CFC rules and their application in Luxembourg
As a part of the transposition of the EU Anti-Tax Avoidance Directive into its national legislation, Luxembourg has also introduced controlled foreign company rules. These rules are completely new to the Luxembourg tax system and apply to Luxembourg taxpayers for financial years starting on or after 1 January 2019.
Christophe De Sutter - Sponsoring Partner - Cross-Border Tax - Deloitte
Peter Kovacik - Senior Manager - Cross-Border Tax - Deloitte
Published on 16 April 2019
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As a part of the transposition of the EU Anti-Tax Avoidance Directive (“EU ATAD 1” or the “Directive”) into its national legislation, Luxembourg has introduced controlled foreign company (“CFC”) rules. These rules are completely new to the Luxembourg tax system and apply to Luxembourg taxpayers for financial years starting on or after 1 January 2019.
The EU ATAD 1 Directive allows member states to choose between two basic options. Under the CFC rules, a taxpayer company is attributed either predefined categories of undistributed (passive) income (Option A) or undistributed income from non-genuine arrangements (Option B), of a greater than 50 percent controlled, low-taxed, direct or indirect foreign entity of the taxpayer/parent company.
Luxembourg opted for Option B provided for by the EU ATAD 1, meaning that it can tax the undistributed income of a CFC arising from non-genuine arrangements that are put in place essentially for the purpose of obtaining a tax advantage.
This is to be interpreted as situations in which Luxembourg resident companies have or retain Significant People Functions (SPFs) that manage assets of a CFC. Here, reference is clearly made to transfer pricing concepts as developed under the BEPS action points, among others. This choice thus demonstrates Luxembourg’s full alignment with the OECD transfer pricing principles, which are already reflected in its domestic legislation by application of articles 56 and 56bis LITL.
Overview of the Luxembourg CFC rules
Under the Luxembourg CFC rules, a Luxembourg taxpayer is required (as a general rule) to include in its taxable basis the net income of foreign collective undertakings or foreign permanent establishments that qualify as controlled foreign companies in application of the CFC rules. A foreign collective undertaking or a foreign permanent establishment qualifies as a controlled foreign company if:
The Luxembourg taxpayer, itself or together with its associated enterprises, directly or indirectly (i) holds more than 50 percent of voting rights, or (ii) holds more than 50 percent of capital, or (iii) is entitled to receive more than 50 percent of profits; and
The actual corporate income tax paid by the foreign collective undertaking or the foreign permanent establishment on its income is lower than the difference between the Corporate Income Tax that would have been paid on the same profits in Luxembourg and the actual Corporate Income Tax paid in the CFC state (“subject-to-tax test”); and
The income of the foreign CFC is not taxable or is tax exempt in Luxembourg.
Luxembourg has opted to apply the option provided for by the Directive and has decided to exclude from the scope of application of the CFC rules foreign entities where either (1) their commercial profits during a financial year do not exceed EUR 750,000, or (2) their commercial profits do not exceed 10 percent of their operating costs (with some exclusions from the calculation of the operating costs).
Specific points about the application of the CFC rules
Municipal Business Tax has been excluded from the scope of application of the CFC rules. As such, it is disregarded for the purposes of the subject-to-tax test performed to assess whether a foreign entity/permanent establishment qualifies as a CFC or not. Similarly, a net CFC pick-up at Luxembourg taxpayer level is subject only to Luxembourg Corporate Income Tax and not to Municipal Business Tax.
The net CFC pick-up is to be included in the taxable basis of a Luxembourg taxpayer in the financial year during which the respective financial year of the foreign CFC ends and proportionally to the ownership percentage (deemed to be) held by the Luxembourg taxpayer in the CFC.
The net CFC pick-up is limited to the revenues generated by the assets and risks located in the CFC, yet controlled by the Significant People Functions located at the Luxembourg taxpayer and determined based on the arm’s length principle as defined in articles 56 and 56bis.
