News

Luxembourg & Financing: All About Substance

On 27 December 2016 Luxembourg issued a new circular on intra-group finance. This circular – LIR No. 56/1–56bis/1 – replaced the 2011 circular on intra-group finance and introduced a significantly changed transfer pricing regime for intra-group financing arrangements.

The main purpose of the transfer pricing regime of the new circular is to ensure that the transfer pricing policy applied by the taxpayer is in line with the functional and risk profile (substance) of the financing company in Luxembourg.  Its principles are in line with Actions 8-10 on Aligning Transfer Pricing Outcomes with Value Creation issued by the OECD in October 2015 under the OECD/G20 project against Base Erosion and Profit Shifting.

What changed?

The new circular introduces a new transfer pricing regime for intra-group financing. In summary, the new transfer pricing regime and changes are:

  • The purpose of the change in rules is to highlight the substance of a Luxembourg finance company, emphasizing the risk that a finance company with little substance may not be considered a beneficial owner for financing transactions;
  • The earlier use of limited recourse clauses limiting the credit risks (to typically 1%) is no longer considered consistent with the arm’s length principle and will be disregarded as from 2017 under an explicit clause in the new circular on transactions without a commercial rationale;
  • The compensation and margin of a finance company must now be determined by taking as a starting point the risks assumed by granting intercompany loans and the related risk-adequate equity required;
  • If a finance company does not comply with the new circular, one consequence is that the Luxembourg tax administration will automatically exchange information with other countries involved in the intercompany transactions of the finance company;
  • The new circular also defines the information and documents required for a request for an advance pricing agreement for a finance company;
  • The new circular is effective as from 1 January 2017 and has terminated existing rulings on intra-group finance issued earlier as non-binding for the Luxembourg tax administration.

 

What do you need to do?

To check if your current transfer pricing policy for the intra-group financing activities of a Luxembourg financing company is compliant with the new circular applicable as from 2017, you should address the following points:

  • Check if the intercompany transactions of the finance company are covered by the new circular;
  • Evaluate substance of the finance company in particular in terms of office premises, equity and decision-making capabilities and authority of directors and employees. In particular, it is critical that directors or employees have the competences and experience to understand, accept and deal with the risks assumed by the finance company;
  • Prepare or update your functional analysis focusing on the creation of the transaction(s) and subsequent risks management;
  • Assess and quantify the credit risks and other risks that the finance company is assuming;
  • Determine arm’s length interest rates on loans granted by the finance company, taking into account the risks assumed by the finance company;
  • Determine the arm’s length amount of equity for the finance company, based on the risks assumed;
  • Determine the arm’s length return on the equity and the gross margin of the finance company;
  • Update intercompany loan agreements;
  • Prepare a transfer pricing documentation covering all the above.