Corporate Tax Law

A basic introduction to switch pricing in Luxembourg

June 22, 2022
hadmin

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Overview

The Luxembourg tax system distinguishes between the taxation of individuals and companies. Resident individuals are subject to income tax, which is levied on eight categories of income:

  1. business income;
  2. agriculture and forestry income;
  3. income from independent professional services;
  4. employment income;
  5. pension and annuities income;
  6. investment income (i.e., interest and dividends);
  7. rental and royalty income; and
  8. miscellaneous income, including capital gains.

Companies limited by share capital are subject to corporate income tax (CIT), which generally follows the computation rules of business income. Both income tax and CIT are governed by the Income Tax Law (ITL).2 In addition, business income is subject to municipal business tax (MBT), which is broadly levied on the same basis as the business income determined for income tax or CIT purposes. Companies are furthermore subject to a net worth tax (NWT). Withholding tax may be levied on dividends distributed by companies in cases where the participation exemption does not apply, as well as on directors’ fees (interest and royalties are not subject to any withholding taxes).

The Luxembourg transfer pricing legislation closely follows the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines (the OECD Guidelines)3 and is provided by Articles 56, 56 bis and 164 of the ITL, as well as Paragraph 171 of the General Tax Law (GTL).4 Accordingly, the transfer pricing rules apply to business income subject to either income tax or CIT and to MBT. Transfer pricing adjustment may, however, also affect NWT and trigger dividend withholding tax (e.g., in the case of a requalification of a controlled transaction as a hidden profit distribution – see below). Partnerships and trusts being as a rule tax-transparent entities (save for the purposes of MBT), transfer pricing issues are generally dealt with at the level of their partners or beneficiaries to the extent that they are engaged in activities generating business profits. As a general principle, the determination of the business profits for income tax and CIT purposes is based on the commercial accounting under Luxembourg Generally Agreed Accounting Principles and hence the accounting treatment of a transaction may impact the tax and transfer pricing treatment thereof. Non-arm’s-length controlled transactions may also trigger corporate interest issues.

Article 56 ITL enshrines the arm’s-length principle into Luxembourg tax law, following the wording of Article 9 of the OECD Model Tax Convention.5 Accordingly, if (1) an enterprise participates directly or indirectly in the management, control or capital of another enterprise, or (2) 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 based on the conditions agreed upon between independent enterprises.

Article 56 bis ITL provides further guidance as to the methodology regarding the application of the arm’s-length principle, based on the conclusions of the Report on Actions 8–10 of the Base Erosion and Profit Shifting (BEPS) Action Plan, revising Chapter I, Section D of the OECD Guidelines.

Although Articles 56 and 56 bis ITL follow the OECD Guidelines, it is generally admitted that the OECD Guidelines are ‘soft law’ only and have no direct binding effect on taxpayers. This being said, the Luxembourg Inland Revenue and courts usually refer to the OECD Guidelines regarding the application of the Luxembourg transfer pricing rules. For the sake of a continued legal security, the OECD Guidelines applicable at the time the transaction was entered into or occurred are typically relevant in this context. Therefore, any transactions entered into before the publication of the OECD guidance on financial transactions (February 2020) or the pandemic (December 2020) will not be considered in the light of those publications.

Article 164(3) ITL requalifies as a hidden profit distribution any advantage that a shareholder, member or other interested party receives directly or indirectly from a company or an association that he or she would normally not have received in the absence of his or her status as an interested party.

Finally, Paragraph 171 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 transfer pricing documentation in the case of transactions between associated enterprises.

In addition, the Luxembourg Inland Revenue has issued certain circular letters and internal notes regarding transfer pricing:

  1. Circular letter LIR No. 164 ter/1, dated 4 March 2020 on controlled foreign companies’ rules;
  2. Circular letter LIR No. 56/1 – 56 bis/1, dated 27 December 2016 relating to the transfer pricing rules applicable to companies engaged in intra-group financing transactions;
  3. Circular letter LIR 164/1, dated 23 March 1998 relating to the interest rates on shareholders’ corporate current accounts; and
  4. Internal note LIR/NS-No. 164/1, dated 9 June 1993 relating to hidden profit distributions within the context of shareholders’ corporate current accounts.

