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