Luxembourg transfer pricing legislation at a glance

2017 EY TAX Alert Luxembourg Luxembourg transfer pricing legislation at a glance Executive summary The law of 23 December 2016 on the budget for the year 2017 ( Budget Law ) has introduced a new article 56bis in the Luxembourg Income Tax law ( ITL ) that aims to clarify the concept of the arm s length principle. This principle was already more solidly forged by the law of 14 December 2014 through a rewording, largely inspired by the arm s length principle as set forth by article 9 paragraph 1 of the 2010 OECD Model Tax Convention on Income and on Capital, of article 56 ITL. In a nutshell, the new article 56bis ITL contains the basic elements to be respected in the framework of a transfer pricing analysis based on the principles as revised in the context of the Organisation for Economic Co-operation and Development ( OECD )/G20 Base Erosion and Profit Shifting ( BEPS ) Package. It particularly focuses on the comparability analysis and contains new elements to be considered, transposing hence into domestic law the conclusions from Actions 8-10 of the BEPS Plan. In addition, the Luxembourg Tax Authorities issued on 27 December 2016 an administrative Circular 1 ( the Circular ) reshaping the transfer pricing framework for companies carrying out intra-group financing activities in Luxembourg. The Circular, which refers to the aforementioned new article 56bis ITL, provides additional guidance in terms of substance and transfer pricing requirements in line with the OECD Guidelines. The new Circular replaces Circulars n 164/2 of 28 January 2011 and n 164/2bis of 8 April 2011 effective as of 1 January 2017 (the 2011 Circulars). On 13 December 2016, the Luxembourg Parliament also adopted draft law n 7031 on Country-by-Country ( CbC ) reporting, implementing Directive 2016/881/EU of 25 May 2016 amending Directive 2011/16/EU with respect to the mandatory automatic exchange of information in the field of taxation. In accordance with the aforementioned Council Directive, this law requires all Luxembourg tax resident entities that are part of a multinational group and meet certain financial thresholds, to comply with the CbC reporting requirements for financial years starting on or after 1 January 2016. This Alert summarizes the measures included in the aforementioned laws and Circular. 1 LIR nº56/1-56bis/1

Detailed discussion Applying the arm s length principle to controlled transactions Given the globalization of transactions and consequently the increased focus on transfer pricing matters, the Luxembourg government decided to forge a more solid framework for the arm s length principle to be applied between associated enterprises. To that effect, the law of 19 December 2014 (on the implementation of the so-called Package for the Future first part) replaced the wording of the transfer pricing rule (article 56 ITL) by a provision largely inspired by the arm s length principle as set forth by article 9 paragraph 1 of the 2010 OECD Model Tax Convention on Income and on Capital. According to the arm s length principle as foreseen by the reworded article 56 ITL and applicable to domestic and crossborder transactions, profits of associated enterprises entering into transactions which do not meet the arm s length principle will be determined according to normal market conditions and taxed accordingly. Based on this wording, both an upward and a downward adjustment has been made possible. It should be noted that there is no explicit reference in the article 56 ITL to article 9 paragraph 1 of the OECD Model Tax Convention. Hence any subsequent change to the current version of article 9 paragraph 1 would not result in an automatic change in the text or the interpretation of article 56 ITL (no dynamic interpretation). The commentaries of the law specify that the arm s length principle is applicable to any taxpayer, irrespective of the legal form under which it exercises its activities in Luxembourg. Therefore, not only are tax opaque collective undertakings as well as tax transparent partnership covered by this provision, but also individual and collective undertakings without legal form. The law did not introduce any specific documentation requirements as regards transfer pricing, but simply extended the existing general obligation for taxpayers to be able to justify the data contained in their tax returns with appropriate information and documentation (codified in 171 of the General Law) to transfer pricing matters. This provision is reinforced by a third paragraph clarifying that the general documentation requirements set forth by this provision also apply to transactions between associated enterprises. In the absence of further guidance, one could rely on OECD Guidelines (referred to in the commentary to the law) and the Practical Manual on Transfer Pricing for Developing Countries issued by the United Nations to get an indication of what types of documentation a taxpayer may be required to provide. Reference is also made to the European Council s Code of Conduct on Transfer Pricing Documentation for Associated Enterprises in the European Union dated 2006, aiming at harmonizing the transfer pricing documentation that multinationals have to provide to tax authorities. Basic principles of a transfer pricing analysis The Budget Law goes further by applying in detail the recommendations of the OECD BEPS Action Plan, and in particular, the Guidance for Applying the Arm s Length Principle set out in Action 8-10 of the BEPS Action Plan, which take the form of amendments to the existing OECD Transfer Pricing Guidelines 2,3, ( the Guidelines ). The main objective of this revised Guidance is to ensure that the transfer pricing rules secure outcomes that see operational profits allocated to the economic activities which generate them and therefore annihilate any opportunities for base erosion and profit shifting resulting from the transfer of risks or intangible assets among members of a same group. In light of the OECD s developments, the new article 56bis ITL contains the basic principles that must be respected in the context of a transfer pricing analysis, including the tool to be used and the methodology to be selected for implementing the arm s length principle. In this context, article 56bis ITL first provides for a number of definitions aiming to clarify some fundamental terms in the area of transfer pricing. 2 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration 2010 3 The final report, which notably contains the Guidance for Applying the Arm s Length Principle, was approved by the OECD committee of tax affairs on 24 August 2015 and published on 5 October 2015. On 9 October 2015, the Finance Ministers of the countries member of the G20 approved the different measures set out in the BEPS Action Plan, including those related to Action 8-10.

