The domestic law of Luxembourg does not provide any specific rules for determining the arm’s length price for transactions involving intra-group services, intangible property, and cost contribution agreement and relies on the OECD transfer pricing guidelines.
On 28 January 2021, Luxembourg adopted new rules which disallow the tax deduction of interest and royalties paid to related parties in non-cooperative jurisdictions. In this regard, on 31 May 2022, the Luxembourg tax authorities issued a circular clarifying that interest and royalties paid are not deductible if:
- The beneficial owner is a company;
- The company is a related party; and
- The company is established in a listed non-cooperative jurisdiction.
Where the interest and royalties are paid to an intermediary, the non-deduction rules apply only if the actual beneficial owner is a related company and is established in any of the listed non-cooperative jurisdictions. In the case of a non-resident partnership, where partners are considered as the beneficial owner, non-deduction depends on the nature of the partner. For example: if in the partnership 60% is owned by a non-resident company in a non-cooperative jurisdiction and the remaining 40% is owned by a foreign natural person, then only 60% of the interest and royalties paid are non-deductible.
The non-deduction rules are effective from 1 March 2021 and apply to the EU list of non-cooperative jurisdictions published on 26 February 2021. Effective 1 January 2022, the non-deduction rules apply to the EU list of non-cooperative jurisdictions published on 12 October 2021. For subsequent years (i.e., effective 1 January 2023), the non-deduction rules apply to the latest non-cooperative jurisdiction list published by the EU as of 1 January every year (see Sec.12.5. for the latest updated EU list of non-cooperative jurisdictions). The guidance further explains with the help of examples the timelines to be considered in case of addition/removal of the jurisdiction from the non-cooperative list during the year.
Interest and royalties paid will be considered deductible expenses if the taxpayer proves that the operations to which the interest or royalties are applicable are used for valid commercial purposes and indicate economic reality. The exception is subject to other limiting provisions of the tax law. The taxpayer must file an application for an advance ruling to claim the exception which will be subject to an assessment by the competent tax authority.
Effective from 1 January 2017, a new circular 56/1 – 56bis/1 dated 27 December 2016 applies to intra-group financing transactions and replaces the circulars published in 2011.
The new circular defines intra-group financing transactions as all activities connected with granting of interest-bearing loans or advances to related entities and funding them, including public debt issuance, private loans, advances or bank loans. A return-on-equity approach based on a comparability analysis is prescribed for determining the arm’s length remuneration of the Luxembourg company. A financial company exercising a purely intermediary activity and meeting substance requirements listed in the circular is considered as compliant with the arm’s length principle if it receives an after-tax return of at least 2% on the assets financed (simplified method). An Advance Pricing Agreement (APA) may also be obtained for intra-group financing transactions, provided certain substance and equity-at-risk requirements are met.
The following factors are to be considered while determining the arm’s length price for financial transactions:
- Whether any intra-group financial transactions are being carried out;
- The nature of the financial transaction. Whether the financial transaction is in the nature of financing of fixed assets, financing of current assets, long-term strategic financing, or any other miscellaneous financing;
- Whether the financial transactions have commercial rationality;
- Whether the contract clearly distinguishes the group member responsible for significant decisions in the financial transactions and the group member has control over the economically relevant risks associated with the financial transactions;
- Whether the functional, risk and asset analysis for the intra-group financial transactions are carried out; and
- Whether the pricing of the financial transaction is at arm’s length based on the return-on-equity approach or under the simplified method.
The European Commission has challenged the legality under State aid rules of alleged tax benefits granted by Luxembourg. Essentially, the Commission’s position is based on its own interpretation of how the transfer pricing rules should have applied in the challenged cases. Cases are still ongoing before the Court of Justice of the European Union, but first instance decisions by the General Court have upheld the position of the Commission in some instances (e.g. in the Engie case) but not in others (e.g. in the Amazon case).
Under the Authorized OECD Approach (AOA), the OECD has published guidelines for the allocation of profits to permanent establishments. Currently, there are only seven tax treaties of Luxembourg that have incorporated the latest Authorised OECD Approach (AOA) which is based on Article 7 of the OECD Model Tax Convention as amended in 2010, and 77 treaties continue to use the pre-existing version.