In a recent court case about transfer pricing for interest rates on intra-group loans, the court ruled in favor of the Luxembourg Tax Authorities (LTA). The LTA had challenged the 12% interest rate payouts of the Luxembourg company (LuxCo), which were considered to deviate from the arm’s length principle. The excessive interest was requalified as hidden dividend distribution on which withholding tax was assessed. This case law creates an additional incentive for Luxembourg taxpayers to prepare appropriate transfer pricing documentation to set the arm’s length price of all their intra-group transactions prior to entering into the transaction.
About the case
The LuxCo acquired real estate in the south of France in 2008. The acquisition price of EUR 26 million was financed by a bank loan of EUR 20 million and a shareholder loan (SHL) of EUR 6 million. An interest rate of 12% was set on the SHL. There is no discussion on the comparison between the bank loan and the SHL.
The LTA issued a withholding tax assessment on 15 October 2014, qualifying part of the interest paid on the SHL for FY 2011 and 2012 as excessive. The LTA deemed an interest rate of 1.87% plus risk premium of 1.7% as arm’s length for FY 2011 and a rate of 0.82% plus premium 1.7% for FY 2012; the LTA’s risk premium was based on a court decision of the Cour administrative, n° 23053C from 13 June 2007. Therefore, the interest rates calculated by the LTA were 3.57% for FY 2011 and 2.52% for FY 2012. The remainder (in comparison to 12% applied by the LuxCo) was qualified as a hidden profit distribution and was subject to a 15% dividend withholding tax.
Following this decision, the LuxCo submitted its objections to the LTA including transfer pricing documentation prepared by an independent party on 7 October 2014 based on information and facts for FY 2011. The transfer pricing documentation estimated an interquartile range of interest rates between 3.21% and 7.88% to be applied on the SHL. The key arguments raised by the LuxCo against the LTA were that:
- the risk premium applied by the LTA was based on outdated data (2007) and should therefore not be considered for the case under review
- a second set of transfer pricing documentation prepared by another independent party on behalf of the LuxCo in November 2017 estimated an interest rate of between 9.95% and 19.61% and therefore an interest rate of 12% applied for FY 2011 and FY 2012 could be considered as being at arm’s length
- the interest rate of 12% was justified, as the LuxCo expected a high and stable return on its underlying investments
The court rejected the arguments submitted by the LuxCo on the following grounds:
- the LuxCo could not explain the significant difference in the findings of the first and the second transfer pricing documents (with a range of 3.21% to 7.88% and a range of 9.95% to 19.61%), even though both used the same methodology for the transfer pricing analysis
- the transfer pricing documentation provided by the LuxCo was performed “ex post” and only for the purpose of the tax assessment
- the rates derived by the LTA were corroborated by the first transfer pricing document prepared for the LuxCo
- however, the first transfer pricing document was prepared based on the facts valid for FY 2011, whereas the year in question, 2012, was not covered by a transfer pricing document
- notably, that the LuxCo’s argument regarding a high interest rate applicable due to the expectation of a high return expectation actually showed that the risk on the underlying investment was low
The court concluded by confirming the qualification of the excessive interest payments as a hidden profit distribution subject to a 15% dividend withholding tax.
Transfer pricing in Luxembourg
This case law reinforces that documenting the arm’s length nature of an intra-group transaction after it has been concluded, or following an audit of the company by the LTA, may be too late for Luxembourg taxpayers and that the LTA are increasing their focus on transfer pricing for intra-group transactions. Luxembourg taxpayers should therefore ensure that robust transfer pricing policies and transfer pricing documentation supporting intra-group transactions are prepared in a timely manner, to avoid challenges from the LTA and potential requalification of income/expenses.
The Luxembourg transfer pricing framework is included notably in article 56 and 56bis of the Luxembourg Income Tax Law, which serves as a legal basis for adjustments when Luxembourg taxpayers do not comply with the arm’s length principle in their intra-group transactions with affiliated entities.
Also, in the past months, the LTA has issued new disclosure requirements specifically related to transfer pricing. From FY 2017 onwards, tax return forms have been amended to include questions on transfer pricing, namely whether the Luxembourg company is engaged in transactions with affiliated entities. Further to this measure, one may expect more transfer pricing compliance related questions from the LTA, and that the LTA will continue to request transfer pricing documentation supporting the arm’s length nature of intra-group transactions of Luxembourg entities. Moreover, on the basis of Paragraph 171 of the Luxembourg General Tax Law, Luxembourg companies should be able to justify the arm’s length price of intra-group transactions. In practice, this means that a valid transfer pricing document prepared in line with the OECD Transfer Pricing Guidelines framework should be available to support the arm’s length price of intra-group transactions.
Find out more
KPMG Luxembourg’s dedicated transfer pricing team, consisting of more than thirty specialists, can assist taxpayers in assessing their transfer pricing positions resulting from intra-group transactions to ensure that they meet the arm’s length principle and are in compliance with current Luxembourg transfer pricing documentation and disclosure requirements.
Find out more on our website.
I would like to thank Khyati Joneja who helped me prepare this article.
 Case n° 40348 of 22 October 2018.
 The second question is whether the Luxembourg entity has opted for simplification measures stated in section 4 of the Circular of Director of tax administration L.I.R. 56/1- 56bis/1 of 27 December 2016.