Christian Schlesser, Tax Partner - Operating Model Effectiveness / Transfer pricing, EY Luxembourg
Miguel Pinto de Almeida, Tax Manager – International Tax Services, EY Luxembourg
On 20 June 2018, the Luxembourg Council of Government officially released the draft law (Draft Law) implementing the European Union (EU) Anti-Tax Avoidance Directive (ATAD) into Luxembourg tax law. This article focuses on the Controlled Foreign Company (CFC) rules covered by the Draft Law.
What is it about?
All EU Member States are requested to adopt CFC legislation in their national laws in accordance with the ATAD. It will become applicable as of January 1, 2019. As a result, Luxembourg parent companies with controlled low-taxed subsidiaries or permanent establishments may, be taxed on income realized by the CFC even if such income has not been distributed. Conditions that are further described below will have to be met before such CFC taxation takes place.
"As with any other anti-avoidance measure, CFC rules are obviously not free from complexity in practice."
Which options existed?
The ATAD granted Member States two implementation options. In short, under option “A”, non-distributed passive income of a CFC would be included in the tax base of the parent company unless a verifiable substantive economic activity was carried out by the CFC. Under option “B”, CFC rules would be triggered whenever the CFC derives income arising from non-genuine arrangements that are put in place for the essential purpose of obtaining a tax advantage. In this option, the allocation of non-distributed income of a CFC to the parent company would be based on the arm’s length principle and would require an analysis of the significant people functions.
Why is option “B” the most consistent rule for Luxembourg?
By choosing option “B”, the Government demonstrated continuity in its tax policy. Indeed, contrary to a rather mechanical (“all-or-nothing”) approach, option “B” includes a proportionate test which limits CFC income inclusion to income attributable to significant people functions carried out in Luxembourg, in relation to the assets owned and the risks undertaken by the CFC. By relying on transfer pricing principles, this is ultimately an option that is consistent with the rules that Luxembourg introduced since 2015. Last but not least, option “B” should also decrease the risk of double or multiple taxation created by CFC rules in chains of holding companies when CFC income is not distributed. In our view, this approach is consistent with the EU law limitations on CFC rules as set forth in case law from the Court of Justice of the EU. As with any other anti-avoidance measure, CFC rules are obviously not free from complexity in practice. The Draft Law provides for a de minimis threshold that excludes CFC income that could otherwise become taxable in Luxembourg.
"The idea of taxing income that was not distributed to Luxembourg is something new in a jurisdiction associated with straightforward, accounting based tax rules"
Why is this useful for treasurers?
The idea of taxing income that was not distributed to Luxembourg is something new in a jurisdiction associated with straightforward, accounting based tax rules. All in all, surprises are surely not a good companion for anyone within a financial oversight role. In this respect, the new CFC rules and the option taken by the Luxembourg Government ensure that taxation will be conditioned to and aligned with the functional profile of Luxembourg entities. Treasurers will be able to rely on transfer pricing analyses that should depict the key people functions carried out in Luxembourg regarding assets not formally owned or risks not legally borne by the Luxembourg controlling entity. The timely collaboration between treasurers and tax departments to assess the impacts of CFC rules in Luxembourg (and abroad) will allow multinationals to identify and avoid situations where parent companies would face a cash shortage to pay taxes on revenues that they have not yet received.
 Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
 An entity or a permanent establishment is treated as a CFC if: (a) the controlling entity holds or holds together with its associated enterprises a direct or indirect participation of more than 50% in the controlled entity (either voting rights, share capital or rights over profits), and (b) the actual corporate tax paid by the controlled entity on its profits is lower than half the corporate income tax (municipal business tax not included) that would have been paid in Luxembourg. The tested rate in 2019 would therefore be 9% if the corporate income tax rate remains at 18%.
 Judgment in case C-196/04, Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v Commissioners of Inland Revenue (2006).
 CFCs with accounting profits of no more than EUR 750,000, or of which the accounting profits amount to no more than 10% of its operating costs, are excluded from the CFC rules.