Transfer pricing and its importance for the Luxembourg directors
Transfer pricing and its importance for the Luxembourg directors
In today's business landscape, the role of Directors extends far beyond traditional boundaries. One critical aspect that demands their attention, particularly in Luxembourg, is transfer pricing (“TP”), a complex domain pertaining to the more general tax field. TP has gained an unprecedented attention from the tax authorities around the world following the OECD Base Erosion and Profit Shifting (“BEPS”) action plan implementation and the fight of tax authorities for taxable income. The topic is further brought in the spotlight due to the current global economic turmoil.
This article delves into the responsibility and importance of managers and directors in ensuring TP compliance and the minimum actions required to avoid TP risks and personal liability in Luxembourg.
Transfer pricing rules in Luxembourg
In a nutshell, TP deals with the determination of the prices and other general conditions between related entities when entering intercompany transactions, such as: sale of goods, licensing of intellectual property rights, advancing of loans or other financial arrangements and provision of services, etc. As it involves setting the prices for cross-border transactions, it can impact on the allocation of profits and therefore the taxes paid by groups of companies across different jurisdictions where they operate.
Due to the potential loss of tax revenue which can lead to detrimental effects on economic development of a country, the topic of transfer pricing practices and their effect on tax collections in Europe has attracted much attention. In fact, during the last years both the European Union (EU) and the Organization for Economic Co-operation and Development (OECD) have issued several new rules and proposals focused on an increased alignment between the OECD and EU members. Consequently, countries around the world have updated their TP laws and regulations and the number of TP audits and case law has increased.
Luxembourg has consistently implemented in its local regulations the recommendations of the OECD. If before 2015 Luxembourg’s TP rules were mainly related to financial transactions, starting with 2015, Luxembourg updated its tax legislation, officially including the arm’s length principle (i.e. conditions of transactions between related parties shall be similar to the ones that would have been agreed between third parties) in article 56 of the Luxembourg Income Tax Law (LITL). Moreover, by adding the new paragraph 171 section 3 to the General Tax Law, Luxembourg introduced the obligation for taxpayers to present the TP documentation when requested.
Further on, the TP regulation which is most relevant for Luxembourg managers and directors is the TP Circular, L.I.R. n° 56/1 – 56bis/1 (TP Circular). In line with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines), the TP Circular tackles the TP aspects to be considered by Luxembourg entities when carrying out financing activities consisting in granting of loans or advances to related parties funded by debt instruments, an activity typical for the financial sector entities in Luxembourg and for MNEs structuring their financing activities and treasury functions through Luxembourg.
The Circular describes how the arm’s length principle must be applied in relation to the intermediary intragroup financing transactions and it establishes that entities carrying out such activities shall have the financial capacity to assume the lending risks, bear the financial impacts in case the risks materialize and earn an arm’s length remuneration. Furthermore, and key for the directors, the entity shall have the capacity to control the risks, actually exercising the decision-making function and determining when to enter into a commercial relationship and how to respond to changes in the risk profile of the borrowing entity.
It is worth it underlining that the substance requirements brought forward by the Circular are directly related to ability and the professional knowledge of the directors to exercise their functions in relation to the execution and management of the intercompany financial transactions. In the case of outsourcing of specific functions or tasks, the directors should have the appropriate professional expertise to exercise the oversight and decision-making functions related to such outsourced functions.
How can the directors be held responsible?
There are several types of liabilities for the directors of a Luxembourg company such as: civil liability, criminal liability, tax liability and liability in a bankruptcy context. Transfer pricing liability falls under the general tax liability based on article 103 and 109 of the Abgabenordnung (general tax law).
Generally, the company director is responsible for the tax returns and for the payment of tax debts of the legal entity he/she represents. As such, they need to make sure that the entity fulfills its obligations related to the tax declarations and has sufficient funds to pay its debts. If they fail to comply with such obligations, they may be held personally liable for the tax debt.
