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Financing activities: what is the right price when no advance pricing agreement with the tax authorities?

Luxembourg
A recent decision of the Luxembourg Administrative Tribunal deals with questions on whether the remuneration on the financing activity performed by a Luxembourg company is an arm’s length remuneration, and whether there is a hidden distribution on loans granted by a Luxembourg company to other group companies. These loans were neither remunerated nor fully documented. The Tribunal also explained circumstances under which the tax authorities are allowed to assess Luxembourg companies automatically (so-called taxation d'office). Taxand Luxembourg investigates the case, which is one of the few in the area of financing activities performed by Luxembourg companies.

Facts and procedure

A Luxembourg company (Luxco) granted loans to other group companies, which were neither fully documented nor remunerated. One loan each was granted to two SA’s (Public Limited Company registered in Luxembourg), and a third loan to a French SCI. When assessing tax years 2005 to 2010, the tax authorities applied a 3.5% margin on these loans, while they had applied a margin of 0.75% when assessing tax years 2003 and 2004 (the margin had been increased by the tax authorities from 0.5 to 0.75%). Luxco challenged the position of the tax authorities, arguing that the tax authorities should apply the same margin (ie 0.75%) as the one they had applied in previous tax assessments.

Luxco argued further that a capital gain had been realised upon the transfer of one of these loans (loan to the French SCI) and that this capital gain corresponded to the amount of interest which should be realised in accordance with arm's length principles, ie 0.5% margin for the tax years 2003 & 2004 and 0.75% margin for the tax years 2005-2010. Luxco concluded that the remuneration on this loan was in line with the arm's length principles and that the tax authorities should not have increased its taxable basis.

Luxco added further that the French SCI had already deducted an interest charge of 0.75% in its accounts and was now no longer able to deduct additional amounts in case of a tax adjustment at the level of Luxco, so that in case of adjustment there would be a situation of double taxation. Regarding the 2 loans to the SAs, Luxco argued that these amounts were not loans but receivables against the SAs which should not be remunerated. The amounts were however reflected as loans in the accounts of Luxco.

Decision of the Tribunal

As far as the receivables/loans to the SAs are concerned, the Tribunal considered that there was a hidden dividend distribution and since Luxco did not provide any supporting documentation or argument/evidence to suggest that another level of remuneration would be appropriate, the tax authorities were right in assessing Luxco automatically and considering a margin of 3.5% as appropriate. The fact that the tax authorities agreed in the past on a lower margin of 0.75% would be irrelevant, given the annual nature of the tax. The only exception to this principle would be the case where a prior written agreement has been reached with the tax authorities in this respect (here reference is informally made to Advance Pricing Agreements), which was not the case.

As far as the loan to the French SCI is concerned, given the facts evidenced by Luxco and the gain made on the transfer of the loan, the Tribunal disagreed with the tax authorities which claimed that there would be a hidden dividend distribution and considered instead that the taxable basis of the Luxco should not have been increased in this respect.


Your Taxand contacts for further queries are:
Olivier Remacle
+352 26 940 239
olivier.remacle@atoz.lu

Samantha Merle
+352 26 940 235
samantha.merle@atoz.lu

Taxand's Take

The case, which is one of the few in the area of financing activities performed by Luxembourg companies, shows that the tax authorities are getting more attentive to application of arm's length principles. The Tribunal states that the position taken by the tax authorities in one year as regards the margin is not binding in the following tax years, except if an agreement has been reached with the tax authorities (which was not the case here). While the variation in the rates is surprising and unsubstantiated, one wonders if the tax authorities would have so increased the margin if Luxco applied a margin of 0.75% instead of no margin at all during 2005 to 2010.

The case law is somewhat suggestive that applying a small margin may be better than not applying any margin at all and thus leaving it to the tax authorities to decide what the appropriate remuneration is. Considering the novel approach of the tax authorities, tax payers should be aware and prudent, and where necessary seek advice while defining the terms and conditions of financing transactions and determining the arm’s length price. Obtaining an Advance Pricing Agreement from the tax authorities may add much needed safety in certain cases, but tax payers need to be strategic about their choices.      

Taxand's Take Author

Olivier Remacle
Luxembourg

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