Luxembourg Tax Authority issues guidance on application of controlled foreign company rules in Luxembourg

• The Luxembourg Tax Authority has issued an updated circular containing clarifications and examples, outlined in this Alert, regarding the country’s CFC regime.
• Taxpayers should review the rules to determine their impact on their Luxembourg operations.

Executive summary

The Luxembourg Tax Authority recently issued an updated administrative circular1 (Circular) containing clarifications and examples in relation to the Luxembourg Controlled Foreign Company (CFC) rules that were introduced with the Luxembourg law of 21 December 2018 implementing the European Union (EU) Anti-Tax Avoidance Directive (ATAD)2.

This Alert summarizes the key provisions of the Circular.

Detailed discussion

Definition of a CFC

According to the law, a CFC is defined as an entity or a permanent establishment (PE) whose income is not taxable or exempt in Luxembourg, if the following two conditions are met:

• In the case of an entity, the Luxembourg taxpayer, alone or together with its associated enterprises, holds a direct or indirect participation of more than 50% in such entity. The threshold is determined in terms of participation in the share capital, voting rights or the entitlement to profits (control criterion).
• The entity or PE is low-taxed, i.e., the actual income tax the entity or PE is required to pay is lower than 50% of the Luxembourg corporate income tax (CIT) it would have paid applying the provisions of the Luxembourg Income Tax Law (low-tax criterion).

A CFC is thus defined by reference to two criteria that have to be met simultaneously, being the control by the taxpayer over the CFC and low effective taxation of the CFC. The Circular provides for some additional clarifications with respect to the aforementioned conditions.

Permanent establishments as CFCs

The Circular clarifies that next to collective undertakings (mainly corporations), PEs located in a jurisdiction with which Luxembourg has a tax treaty (whether an EU Member State or not) can also constitute a CFC. The same applies to any foreign entity that is tax-transparent (e.g., certain partnerships) from a Luxembourg perspective if it constitutes a PE of the taxpayer abroad. With reference to the final report of the Organisation for Economic Co-operation and Development on Action 3 (Designing Effective Controlled Foreign Company Rules), such inclusion is justified to ensure that the CFC rules are not circumvented just by changing the legal form of a subsidiary. 

Control criterion

The Circular first outlines that the control test requires an aggregation of the participations in a given entity held by the taxpayer directly and indirectly (i.e., those held through a participation in an entity that does not constitute a CFC), together with those held by its associated enterprises. The control test covers both the legal and the economic control exercised by the taxpayer, together with its associated enterprises, at any time during a given financial year.

Legal control is understood as control based on voting rights held directly and indirectly (i.e., the right to deliberate and vote during shareholders’ meetings on any decision conferred to the shareholders, such as the appointment or the revocation of the management, the transfer of the statutory seat, etc.), as well as control based on capital held directly or indirectly in the CFC.

Economic control refers to the entitlement to profits of the CFC, and thus covers the entitlement to dividends, capital gains on the sale of shares of the CFC or liquidation proceeds.

Own shares held by the CFC as well as any shares of the CFC held by one of its subsidiaries are nevertheless excluded from the control test. The Circular illustrates this with an example of a CFC whose capital is divided into 100 shares, out of which 10 are held by the CFC itself: the taxpayer is considered to exercise control over the CFC if it holds more than 45 of the shares of the CFC.

Control over a CFC can take various forms, including in particular shares with or without voting rights and securities not representing the capital of the CFC. Where the various rights are dissociated (e.g., taxpayer A holding more than 50% of the voting rights and taxpayer B having an entitlement to more than 50% of the profits), the control test may be met by more than one taxpayer (in the example, both A and B are considered to exercise control over the same CFC). Whether a taxpayer effectively controls the CFC is assessed in light of the economic ownership criteria set forth in Luxembourg tax legislation.

The control test requires an assessment of the direct and indirect control by the taxpayer in a given entity. The control with respect to an indirect participation is determined by multiplying the holding rates successively at the various levels down the chain. The control that the taxpayer has, together with its associated enterprises, in a CFC equals the sum, on the one hand, of the direct participation of the taxpayer in that CFC as well as the indirect participations that the taxpayer has in that CFC through a participation in an entity that is not an associated enterprise and, on the other hand, of the participations held by the associated enterprises of the taxpayer in the same CFC. In contrast, a company in which the taxpayer has no direct or indirect control cannot be a CFC for this taxpayer.

Finally, the Circular states that any restructuring lacking valid commercial reasons which reflect economic reality and undertaken with the aim to reduce the control exercised by the taxpayer over a CFC, may constitute an abuse of law in the meaning of the Luxembourg General Anti-Abuse Rule (GAAR). 

Low-tax criterion

The low-tax criterion is met if the effective tax the CFC is required to pay is less than half of the Luxembourg tax that the CFC would have been subject to as a Luxembourg resident taxpayer under the Luxembourg income tax law. Reference is made to CIT only, excluding thus the contribution to the employment fund which is calculated on and added to the CIT. As a consequence, the reference CIT rate for comparison purposes for the tax year 2022 is 8.5% for taxable income exceeding €200,000.

