Over the last few years, transfer pricing and related documentation has become the hot topic in Luxembourg taxation in an evolving environment that is relying increasingly less on tax rulings. In the past, taxpayers have viewed tax rulings as a way to provide legal certainty and to mitigate tax risks relating to investments and intra-group transactions. However, for a number of reasons this is no longer the case.
With the new reporting obligations on controlled transactions, the Luxembourg tax authorities make clear that there is an increased focus on transfer pricing documentation, forcing Luxembourg companies to consider whether their transfer pricing position is sustainable in the long term.
The new reporting obligations
The recently released 2017 corporate tax return requires Luxembourg companies to answer the following two yes/no questions in relation to transfer pricing:
1. Did the company engage into transactions with related parties (articles 56 and 56bis L.I.R. of the Luxembourg Income Tax Law (LITL))?
Whenever a Luxembourg company is involved in transactions with another group company, the answer to this question should be YES. In practice, most Luxembourg companies are most likely involved in intra-group transactions in one way or another.
With this question, the Luxembourg tax authorities force Luxembourg companies to consider whether their transfer pricing is consistent with the arm’s length principle, to analyse potential tax risks and to prepare transfer pricing documentation for tax risk mitigation purposes. It can be expected that the Luxembourg tax authorities will systematically request additional information on transaction(s) with related parties.
Transfer pricing should also be in the centre of attention of tax audits that will be performed more frequently in the future. During such tax audits the tax authorities may review the transfer pricing of several years. This only increases potential tax risks.
If the Luxembourg tax authorities can prove that a transfer price is not within the range of arm’s length prices, there exists a rebuttable presumption that the transaction does not comply with the arm’s length principle, exerting pressure on taxpayers to produce transfer pricing documentation. Overall, the burden of proof for the non-arm’s length character of intra-group transactions should be relatively low.
Should the taxpayer be unable to justify the arm’s length character of intra-group transactions, the tax authorities may rely on the “hidden dividend distribution” concept or on Article 56 of the Luxembourg Income Tax Law to perform tax adjustments resulting in an increase of the taxable basis and, therefore, tax costs.
2. Did the company opt for the simplification measure stated in section 4 of the Circular of the Director of the tax administration L.I.R. 56/1 ‐ 56bis/1 as of 27 December 2016?
This question relates to companies that on-lend funds, financed by debt instruments, to associated enterprises. The circular provides a simplification measure for Luxembourg companies that merely act as intermediaries, on-lending funds received without bearing any significant risks.
Based on the simplification measure, transactions are deemed to comply with the arm’s-length principle if the Luxembourg company realises a minimum return of 2% after-tax on the amount of the financing volume (safe harbour rule).
Taxpayers that want to apply the simplification measure must opt for this. Should a company opt in, a procedure for exchange of information will be launched based on the rules on administrative cooperation or in accordance with tax treaties.
However, in practice, Luxembourg companies that merely on-lend funds to other group companies, not taking any risks in relation to this activity, will hardly ever opt into this simplification measure given that the safe harbour remuneration is significantly higher than what might be expected at arm’s length for the functional and risk profile of an intermediary. Instead, a cost/benefit analysis should prompt Luxembourg companies involved in such activities to systematically prepare transfer pricing documentation substantiating the arm’s length nature of the remuneration on a case-by-case basis.
The Importance of Transfer Pricing Documentation
As a matter of principle, the arm’s length character of intra-group transactions should be substantiated in sound transfer pricing documentation. Despite the fact that Luxembourg tax law does not specifically require the preparation of transfer pricing documentation, taxpayers are under a duty to co-operate with the Luxembourg tax authorities and have to evidence facts and provide information in regard to statements made in the tax returns.
When the Luxembourg tax authorities can reasonably evidence that the transfer pricing of an intra-group transaction does not adhere to the arm’s length principle, it is the responsibility of the taxpayer to disprove this rebuttable presumption. Another factor to be considered is that transfer prices may be reviewed several years after a transaction takes place. This makes it increasingly more difficult from a practical perspective to trace back relevant facts and circumstances of the transaction as well as data on comparable transactions. This evidently exerts pressure on Luxembourg companies to develop and apply appropriate transfer pricing policies for risk mitigation purposes.
Best Practice Recommendations
Transfer pricing inevitably compels taxpayers to find a balance between a comfortable level of security and the costs for the preparation of sound transfer pricing documentation. In practice, Luxembourg companies should screen major intra-group transactions in order to identify specific issues that could raise suspicion on the part of the tax authorities and assess the magnitude of related tax risks.
The effort and resources used to determine and document arm’s length conditions should be proportionate to the significance of the intra-group transaction. It is also important that transfer pricing policies are not disregarded after their implementation. However, transfer pricing documentation should be regularly reviewed and updated to reflect the actual fact pattern.
Ultimately, transfer pricing documentation has become a key element in tax risk management. Its role will only increase in the years to come. In the current international tax environment of heightened transparency and scrutiny, Luxembourg companies would be wise to take it one step further and to integrate the documentation of transfer prices in their wider tax strategy, using it as a means to reflect the business rationale behind their investment structure and intra-group transactions.