A tax credit is provided for a foreign tax paid by the CFC on the part of the net CFC income included in the taxable basis of the Luxembourg taxpayer.
Interaction with double taxation treaties
In line with the opinion of the Council of State expressed during the legislative process, the CFC rules should not apply to foreign CFC permanent establishments located in a contracting state outside the European Union where the taxation right to the income attributed to a foreign CFC permanent establishment lies with the state where the permanent establishment is located.
On the contrary, if a foreign CFC permanent establishment is located in an EU member country, the CFC rules should apply and should prevail over the application of a respective double taxation treaty.
Unless further guidance on how to interpret this is issued by the Luxembourg tax authorities, the situation must be assessed on a case-by-case basis.
Assessment of the practical impact of the CFC rules for Luxembourg taxpayers
As the CFC rules are completely new to Luxembourg tax legislation, certain aspects of their practical application will need to be clarified and/or further guidance will need to be issued by the Luxembourg tax authorities.
We believe that the impact of the CFC rules should be assessed on a case-by-case basis and the following two-step approach should be followed:
1. Identification of all entities that qualify as foreign CFCs of the Luxembourg taxpayer
2. Assessment of whether (and to what extent) the income of a foreign CFC is to be attributed to the Luxembourg taxpayer on the basis of the Significant People Functions performed in relation to the income-generating assets/risks of a CFC
Further to the broad definitions provided for by the Luxembourg CFC rules, almost all companies within a group structure/foreign permanent establishments of a Luxembourg taxpayer may qualify as CFCs if they do not pass the subject-to-tax test.
As such, it is important to determine for every entity/permanent establishment that qualifies as a CFC of a Luxembourg taxpayer whether there are any Significant People Functions effectively performed at Luxembourg taxpayer level in relation to the income-generating assets and/or risks of CFCs (so called “unilateral test”). This exercise may prove difficult when CFCs are indirectly held by EU intermediary companies.
There is no specific definition of the Significant People Functions in the Luxembourg tax legislation or in the Directive. The concept of “Significant People Functions” is only mentioned in the 2010 OECD Report on Attribution of Profits to Permanent Establishments. Without any specific definition or clarification, and in line with the recommendations of the 2010 Report, we believe that the character of the main income-generating assets and activities of a CFC will be decisive for the Significant People Functions test.
By way of example, the following activities performed at Luxembourg taxpayer level for the benefit of a CFC may constitute Significant People Functions:
- Participation in the day-to-day management of a CFC (mainly in a situation where the same persons are appointed as the managers and/or employees of both a Luxembourg resident taxpayer and its CFC)
- Performance of Key Entrepreneurial Risk-Taking (KERT) functions in relation to the origination and management of a financing activity at CFC level
- Performance of Development, Enhancement, Maintenance, Protection, or Exploitation functions (DEMPE functions) in relation to the IP asset located at the CFC, without direct oversight or control of these activities by a CFC
If there are Significant People Functions effectively performed Luxembourg taxpayer level in relation to the income-generating assets and/or risks of a CFC, the CFC net income of the Luxembourg taxpayer is to be determined in line with the applicable transfer pricing rules (articles 164ter 4.1, 56, and 56bis LITL) and on the basis of a complete value chain analysis.
Multinational groups present in Luxembourg should assess the impact of the CFC rules on their structure and Luxembourg companies. The CFC rules are completely new to the Luxembourg tax legislation and follow in principle the wording of the Directive. While the Luxembourg CFC rules do not go beyond the minimum framework required by the Directive, they do not provide additional definition and rules for their practical application (as it is the case for any new law and in absence of any Luxembourg case law).
We believe that further guidance (mainly on how to analyse the ‘significant people functions’ concept) is needed for the practical application of the CFC rules. The assessment of their impact is to be done on a case-by-case basis and taking into account the character of the assets and activities of the foreign CFCs of a Luxembourg company and the significant people functions performed in Luxembourg in relation to them.
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