Whilst some countries have had comprehensive rules on controlled foreign corporations for years, Luxembourg only introduced such rules recently, further to the implementation of a European directive. The position of the Luxembourg tax authorities (the "Administration") on the new rules was therefore eagerly awaited. Detailed guidance was finally provided in the form of a circular issued on 4 March 2020.
A Luxembourg-resident legal entity (i. e. organisme à caractère collectif, such as a public limited company or a limited-liability company) or a Luxembourg permanent establishment (hereinafter the "Company") may, under certain conditions, be subject to the controlled foreign corporation (CFC) rules set out in Article 164ter of the Income Tax Act ("ITA") for tax years commencing on or after 1 January 2019.
A CFC is a legal entity or permanent establishment whose income is not subject to tax or is exempt from tax in Luxembourg when both control and taxation requirements are met.
The control requirement will be met if the Company, alone or together with associated enterprises, (a) holds, directly or indirectly, more than 50% of the CFC's voting rights, (b) holds, directly or indirectly, more than 50% of the CFC's capital, or (c) is entitled to receive more than 50% of the CFC's profits. The taxation requirement will be met if the tax (effectively due and paid) on the income realised by the CFC is less than half the applicable Luxembourg corporate tax had the same income been taxable in Luxembourg. If these two cumulative conditions are met, the CFC's net income for a given tax year which is not distributed to the Company during that tax year and which arises from "non-genuine" arrangements put in place for the essential purpose of obtaining a tax advantage must be included in the Company's net income. An arrangement or series of arrangements shall be regarded as non-genuine to the extent the CFC would not own the assets or would not have undertaken the risks which generate all, or part, of its income if it were not controlled by the Company and provided the Company performs significant people functions relevant to the assets and risks that are instrumental in generating the CFC's income.
Article 164ter ITA also contains provisions to avoid double taxation resulting in particular from a distribution of the CFC’s profits or a disposal of a shareholding in the CFC (for amounts already included in the Company's net income).
In its circular, the Administration provides several examples and mentions a number of factors to be taken into account, the most interesting of which are summarised below.
Permanent establishment (PE) CFC
- No distinction is made between a CFC located in an EU Member State and one based in a third country when Luxembourg has concluded a double tax treaty with the country in question.
- A foreign entity that is transparent for Luxembourg tax purposes and constitutes a permanent establishment may be a CFC.
- If the Company has a permanent establishment, the control requirement will be deemed met.
- The control requirement may be assessed at any time during the relevant tax year and shall be assessed on the basis of economic criteria, notably with regard to who holds control of the CFC for tax purposes.
Concept of an associated enterprise
- Any relationship of association at any time during the Company's tax year is covered, regardless of its duration during the tax year and without the need to prorate the shareholding over the course of the relevant period.
- The permanent establishment of a legal entity (organisme à caractère collectif) considered a CFC, which is not subject to tax or which is exempt from tax in the CFC's country of residence, shall not be taken into account.
- Where the taxable income of a CFC is denominated in a foreign currency, the tax due and paid by the CFC shall be converted into euros at the rate prevailing on the closing date of the CFC's tax year. The applicable rate is that published by the European Central Bank.
- The tax that should have been borne by the CFC shall be determined in accordance with the provisions of the ITA, including those relating to tax loss carryforwards.
Undistributed net CFC income to be included
- This income, characterised as business profits and determined on an arm's-length basis, is limited to amounts generated by the assets and risks associated with the significant people functions performed by the controlling Company. This implies that, for each tax year, it will be necessary to perform an analysis of the significant people functions related to the CFC's income-generating assets (or a portion thereof) and the associated risks, where these are instrumental in generating the CFC's income. This analysis should be provided to the Administration upon request.
- Interim dividends paid to the Company and distributions of dividends from profits relating to prior tax years should therefore be deducted from the net CFC income to be included by the Company in its tax base. Likewise, hidden profit distributions to the Company are treated as disclosed distributions.
It is noted that in the event of circumvention of the CFC rules through a reorganisation without valid commercial reasons reflecting economic reality, the tax effects of the abusive practice will be neutralised through application of the general rules on abuse of law (§6 Tax Adaptation Act).
Imputation of tax paid by the CFC
Subject to certain conditions and limitations, tax due and paid by the CFC (including foreign withholding tax) may be credited against the corporate tax due by the Company on the net CFC income to be included in its tax base and, if applicable, deducted from the Company's tax base, but in any case is not refundable.