The article then states that companies have to apply the arm s length principle to all controlled transactions and specifies, in line with paragraph 1.11. of the Guidelines, that the mere fact that a transaction may not be found between independent parties does not itself mean that it is not at arm s length. As per the mechanism to be applied, article 56bis ITL particularly focuses on the comparability analysis, which is at the heart of the application of the arm s length principle. In compliance with the Guidelines, this comparability analysis is based on the two following aspects: The identification of the commercial or financial relations between related entities and the determination of the conditions and economically relevant circumstances linked to those relations in order to accurately delineate the controlled transaction The comparison of the conditions and economically relevant circumstances of the accurately delineated controlled transaction with those of comparable transactions on the free market In the same line, the economically relevant conditions and circumstances or comparability factors that have to be identified broadly include the following: The contractual terms of the transaction The functions performed by each of the parties to the transaction, taking into account the assets used and the risks assumed and managed The characteristics of the asset transferred, the service rendered or the engagement concluded The economic circumstances of the parties and the market on which the parties exercise their activities The business strategies pursued by the parties The methods to be used for the determination of the appropriate arm s length price must take into account the factors of comparability identified and be coherent with the nature of the accurately delineated transaction. The most suitable method for the transaction concerned has to be used. The text provides more clarity on the tools and approaches to be considered by taxpayers when applying international transfer pricing guidance and standards under Luxembourg law. In particular, it reinforces that the methods to be used for the determination of the appropriate arm s length compensation must take into account the OECD comparability factors and be coherent with the nature of the accurately delineated transactions. The most suitable method for the transaction assessed has to be used. The selection of the most reliable and relevant tools, as well as the consistence of the outcomes reached with the arm s length principle, should be supported by appropriate transfer pricing analysis and documentation. A pragmatic approach should be taken by taxpayers looking to support their transfer pricing positions, meeting various risk profiles with various levels of efforts/analysis. The measures have entered into effect as from the fiscal year 2017. New circular on transfer pricing for companies carrying out intra-group financing Financing activity definition The new Circular defines intra-group financing transactions as all activities consisting in granting interest bearing loans or advances to related entities and funding them with, for instance, public debt issuance, private loans, advances, or bank loans. It excludes any activities related to the funding of participations. Substantial guidance on the comparability analysis and functional analysis In line with article 56bis ITL, the Circular focuses on the importance of the comparability analysis and provides substantial details on how to conduct it consistent with OECD principles. In this respect, the comparability analysis should contain the following two elements: Identification of the commercial or financial relations existing between related parties and determination of the conditions and significant economic circumstances attached to the controlled transaction in order to precisely delineate the controlled transaction Comparison of the conditions and significant economic circumstances of the controlled transaction, accurately delineated, with comparable transactions between independent parties In order to precisely delineate a controlled transaction, the Circular stresses the importance of understanding the structure and organization of the multinational enterprise (MNE) group and to determine the extent that they influence the functioning of the group itself, the interdependent links between the functions performed by the companies having a role in the controlled transactions and the rest of the group, the contribution of the associated enterprises to the value creation in the group and how this contribution influences the arm s length remuneration of each entity involved in the controlled transactions.

