On March 4, 2020, the tax authorities of Luxembourg (hereinafter NOL) has published a Guide to controlled foreign companies (CFC). Interestingly, these rules should apply from 2020.
Their main purpose is to prevent taxpayers from withdrawing profits from Luxembourg to CFC or foreign representative offices and branches registered in low-tax countries.
Under the new rules, a Luxembourg taxpayer can be subject to corporate income tax on their share of the undistributed income of a controlled foreign company.
The guide introduces additional compliance requirements (transfer pricing) in Luxembourg for resident taxpayers who own a CFC. A functional analysis should be provided annually (on request), including information about the assets and income of the CFC. The guide also provides a number of explanations on how to determine whether there is control over a foreign company and on violations of the law.
The control and verification of effective tax rates
In order for a foreign company to be considered controlled, a tax resident of Luxembourg must directly or indirectly own more than 50% of the voting shares and/or have the power to participate in the profits or capital of the enterprise. This is called a control test.
As for permanent representation abroad, the control test is also usually applied to them. In addition, the tax rate effectiveness test, called the ETR test, is also applied. This test measures how much the foreign tax rate is. If it is less than 50% of the Luxembourg income tax rate (i.e. less than 8.5%), the client must pay the full CFC income tax rate to the Luxembourg budget.
As for the control test, the Guide mentions that it requires consideration of economic reality, not legal formalization.
In addition, the Guide concludes that the 50% threshold can be exceeded when ownership is concentrated simultaneously in the hands of several taxpayers when different types of participation are not agreed upon. For example, when there is a gap between the right to vote and the right to profit.
In addition, the control test takes into account the participation of a foreign person belonging to businesses “related” to the Luxembourg taxpayer. Associated enterprises are enterprises with which the Luxembourg taxpayer has a direct or indirect connection through the ownership of at least 25% of shares, voting rights, capital, or profit rights. The guidelines provide that any such Association existing during the tax year should be taken into account, regardless of the time of its existence.
As for the ETR test, the Guide specifically mentions that the assessment of a tax position in a foreign country must include the tax rate, tax base, including all other tax rules that may affect the effective tax on the subsidiary’s income, and must cover all income, not just the income considered in relation to the application of the CFC rules.
Only after completing the control and ETR tests, an organization or permanent establishment can be recognized as a CFC.
The accession of the income of a CFC for the taxable base
The CFC guidelines grant NOL the right to tax the taxpayer’s share of the CFC’s undistributed income arising from an inauthentic agreement.
HOWEVER, CFC income can only be taxed in Luxembourg to the extent that it is generated by assets and risks associated with “significant human functions” performed by the Luxembourg taxpayer.
The latter requirement should be evaluated on the basis of the fair price principle. Expenses that are economically related to this income are deductible.