In this context, in relation to TP, it is to be noted that as of 2017 the tax returns have a specific field with a box that needs to be checked if the respective taxpayer was engaged into transactions with related undertakings (article 56 and 56 bis L.I.R) during the specific year. This is also a confirmation that the director is aware of such intercompany dealings and of the obligations as per the tax law. Further, during the tax assessment process, additional information can be requested by Luxembourg Tax Authorities (LTA) to support the arm’s length nature of the intercompany transactions.
What are the risks related to TP?
As mentioned above, the TP regulations aim to guarantee that prices in intercompany transactions will be set as if the entities involved were independent and dealing at arm's length. TP then ensures that companies carry out the transactions with related parties in the best interest of the standalone company, and thus, in all cases should be a key aspect for directors.
Failure to comply with the general TP rules could lead to challenges and adjustments from the LTA on the amounts included in the corporate income tax return of the Luxembourg entities, which could further trigger significant additional taxes and potential unexpected cashflow constrains and penalties for late payments for taxpayers. As the number of TP audits, request for additional information from the LTA as well as the TP case law in Luxembourg has substantially increased recently, it is advisable for all directors to prepare and ensure appropriate documentation is in place.
In relation to the application of the TP Circular, it is noteworthy that, if the requirements are not met, the consequences are not only related to TP challenges from the LTA on the figures included in the corporate income tax return and potential adjustments, but also the automatic exchange of information with other jurisdictions and potential denial of the beneficial ownership status of the Luxembourg lender (with implications on the application of the Double Tax treaties). The automatic exchange of information could then lead to challenges also in the jurisdiction of the subsidiaries and more intensive tax reviews for the whole structure.
Recommendations for handling TP risks
Considering the increased focus from governments and tax authorities on TP, to be well equipped to handle the TP risks, we suggest that managers and directors:
The consequences of not complying with the TP rules could have disastrous effects on the Luxembourg structure and carry significant liability for directors.
This article delves into the responsibility and importance of managers and directors in ensuring TP compliance and the minimum actions required to avoid TP risks and personal liability in Luxembourg.
Transfer pricing rules in Luxembourg
In a nutshell, TP deals with the determination of the prices and other general conditions between related entities when entering intercompany transactions, such as: sale of goods, licensing of intellectual property rights, advancing of loans or other financial arrangements and provision of services, etc. As it involves setting the prices for cross-border transactions, it can impact on the allocation of profits and therefore the taxes paid by groups of companies across different jurisdictions where they operate.
Due to the potential loss of tax revenue which can lead to detrimental effects on economic development of a country, the topic of transfer pricing practices and their effect on tax collections in Europe has attracted much attention. In fact, during the last years both the European Union (EU) and the Organization for Economic Co-operation and Development (OECD) have issued several new rules and proposals focused on an increased alignment between the OECD and EU members. Consequently, countries around the world have updated their TP laws and regulations and the number of TP audits and case law has increased.
Luxembourg has consistently implemented in its local regulations the recommendations of the OECD. If before 2015 Luxembourg’s TP rules were mainly related to financial transactions, starting with 2015, Luxembourg updated its tax legislation, officially including the arm’s length principle (i.e. conditions of transactions between related parties shall be similar to the ones that would have been agreed between third parties) in article 56 of the Luxembourg Income Tax Law (LITL). Moreover, by adding the new paragraph 171 section 3 to the General Tax Law, Luxembourg introduced the obligation for taxpayers to present the TP documentation when requested.
Further on, the TP regulation which is most relevant for Luxembourg managers and directors is the TP Circular, L.I.R. n° 56/1 – 56bis/1 (TP Circular). In line with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines), the TP Circular tackles the TP aspects to be considered by Luxembourg entities when carrying out financing activities consisting in granting of loans or advances to related parties funded by debt instruments, an activity typical for the financial sector entities in Luxembourg and for MNEs structuring their financing activities and treasury functions through Luxembourg.
