As a result of the OECD recommendations on the elimination of Base Erosion and Profits Shifting (BEPS) and as further required by the EU Directive on Anti-Tax Avoidance (ATAD1), Luxembourg has implemented its first CFC regime by introducing a specific provision in the Corporate Income Tax Law (article 164ter).
The Luxembourg provision which was introduced by the law of 21 December 2018, is an anti-abuse measure aiming at preventing Luxembourg taxpayers from shifting profits to foreign controlled associated entities or permanent establishments located in low taxed jurisdictions (hereafter “CFC Entities” or individually a “CFC Entity“) through arrangements put in place for the essential purpose of obtaining a tax advantage (i.e. non-genuine arrangements).
Based on this provision, Luxembourg will apply Corporate Income Tax (CIT) on non-distributed profits of a CFC Entity under certain conditions.
The Luxembourg CFC regime is applicable from the fiscal year 2019 onwards and will therefore affect for the first time, the reporting position taken in the corporate tax returns 2019 which will be filed in the course of 2020.
In that respect, a Circular letter N°164ter/1 was released by the Luxembourg tax authorities on March 4, 2020 (the “Circular”) in order to provide clarifications and to outline their position with respect to the application of article 164ter to non-distributed profits of a CFC Entity. The Circular further adds certain transfer pricing requirements and documentations to be transmitted to the tax authorities upon request.
Qualification as a CFC Entity
According to article 164ter CIT a CFC Entity is a foreign:
- collective undertaking held by a Luxembourg corporate taxpayer, or
- permanent establishment of a Luxembourg corporate taxpayer, or
- tax transparent entity which qualifies as a permanent establishment of a Luxembourg corporate taxpayer.
In order to qualify as a CFC Entity, the following conditions must be cumulatively fulfilled:
As regards a foreign collective undertaking, the Luxembourg taxpayer (i.e. the shareholder) must, directly or indirectly, alone or in conjunction with other associated enterprises:
- hold more than 50% of the voting rights in the CFC Entity, or
- hold more than 50% of the share capital of the CFC Entity, or
- be entitled to more than 50% of the profits of the CFC Entity.
The term “Control” is to be understood from both a legal and an economic perspective (i.e. where the economic reality does not align with the legal qualifications, the economic reality will prevail).
With respect to a foreign permanent establishment this condition is obviously always fulfilled.
According to the Circular, whether the foreign permanent establishment is located within the EU or outside the EU is irrelevant.
An associated enterprise is defined as an entity or an individual which holds directly or indirectly at least 25% of the share capital, the voting rights, or the right to profits of another entity. An enterprise is deemed associated to a Luxembourg company if the above thresholds and conditions are met.
The CFC regime will apply regardless of the duration of the control or of the “association link” throughout the fiscal year.
2. Effective tax rate (ETR)
The corporate income tax effectively paid by the CFC Entity must be lower than the difference between the CIT that would have been paid on the same profits if the CFC Entity was established in Luxembourg and the corporate income tax actually paid in the CFC Entity’s State of residence.
In other words, the CFC Entity must have paid less than half of the CIT it would have paid if it was established in Luxembourg (i.e. less than 8.5% in 2019).
For comparison purposes, the taxable basis of the CFC Entity will, if necessary be converted into Euro based on the conversion rates published by the European Central Bank at the closing date of the relevant fiscal year of the Luxembourg taxpayer.
The taxable basis of the CFC Entity will further be determined based on the Luxembourg corporate tax rules (including the utilization of tax losses carried forwards of the CFC Entity to offset taxable profits of the CFC Entity).
A theoretical Luxembourg CIT charge will then be calculated (excluding the 7% employment surcharge and the Municipal Business Tax) and compared with the foreign corporate income tax due and paid in the State of residence of the CFC Entity.
Upon request, the tax assessments of the CFC Entity must be disclosed to the Luxembourg tax authorities, and must include not only the tax rate and the taxable basis but also any other relevant information which may have had an impact on the effective tax due by the CFC Entity.
A proof of payment of taxes by the CFC Entity may be requested by the Luxembourg tax authorities. Any tax refund received by the CFC Entity will decrease the amount of its effective tax for the purpose of the comparison.
The Luxembourg CFC rules are not applicable if:
- the commercial profits of the CFC Entity are lower than EUR 750,000 or
- the commercial margin of the CFC Entity does not exceed 10% of its operating costs.
The Luxembourg CFC rules apply for:
- Luxembourg collective undertakings which have their statutory seat or their place of effective management in Luxembourg, and
- Luxembourg permanent establishments of foreign companies located within the EU or not.
Determination of CFC profits to be declared in Luxembourg
In principle, only non-distributed profits realized by a CFC Entity and resulting from artificial constructions are taxable in Luxembourg.
Such non-genuine profits must be generated by assets and risks which are linked to the key functions exercised by the Luxembourg taxpayer (and not by the CFC Entity). This is generally the case if the CFC Entity would not have been the owner of the assets or would not have assumed the risks which have generated its income if the CFC Entity was not controlled by the Luxembourg taxpayer. Additionally, the Luxembourg taxpayer must have exercised the relevant key functions and must have played an essential role in generating the income of the CFC Entity. The above is consistent with the application of the arm’s length principle, with respect to the” Significant People Functions” concept which determines the genuine character of an arrangement.
In order to avoid any taxation of the non-distributed profits in Luxembourg, the taxpayer must demonstrate that non-distributed profits of the CFC Entity are the result of genuine business arrangements. In that respect, the Luxembourg taxpayer must annually prepare (and send to the tax authorities upon request) a transfer pricing functional analysis which indicates that the “Significant People Functions” in relation to the assets and risks of the CFC Entity have not been carried out from Luxembourg.
Once available, we expect the 2019 corporate tax return form to provide more clarity on how the taxpayers falling under the scope of the CFC rules should declare the existence of a CFC Entity, calculate the amount of non-distributed profits attributable to Luxembourg taking into account the percentage held by the Luxembourg taxpayer’s in the CFC Entity and include such amounts in their taxable basis. E.g. It is not clear at this stage whether the taxpayer will be entitled to apply for tax credit as regards the amount of corporate income tax paid abroad.
General Anti-Abuse provision (GAAR°
Any reorganization which would not be justified by sounds commercial reasons and would not be supported by the economic reality, aimed solely at reducing the level of control of a CFC Entity, or decreasing the commercial profits of the CFC Entity or reducing the thresholds required in order to qualify as an associated enterprise would fall under the General Anti-Abuse provision (§ 6 StAnpG) if conditions are met.
How can we help?
Business should start assessing the impact of the CFC provision on their existing structures and on their group transfer pricing strategies.
We can assist with the review of current and future structures, with the review of transfer pricing documentations as well as with the proper reporting in the corporate income tax returns.
Should you have further questions please contact us
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