The comparison includes the tax rate, the tax base and other tax provisions that may have an impact on the effective tax in relation with any taxable income realized by the CFC. The starting point for the comparison with the Luxembourg tax burden is the actual tax the CFC is required to pay, i.e., the final tax burden of the CFC. The amount of tax, comparable to Luxembourg CIT, paid by the CFC must be reduced by any subsequent reimbursement or amount that has ultimately not been collected. Where the CFC determines its taxable income in a foreign currency, the actual tax that the CFC is required to pay must be converted into euros by applying the exchange rate, as published by the European Central Bank, applicable at the closing date of the financial year of the taxpayer. Evidence such as tax assessments or payment confirmations must be produced upon request by the Luxembourg tax authorities.

In a second step, the Luxembourg CIT that would be due on the income of the CFC, determined in accordance with the provisions of the Luxembourg CIT law, must be calculated, taking into account any deductions, abatements and use of tax losses carried forward (in line with the Luxembourg provisions on the carry-forward of losses, including thus the 17-year limitation in time of the possibility to carry forward losses incurred as from tax year 2017). Profits and losses of the CFC are to be determined based on the same rules as apply to domestic income.

It is noted that a PE of a CFC, which is not taxable, or which is tax exempt in the jurisdiction of the CFC, is not taken into account for determining the low-tax criterion. Inversely, the income and the taxes of such PE are considered if its income is also included in the tax base of the CFC. 

De-minimis exclusion from CFC rules based on commercial profits

In line with the option under ATAD, a foreign company is excluded from the CFC rules if: (i) it has accounting profits of no more than €750,000 (exemption based on low profits); or (ii) it has accounting profits amounting to no more than 10% of its operating costs for the tax period (exemption based on low-profit margin).

Accounting profit is understood as the profit determined according to accounting standards equivalent to generally accepted accounting standards in Luxembourg, including International Financial Reporting Standards (IFRS).

The exemption based on low-profit margin aims at excluding CFCs with limited added-value functions, e.g., administrative, marketing and local distribution functions. Operating costs, to which the accounting profit is compared, comprise running expenses borne by the CFC in relation to the provision of goods or services, including distribution costs, staff costs, administrative costs or lease payments, but excluding costs of goods sold outside the jurisdiction of residence or establishment of the CFC, as well as payments to associated enterprises.

Again, the Circular refers to the possibility of GAAR applying to counter any restructuring aimed at splitting the profit originally realized by one single CFC between several CFCs in order to benefit from the above exemptions.

The concept of associated enterprises

The term “associated enterprises” includes the following:

• Resident or nonresident entities (irrespective of their legal form), in which the taxpayer holds, directly or indirectly, a participation in terms of voting rights or capital ownership of 25% or more, or is entitled to receive 25% or more of the profits of that entity. 
• Individuals or resident or nonresident entities (irrespective of their legal form) that hold, directly or indirectly, a participation in terms of voting rights or capital ownership in the taxpayer of 25% or more, or are entitled to receive 25% or more of the profits of the taxpayer.
• All entities, including the taxpayer, 25% or more in terms of voting rights or capital ownership of which are held, directly or indirectly, by an individual, or a resident or nonresident entity.

According to the Circular, it is sufficient that any of the aforementioned thresholds is met at any time during the financial year, irrespective of the duration. 

The concept of associated enterprises thus differs from the concept of related enterprises used in the context of transfer pricing rules and from the concept of associated enterprises for purposes of the anti-hybrid rules.

For purposes of determining the 25% threshold, shares held directly and indirectly are to be aggregated. For determining the indirect holding, the holding rates are multiplied successively at the various levels down the chain. Own shares held by the taxpayer or the entity as well as shares of the taxpayer or of a determined entity held by one of the subsidiaries of the taxpayer or the said entity, are disregarded.

Any restructuring undertaken lacking any valid commercial reasons which reflect economic reality, with the aim to reduce the 25% threshold, may fall under the provisions of the GAAR.

Income to be included

General

The undistributed income of a CFC must be included in the tax base of the Luxembourg taxpayer if the income arises from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage.

The Circular clarifies that any advance on the profit of the current financial year (interim dividend) distributed to the taxpayer during the same financial year reduces the net income of a CFC that must be included in the tax base of the taxpayer. This includes distributions to transparent entities in which the taxpayer holds a participation (including through another transparent entity) to the extent of the pro-rata share in the distribution that is allocable to the taxpayer.

An arrangement or a series thereof is regarded as non-genuine to the extent that the CFC would not own the assets which generate all or part of its income or would not have undertaken the risks if it were not controlled by a taxpayer who carries out the significant functions related to those assets and risks and are instrumental in generating the CFC’s income. This targets CFCs that, on the basis of the assets owned, the functions performed, and the risks undertaken, would not be able to generate the income at stake by themselves.

