belgian companies to promote direct invoicing to the Belgian company to prevent the margin provided for in the transfer pricing policy being recorded and thus reducing the tax base in Belgium. The Belgian company lodged a claim to annul the information order. However, the judges dismissed the claim and confirmed that the information request was not a fishing expedition. This case shows recent trends in the transfer pricing audits of inter-company services. The tax authorities are increasing scrutiny on transfer pricing matters, verifying the economic rationality of the transactions and checking the alignment of functions expressed in transfer pricing documentation with the actual conduct of the related parties.
Luxembourg does not, in any way, restrict outbound payments relating to uncontrolled transactions.
Luxembourg does not, in any way, restrict outbound payments relating to controlled transactions.
Luxembourg does not have any rules regarding the effects of other countries' legal restrictions.
The LTA publish APA and transfer pricing audit data either in the form of an annual report or through the disclosure of data in public forums.
The LTA do not use secret comparables.
Undoubtedly, the current health situation is having a tremendous impact on global and local businesses value chains. Multinational cash flow and swings in profitability have affected transfer pricing policies and revenue forecasts for the past 12 months.
The impact on default risk appears to be the most important for transfer pricing in Luxembourg. Indeed, most Luxembourg transfer pricing activities are linked to intra-group financing and services, creating challenging transfer pricing adjustments in many jurisdictions.
The Luxembourg government has not relieved payment obligations or otherwise relaxed standards.
As in all EU jurisdictions, the progress of tax audits in Luxembourg has been affected by the pandemic.
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