Substance over form The Circular further states that economic reality should prevail over the contractual terms of the agreement. One should refer to the effective role of the parties in the transaction, thus reinforcing the application of the substance over form concept in the application of OECD transfer pricing principles. Functional analysis The Circular also provides substantial details on the approach to be taken in order to conduct a functional analysis, stressing the importance of identifying functions performed and assets used to determine the risk related to a financing transaction. These functions include, but are not limited to: Initiation of a financing transaction Management of a financing transaction Risk analysis and required amount of equity In line with the OECD BEPS Action Plan (Actions 8-10), the Circular refers to the importance for group financing companies to have the capacity to accept, manage, and assume risks in order to precisely delineate the controlled financing transaction. As opposed to the 2011 Circulars which foresaw a 1% minimum equity at risk of the amounts lent, capped at 2 million, the Circular requires the performance of a comprehensive risk analysis in order to determine the adequate level of equity. In that respect, the Circular refers to the need to estimate - based on facts and circumstances of each situation - the economically significant specific risks in relation to a financing transaction. If the activity of a group financing company would be comparable to a typical regulated entity, the use of solvency requirements applicable to such regulated entities should lead to an amount of equity to be considered as sufficient in light of the risks borne by the group financing company. If the activity of a group financing company would be different from a typical regulated entity, other methods (for instance methods based on credit rating analysis) could be used to determine the appropriate level of equity of the group financing company. A group financing company is considered to control the risk if it has both: The decision-making capacity to enter into a risk-bearing opportunity together with the actual performance of such decision-making function The capacity to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of such decision-making function New substance requirements Under the Circular, a group financing company should have a physical presence in Luxembourg in order to perform risk control functions. A group financing company is considered to have physical presence in Luxembourg, provided the following conditions are met: The majority of the members of the board of directors, the directors or the managers who have the capacity to engage the group financing company are either residents or nonresidents carrying on a qualifying professional activity in Luxembourg and taxable in Luxembourg on at least 50% of their income. In the event that a legal person is a member of the board of directors, it must have its registered office and its central administration in Luxembourg. The company must have qualified personnel able to control the transactions carried out by the company. It may nonetheless outsource the functions that do not have a significant impact on the control of the risk. Key decisions relating to the management of the company must be made in Luxembourg. In addition, for companies, which are required to hold general meetings, at least one general meeting must be held each year in Luxembourg. The company must not be considered tax resident of another State. Transactions without commercial rationality For transactions having no commercial rationality (i.e., transactions that would not have been concluded by independent parties in comparable conditions), the Circular further mentions that these transactions and their tax consequences should be ignored in order to be compliant with the arms length principle. Simplifies measures For group companies exercising a purely intermediary financing activity and meeting the three substance requirements listed above, the transactions entered into by such group financing companies will be considered as compliant with the arm s length principle if a minimum return on the assets financed of at least 2% after tax 4 is achieved. The percentage of 2% after tax could not be used for controlled transactions to be entered into by group financing companies exercising a purely intermediary financing activity and having limited functional profile. A specific transfer pricing analysis documenting the remuneration to be applied on those controlled transactions should be performed in such a case. Reliance on the simplified measure needs to be disclosed (when applied) in the tax return of the company and could be subject to exchange of information. A deviation with the above-described requirement of a 2% minimum return is acceptable on an exceptional basis when duly justified in a transfer pricing analysis. Simplified measures are also introduced to determine the arm s length return on equity for a company having a functional profile comparable to the one of certain regulated entities (reference is made to financial institutions). In such a case, a return on equity of 10% would be considered as compliant with the arm s length principle. Advance Pricing Agreements (APAs) and decisions from the Luxembourg tax administrations Application for new APAs have to meet specific requirements, including the disclosure of employees qualifications and appropriate transfer pricing documentation. Any individual decision in relation with the application of the arm s length principle, which was made by the Luxembourg tax authorities before article 56bis ITL entered into force, is considered as non-binding on the Luxembourg tax authorities after 1 January 2017. 4 This percentage will be updated by the Luxembourg tax authorities to reflect market changes.