The Circular describes how the arm’s length principle must be applied in relation to the intermediary intragroup financing transactions and it establishes that entities carrying out such activities shall have the financial capacity to assume the lending risks, bear the financial impacts in case the risks materialize and earn an arm’s length remuneration. Furthermore, and key for the directors, the entity shall have the capacity to control the risks, actually exercising the decision-making function and determining when to enter into a commercial relationship and how to respond to changes in the risk profile of the borrowing entity.
It is worth it underlining that the substance requirements brought forward by the Circular are directly related to ability and the professional knowledge of the directors to exercise their functions in relation to the execution and management of the intercompany financial transactions. In the case of outsourcing of specific functions or tasks, the directors should have the appropriate professional expertise to exercise the oversight and decision-making functions related to such outsourced functions.
How can the directors be held responsible?
There are several types of liabilities for the directors of a Luxembourg company such as: civil liability, criminal liability, tax liability and liability in a bankruptcy context. Transfer pricing liability falls under the general tax liability based on article 103 and 109 of the Abgabenordnung (general tax law).
Generally, the company director is responsible for the tax returns and for the payment of tax debts of the legal entity he/she represents. As such, they need to make sure that the entity fulfills its obligations related to the tax declarations and has sufficient funds to pay its debts. If they fail to comply with such obligations, they may be held personally liable for the tax debt.
In this context, in relation to TP, it is to be noted that as of 2017 the tax returns have a specific field with a box that needs to be checked if the respective taxpayer was engaged into transactions with related undertakings (article 56 and 56 bis L.I.R) during the specific year. This is also a confirmation that the director is aware of such intercompany dealings and of the obligations as per the tax law. Further, during the tax assessment process, additional information can be requested by Luxembourg Tax Authorities (LTA) to support the arm’s length nature of the intercompany transactions.
What are the risks related to TP?
As mentioned above, the TP regulations aim to guarantee that prices in intercompany transactions will be set as if the entities involved were independent and dealing at arm's length. TP then ensures that companies carry out the transactions with related parties in the best interest of the standalone company, and thus, in all cases should be a key aspect for directors.
Failure to comply with the general TP rules could lead to challenges and adjustments from the LTA on the amounts included in the corporate income tax return of the Luxembourg entities, which could further trigger significant additional taxes and potential unexpected cashflow constrains and penalties for late payments for taxpayers. As the number of TP audits, request for additional information from the LTA as well as the TP case law in Luxembourg has substantially increased recently, it is advisable for all directors to prepare and ensure appropriate documentation is in place.
In relation to the application of the TP Circular, it is noteworthy that, if the requirements are not met, the consequences are not only related to TP challenges from the LTA on the figures included in the corporate income tax return and potential adjustments, but also the automatic exchange of information with other jurisdictions and potential denial of the beneficial ownership status of the Luxembourg lender (with implications on the application of the Double Tax treaties). The automatic exchange of information could then lead to challenges also in the jurisdiction of the subsidiaries and more intensive tax reviews for the whole structure.
Recommendations for handling TP risks
Considering the increased focus from governments and tax authorities on TP, to be well equipped to handle the TP risks, we suggest that managers and directors:
- Perform an inventory of all intercompany transactions and fully understand the TP rules and obligations of the entity they manage.
- Understand the impact of the TP implementation on the financial statements and on the wider tax aspects for the structures they manage.
- Ensure that the functional and risk profile of the entity is in line with the TP documentation and that the functions are effectively performed in accordance with it.
- In relation to the financing activities, the directors should ensure that: they have the professional ability to perform the necessary risk management and the active management of the financing activities; they are able to exercise their decision-making function; there is an appropriate level of equity and remuneration to support the risks assumed.
- Ensure they have the appropriate support to reply to the LTA’s requests and audits in a timely, professional, and complete manner.
The consequences of not complying with the TP rules could have disastrous effects on the Luxembourg structure and carry significant liability for directors.