ATAD Luxembourg implementation: Controlled foreign company rules

In a nutshell: what is a CFC?

Control foreign company ("CFC") is a brand new concept in Luxembourg, included in the Luxembourg income tax law ("LITL") by means of a new article 164ter, which aims to attribute net income to a Luxembourg taxpayer when its subsidiary or permanent establishment is located in a low- or no-tax jurisdiction, and this even if this income is not distributed.

Such undistributed net income may then be subject to Luxembourg corporate tax, exclusive however of Luxembourg municipal business tax.

In nutshell: when are the CFC rules triggered?

Two main conditions must be met for the CFC rules to apply, being:

(a) Control test

To be considered as a CFC, we must be in the presence of:

1. a collective entity (organisme à caractère collectif), in which the Luxembourg taxpayer, by itself or together with its associated enterprises, holds a direct or indirect participation of more than 50%; 
2. a permanent establishment; and
3. the income of which is not taxable or tax exempt in Luxembourg.

For the purposes of the CFC rules, a taxpayer includes the Luxembourg entities enumerated under articles 159 LITL or the Luxembourg permanent establishments enumerated under article 160 paragraph 1 LITL.

(i) Clarification as regards the participation in a CFC

The participation of above 50% in a CFC, held directly or indirectly together with any associated enterprises, is analysed from a legal perspective (i.e., share capital holding or voting rights) as well as from an economical perspective (i.e., profit rights).

(ii) Clarification as regards the concept of "associated enterprise"

For the purposes the CFC rules, an associated enterprise is to be considered as:

1. an entity enumerated under articles 159, 160 or 175 LITL 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;
2. an individual or an entity enumerated under articles 159, 160 or 175 LITL, which holds directly or indirectly a participation of at least 25% in terms of voting rights or capital ownership in the taxpayer or is entitled to receive at least 25% of the profits of the taxpayer; and
3. all entities, including the taxpayer, if an individual or entity enumerated under articles 159, 160 or 175 LITL holds directly or indirectly a participation of at least 25% in terms of voting rights or capital ownership in both the taxpayer and one or more entities.

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(b) Effective tax test

The CFC rules will only be triggered if, in essence, the actual tax paid by the CFC is lower than 50% of the Luxembourg corporate income tax (i.e., currently below 9%) that would have been paid in Luxembourg had such CFC been resident in Luxembourg for tax purposes.

Are there any exceptions to the CFC rules?

ATAD gives the choice to Member States to exclude certain types of entities which have low risks of tax evasion. The ATAD Draft Law therefore provides that are excluded from the scope a CFC:

• with less than EUR 750,000 accounting profits; or
• with accounting profits of no more than 10% of its operating costs (not all operating costs can however be included, such as for instance payments to associated enterprises).

As regards the former, it is interesting to stretch that the ATAD Draft Law provides an additional threshold for the exclusion of these entities (i.e., entities with accounting profits above EUR 750,000), being non-trading income of no more than EUR 75,000. It seems thus that the Luxembourg legislator has slightly extended the list of entities - initially set out in ATAD - that may be excluded upfront from the CFC rules.

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Could you please provide a straightforward example to explain the CFC rules?

Each time when you need to analyse whether a given entity (in our example "S") is a CFC, different steps need to be followed.

(i) Step 1: Associated enterprises

The first step is to analyse the presence of associated enterprises of any given company (in our example "LuxCo"). Here, as LuxCo holds 40% in HoldCo1 as well as HoldCo2, the latter are to be considered as associated enterprises. However, as LuxCo only indirectly holds 24% in S, the latter will not be considered as an associated enterprise.

(ii) Step 2: CFC

Once you have determined all the associated enterprises of LuxCo, you will need to assess whether the control and the effective tax tests are fulfilled to be in the presence of a CFC.

As LuxCo holds with its associated enterprises 60% in S, the control test is met.

If the effective tax rate test is also met (generally, low or no taxation in the State where S is resident), S will be considered as a CFC of LuxCo.

(iii) Step 3: Attributable income

Under this step, it will need to be considered whether (i) LuxCo has significant people functions to which undistributed net income of the CFC can be attributed and (ii) we are in the presence of a non-genuine arrangement which has been put in place for the essential purpose of obtaining a tax advantage. If those conditions are met, the undistributed net income is to be included in the tax base of LuxCo.

In the present scenario, based on a proportional analysis approach, the undistributed net income would be limited to a maximum of 24%.

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How is double taxation generally be avoided?

Double taxation is avoided by means of the use of the tax credit method. This means that a Luxembourg taxpayer can credit - in accordance with the existing provisions on foreign tax credit - any foreign tax applied to the undistributed CFC income allocated to such taxpayer under the CFC rules.