Broader taxation issues

i Diverted profits tax, digital sales taxes and other supplementary measures

Luxembourg has not enacted any diverted profit tax or digital sales tax.

ii Tax challenges arising from digitalisation

Luxembourg has not commented on Pillars One or Two of the OECD/Inclusive Framework recommendations, but it has officially confirmed its support for the project. There is no local digital sales tax that would have to be repealed if the proposals are agreed.

iii Transfer pricing implications of covid-19

Luxembourg has not issued any guidance on the transfer pricing implications of the covid-19 pandemic, although it is likely to apply the OECD guidance issued in December 2020. However, the European Commission has approved a Luxembourg scheme of grants to companies that suffered a monthly turnover decline between November 2020 and March 2021 of at least 40 per cent compared with the same period in 2019. The payment will be equal to 70 per cent of the fixed costs that are not covered by revenues, up to €1 million per undertaking.

iv Double taxation

Luxembourg tax treaties generally follow Article 25 of the OECD Model Tax Convention, which provides for a mutual agreement procedure. In cases where none of the contracting states provide for unilateral relief, they shall endeavour to reach a mutual agreement, even though, practically speaking, there is no obligation to reach such an agreement.

In addition, for transactions between enterprises of different Member States of the European Union, the resolution of double taxation disputes resulting from transfer pricing adjustments can also be made through the EU Arbitration Convention.35 The EU Arbitration Convention provides for mandatory arbitration where Member States cannot reach mutual agreement on the elimination of double taxation. The competent authorities have to reach an agreement within two years of the date on which the file was submitted to one of the competent authorities. In Luxembourg, the Minister of Finance is the competent authority. In the event that the Member States are not able to reach an agreement within this two-year period, the competent authorities shall set up an advisory commission whose opinion on the elimination of the double taxation ultimately binds the competent authorities.

Luxembourg has also signed the Multilateral Instrument (MLI)36 developed by the OECD under Action 15 of the BEPS Action Plan. Article 14 of the MLI introduces a mandatory mutual agreement procedure: a person who considers that the actions of one or both of the contracting states result in taxation not in accordance with the provisions of the covered treaty may present the case to the competent authority of either contracting state within three years. The competent authority must then resolve the case, either by itself or by mutual agreement with the competent authority of the other contracting state. Article 17 of the MLI further introduces a mandatory corresponding adjustment of tax charged on profits in one contracting state if the other contracting state includes a portion of those taxable profits under applicable transfer pricing rules. An optional clause for mandatory binding arbitration is contained in the MLI, which will allow participating countries to limit the cases eligible for arbitration (based on reciprocal agreements).

v Consequential impact for other taxes

The Luxembourg tax authorities are divided into three administrations, each being responsible for a particular area of competence:

  1. the administration for direct taxes is mainly competent for CIT, MBT and NWT, as well as withholding taxes;
  2. the Indirect Tax Authority is mainly competent for valued added tax and registration duties; and
  3. the Customs and Excise Agency is mainly competent for customs and excise duties.

As from 2008, information that is relevant for the accurate assessment of taxes must be exchanged between tax administrations. Accordingly, in the case of transfer pricing adjustments, the relevant tax administration could proceed to a corresponding adjustment in respect of the taxes or duties for which it is competent if the adjustment is not barred by the expiry of the statute of limitations.

Outlook and conclusions

The Luxembourg financial centre originally developed as a private banking centre and has grown to become a diversified hub for investment funds, banks, insurance and reinsurance companies, holding companies and family offices. The Luxembourg transfer pricing environment is hence largely focused on financial services. Precise transfer pricing regulations were first introduced in Luxembourg in 2011 with respect to intra-group financing transactions. Since then, the legislation has been completed and rendered BEPS compliant. Transfer pricing now applies to all controlled transactions in all industries.

In practice, the authors are most often solicited on controlled transactions in the asset management industry, although banking and insurance, as well as the manufacturing industries, are increasingly active in establishing their transfer pricing documentation.

Notably, the number of unilateral APA requests has diminished while transfer pricing audits and disputes have significantly increased. The new OECD Guidelines on financial transactions, which were published on 11 February 2020, further impact certain aspects of the Luxembourg transfer pricing practice, in particular regarding acceptable debt-to-equity ratio, classification of financial instruments as debt or equity and more generally the content of the transfer pricing documentation. Finally, mutual agreement procedures in transfer pricing matters also seem to be increasing, a trend that could change through broader reliance on bilateral or multilateral APAs.