Calculation of net income of the CFC to be included

First, the Circular recalls that the income to be included is deemed to be commercial profit (as is any other income realized by a corporate taxpayer), independently of the qualification of the income at the level of the CFC. Furthermore, only income generated by the assets and risks in relation to significant people functions carried out by the controlling taxpayer are to be included. Therefore, taxpayers must be able to provide, for each financial year, an analysis of the significant people functions in relation to the assets owned by the CFC, which produced all or part of its income and of the risks attached thereto, and which have an essential role in the creation of the income of the CFC. The determination of the net income to be included must further comply with Luxembourg transfer pricing rules. Expenses are only deductible insofar as they are economically linked to the net income to be included.

Losses of the CFC are generally not included in the controlling taxpayer’s tax base. Nevertheless, a mechanism of unlimited CFC loss carryforward is foreseen, allowing the taxpayer to deduct CFC losses from previous financial years, insofar as they relate to periods after the entry into effect of the CFC provisions (i.e., after 1 January 2019), from positive income of the same CFC. The Circular clarifies that a CFC loss carryforward is not to be assimilated to a loss carryforward under Luxembourg Income Tax Law, which implies that the CFC loss carryforward cannot be used to offset taxable income of the taxpayer other than from positive income of the same CFC.

The income to be included in the tax base is calculated in proportion of the taxpayer’s direct and indirect participation in the CFC. Contrary to the control criterion, participations held by associated enterprises are not relevant. Where a taxpayer meets the control criterion by exceeding more than one of the relevant thresholds, income inclusion will be based on the higher of the threshold. The Circular gives an example of a taxpayer holding 70% of voting rights in the CFC, but only 60% of profit entitlement. In that case 70% of the relevant income of the CFC would be included in the taxpayer’s Luxembourg tax base.

In the case of change of a controlling taxpayer during a given financial year, the net income of the CFC is included in the net income of each taxpayer holding, at any time during the financial year concerned, a participation in the CFC that meets the control criterion. Income is included in proportion to the size of the participation and the period during which such participation is held by the taxpayer concerned for the given financial year.

The net income of the CFC is taxed in the financial year of the taxpayer in which the financial year of the CFC ends.

Avoidance of double taxation

The Circular also clarifies the specific provisions of the CIT law that apply to avoid double taxation that may arise under the following situations:

• The CFC distributes profits that have already been included in the taxpayer’s net income by application of the CFC rules: The amount of net income that was included previously will be deducted from taxable income (up to the taxable amount of the profit distribution). The deduction will not apply if the distributed profits are exempt under the domestic participation exemption or under a double taxation treaty. Furthermore, the distribution by an entity that is a CFC to a tax transparent entity, in which the taxpayer holds a direct or indirect (through one or more tax transparent entities) participation, is taxwise assimilated to a distribution by the CFC to the taxpayer in proportion of the taxpayer’s share in the net assets of such tax transparent entity.
• The taxpayer sells either the (direct or indirect) participation it holds in an entity that is a CFC or the activity exercised by a PE that is a CFC and the related capital gain has already been included in the net income of the taxpayer under the CFC rules: The amount of net income that was previously included will be deducted from the taxable capital gain (up to the amount of the taxable capital gain). The deduction will not apply if the capital gain is exempt under the domestic participation exemption or if the right to tax the capital gain is allocated to another jurisdiction under a double taxation treaty.
• The net income of the CFC, which has been included in the net income of the taxpayer under the CFC rules, is also taxed in the jurisdiction of residence or establishment of the CFC: A tax credit against CIT and the surcharge is granted up to the amount of income tax levied in the CFC jurisdiction on the same net income, including taxes withheld at source, that the CFC is required to pay and pro rata to the taxpayer’s direct and indirect holding in the CFC. The non-creditable amount of the tax owed and paid by the CFC in relation to positive net income to be included is deductible in proportion to the direct or indirect holding of the taxpayer in the CFC. The Circular further highlights that the tax the CFC is required to pay cannot be credited against Luxembourg CIT(e.g., lacking any CIT due by the taxpayer for a given tax year) and will not be reimbursed by the Luxembourg tax authorities.

Treatment of CFC for purposes of Luxembourg municipal business tax (MBT)

Luxembourg MBT generally only applies to income derived from an activity carried out by the taxpayer in Luxembourg (territoriality principle). Therefore, the net income of a CFC should not be considered as having been realized by the taxpayer. Given that the CIT base serves as a starting point for the determination of the MBT, the taxable profit for MBT purposes is reduced by the amount of the CFC income included in the CIT base; such income being assimilated to the income realized by a foreign PE of the taxpayer. Conversely, if the CIT base has been reduced by a deduction of net income of a CFC that has already been included in the taxpayer’s net income by application of the CFC rules in previous years, such amount must be added back to the tax base for MBT purposes.

[1] Circular L.I.R. n°164ter/1 of 17 June 2022.

[1] See EY Global Tax Alert, Luxembourg: A detailed review of the EU ATAD implementation law, dated 28 December 2018.