Further, if income had previously been taxed under the CFC rules at the level of a Luxembourg taxpayer, the latter can decrease this amount up to any taxable amount realised due to a profit distributions to, or capital gains realised by, the Luxembourg taxpayer in respect of its CFC direct or indirect investment. A recent amendment to the ATAD Draft Law was in this context welcome. Indeed, beforehand, the ATAD Draft Law did not really provide the possibility to exempt at the level of a Luxembourg taxpayer capital gains realised indirectly as regards its CFC investment (e.g., via the sale of associated enterprises holding the CFC even if the undistributed income had previously been taxed under the CFC rules at the level of the Luxembourg taxpayer). The ATAD Draft Law now contemplates the possibility to deduct income previously taxed under the CFC rules as well as regards direct as indirect CFC sales.

For instance, if in the example provided above, LuxCo had been taxed in the financial year N on undistributed profits of S, and had sold in N+1 HoldCo1 and HoldCo 2 with a taxable capital gain (thus in a scenario where the conditions to benefit from the participation exemption would not be complied with), such taxable capital gain can under the ATAD Draft Law now be reduced by the amount allocated to the tax base of the taxpayer in the year N.

Are there other important considerations to be taken into account in relation to the CFC rules?

There are indeed some, the most important ones being enumerated below.

(a) Interaction between the CFC rules and the transfer pricing rules as well as the general anti-abuse rule

The commentaries included in the ATAD Draft Law specified that the CFC rules were only applicable after the application of the Luxembourg transfer pricing rules (More information about the Luxembourg transfer pricing rules). Indeed, some of the undistributed profits of the CFC may already be attributable to the Luxembourg taxpayer based on the Luxembourg transfer pricing rules and as such, do not need to be allocated to the Luxembourg taxpayer a second time based on the CFC rules.

Another interesting point is the interaction between the CFC rules and the general anti-abuse rule in tax matters set out in §6 of the (Steueranpassungsgesetz - "StAnpG"). As highlighted by the State Council, the general anti-abuse rule should no longer apply once the CFC rules are triggered, based on the general principle that special rules overrule general rules (i.e., specialia generalibus derogant).

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(b) Clarifications regarding undistributed net income, and related (double taxation) risks

The State Council commentaries include some interesting opinions as regards the undistributed net income. First, the CFC rules and the concept of "undistributed net income" should not be applicable to, for instance, share premium reimbursements or freely available reserves.

Second, as the net income to be included under the CFC rules in the tax base of a taxpayer has to be included in the financial year of such taxpayer in which the financial year of the CFC ends, the State Council reminded that dividend distributions of the CFC only impacts the computation of the "undistributed net income" to be reallocated to the taxpayer in accordance with the CFC rules if such distribution is in relation to the current financial year (i.e., the so-called "interim distributions"). This has also been clarified in the recent amendment of the ATAD Draft Law by reflecting that only undistributed net income of a given financial year of a CFC that are not distributed during that year may fall within the CFC rules.

Finally, the Council of State noticed a recent change as regards the ATAD Draft Bill, whereby the Luxembourg government included as regards the concept of "undistributed net income" the reference to "the taxpayer". Consequently, distributions made by a CFC to associated enterprises only (but not to the Luxembourg taxpayer) should no longer be sufficient to fall outside the CFC rules. This restriction may increase the risk of double taxation (at the level of the associated enterprises and the Luxembourg taxpayer).

(c) Interaction of the CFC rules in relation to foreign permanent establishments located in a State with which Luxembourg has a double tax treaty

The State Council in its commentaries also addressed the question as to how the CFC rules should interact if the CFC would be a permanent establishment of the Luxembourg taxpayer located in a country with which Luxembourg has signed a double tax treaty (the "DTT"). A distinction needs to be made between Member States and third countries.

If the CFC is located in another EU Member State with which Luxembourg has signed a DTT, then the CFC rules should prevail as EU directive are overriding DTT. However, if the CFC is not located in another EU Member State (thus, located in third State) with which Luxembourg would have signed a DTT, then the DTT should prevail with a potential risk of double non-taxation. However, this risk of double non-taxation should be reduced once the multilateral convention to implement tax treaty measures to prevent base erosion and profit shifting ("MLI") will be in force.

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When will these rules be applicable?

The CFC rules will be applicable as of 1 January 2019.

What will be the impacts of the CFC rules in Luxembourg?

Whilst of course the impact of the CFC rules will need to be checked on a case-by-case basis, we generally do not anticipate that these rules, even though new, will have a major impact in Luxembourg in view of the multiple conditions that needs to be met for these rules to apply.

Authored by Gérard Neiens, Jean-Philippe Monmousseau, and Pierre-Luc Wolff

Hogan Lovells (Luxembourg) LLP is registered with the Luxembourg bar.