Introducing CbC reporting One of the cornerstones of the OECD s BEPS project is the final report on Action 13, Transfer Pricing Documentation and Country-by-Country Reporting, which aims at providing tax administrations with relevant information to conduct transfer pricing risk assessment analyses and audits of transfer pricing practices. Subsequently, on 25 May 2016, the Economic and Financial Affairs Council of the European Union (ECOFIN), unanimously voted in favor of the implementation of BEPS Action 13 in the EU Directive on exchange of information (the Directive) 5. The Directive requires multinationals to report information on revenues, profits, taxes paid, capital, earnings, tangible assets and the number of employees on a country-by-country basis. In line with the Directive, the law transposing said Directive provides that if the UPE of a multinational enterprise (MNE) group required to prepare consolidated financial statements, or which would be required to do so if equity interests in any of its enterprises were listed, with a consolidated annual group turnover of at least 750 million is a Luxembourg tax resident, the entity must submit a CbC report to the Luxembourg tax authorities. Alternatively, a Luxembourg group entity that is not the UPE of the MNE group (the surrogate parent entity ) should file a CbC report with the Luxembourg tax authorities in one of the following cases: The UPE is not obliged to file a CbC report in its country of residence The UPE is obliged to submit a CbC report, but there is no automatic exchange of CbC reports between Luxembourg and the country of residence of the UPE The UPE is obliged to submit a CbC report, and there is automatic exchange of CbC reports, but due to systematic failure, no effective exchange of information takes place. A Luxembourg group entity must notify the Luxembourg tax authorities whether it is the UPE or surrogate parent entity. If it is not, it must inform the Luxembourg tax authorities of the identity of the UPE or surrogate parent entity (including the identification of its tax residency). The deadline for filing the notification for the first CbC report was set at 31 March 2017. For the purpose of the CBCR notifications, the Luxembourg Tax Authorities have launched a specific e-filing system via MyGuichet online assistant (www.guichet.lu) allowing Luxembourg tax resident entities that are part of a reporting group to electronically file their CbCR notifications as required by the Law. The notification form includes as regards the constituent entity identification: Constituent entity name Tax identification number (TIN) Fiscal year MNE group name Address of the constituent entity Constituent entity type (one of the following) UPE Surrogate Constituent entity of an MNE group where: (i) the UPE is not obliged to file a CbC report in its country of residence, or (ii) the UPE is obliged to submit a CbC report, but there is no automatic exchange of CbC reports between Luxembourg and the country of residence of the UPE, or (iii) the UPE is obliged to submit a CbC report, and there is automatic exchange of CbC reports, but due to systematic failure, no effective exchange of information takes place Other Ultimate Parent Entity (UPE) name UPE country The notification form also includes the constituent entity contact details, being the first and last name, the email and the phone number. The CbC report should be filed annually, within 12 months of the last day of the financial year. If the report is not filed or filed late, the Luxembourg tax administration may impose a penalty of up to 250,000. This penalty may also apply if the information included in the CbC report is incomplete or inaccurate, or if the report does not comply with other specific requirements of the law. The penalty is also applicable to the failure to notify the Luxembourg tax authorities whether a group entity is the group s ultimate parent entity or a surrogate parent entity. The penalty may also apply in case of late notification to the tax authorities. The Luxembourg tax authorities will automatically exchange the information contained in the CbC report with EU Member States or other relevant tax authorities pursuant to the provisions of the applicable international agreements (Multilateral Convention on Administrative Assistance in Tax Matters (MCAA), bilateral tax conventions, or Tax Information Exchange Agreements). According to the law, a Luxembourg grand-ducal decree will be issued listing the jurisdictions with which the CbC report will be exchanged by reference to the MCAA. The law provides that the tax administrations can solely use the reported information for the purpose of assessing high level transfer pricing risks and other risks related to BEPS. Transfer pricing adjustments by tax authorities should not be based on the information exchanged. The aforementioned legislation applies to fiscal years starting on or after 1 January 2016. 5 Directive 2016/881/EU of 25 May 2016, which amends Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation.

For additional information with respect to this Alert, please contact one of the following or your usual EY contact: Nicolas Gillet Partner Transfer Pricing +352 42 124 7524 nicolas.gillet@lu.ey.com Christian Schlesser Partner Transfer Pricing +352 42 124 7500 christian.schlesser@lu.ey.com Fernando Longares Executive Director Transfer Pricing +352 42 124 7312 fernando.longares@lu.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. 2017 Ernst & Young S.A. All Rights Reserved. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com/luxembourg