Agefi Luxembourg - novembre 2024

Novembre 2024 19 AGEFI Luxembourg Assurances I n the recent years, many banking and insurance groups have opted to operate in different jurisdic- tions by using branches as opposed to a set up using subsidiaries. This development of the number of branches trigger questions fromTax Authorities around the world, in particular on the allocation of profits between the HeadOffice (HO) and its branches. As a major financial cen- ter, Luxembourg is also exposed to this issue. Cur- rently, TheTax andTransfer pricing (TP) rules currently applicable in Luxembourg do not explicitly cover the allocationof profits between the HO and its branches. In the absence of explicit references in the current TP legislation, theOECDguidelines are often used as a guidance to determine the profits to be allo- cated to its branches. TheOECDframework The Authorized OECD Approach (AOA) was in- troduced in the 2008 OECDReport on theAttribu- tion of Profits to Permanent Establishments to address the limitations of the older static approach to allocate profits to permanent establishments (PEs). The static approach,whichhadbeenusedbe- fore theAOA introduction, often failed to reflect the true economic activities and risks of PEs, leading to inaccurate profit allocations. The 2008 AOA intro- duced a more dynamic framework, requiring a functional and factual analysis to treat the PE as a separate entity for tax purposes. In 2010, the OECD formalized theAOA into a two- step process: first, performing a functional analysis to identifyKeyEntrepreneurial Risk-Taking (KERT) functions, and second, applying the arm’s length principle to allocate profits. In2017, theOECDfurther refined theAOAthrough its commentary, incorporating lessons fromtheBase Erosion and Profit Shifting (BEPS) project. This up- date emphasized the need for precisedelineationof transactions between the HO and PE, introduced new guidance on capital allocation, and aimed to address tax avoidance concerns. TheAOA’s devel- opment reflects theOECD’s efforts tomodernize tax principles in line with the complexities of global business operations. General Description of the Luxembourg Legal Framework for ProfitAllocation to PE Although a PE does not have any legal personality different than its HO, HO and its PE constitute two separate entities froma taxperspective. Ifwe take the example of a Luxembourg HO having different PEs established in the EuropeanUnion (EU), the profit of thecombinedlegalentitywillhavetobebrokendown betweenLuxembourg and the respective countries. As the Luxembourg TP rules and regulations do not explicitly cover the case of aprofit allocationbe- tween the HO and its PEs, reference should be made to the relevant tax treaty entered intobetween Luxembourg and the relevant host country. Luxembourg’s tax treaties followtheOECDModel Tax Convention and include provisions for profit allocation under Article 7. This article aims to pre- vent double taxation and ensure that profits are fairly attributed to the jurisdiction where the busi- ness activities occur. The AOA dynamic approach is used in most of Luxembourg’s double tax treaties withOECD and EU countries, such as France, Germany, Belgium, and the Netherlands (following the OECD 2010 version of Article 7). However, Luxembourg still applies a static approach in tax treaties with some countries thatwere signedbefore the 2008 introduc- tionof theAOA, where older, formula-basedmeth- ods are used (for example, Brazil, India, and certain non-OECD countries). These static methods typi- cally allocate profits, without a detailed analysis of the PE’s actual activities or risks. General Description of the Profit AllocationProcess under theAOA Typically, in accordance withAOA the profit alloca- tionprocess consists of the following steps: FunctionalAnalysis This step involves identifying the key functions per- formed, assets used, and risks assumed by the PE, withafocusonthesignificantpeoplefunctions(SPFs). Forfinancialinstitutions,theKERTfunctionsaretyp- icallyassociatedwithmanagingfinancialassets,mak- ingdecisionsonlendingandinvesting,andmanaging risks such as credit andmarket risks. Allocation ofAssets and Risks In the banking industry, the allocation of assets under the AOA relies heavily on identifying key functions related to the creation of assets and the management of risks. A) Creation ofAssets The creation of financial assets in a banking context generally refers to activities such as loan origina- tion, investment, anddeposit-taking. The key func- tions involved in the creation of these assets often include: - The loanorigination: Where the PE is responsible for evaluating creditworthiness, approving loans, and setting the terms and conditions of lending, the asset should be attributed to the PE. - The investment decisions: When the PE makes decisions regarding the acquisition or disposal of a loanor other financial assets, financial assets should be attributed to the PE. B) Management of Risks In the banking industry, risks such as credit risk, market risk, and operational risk need to be man- aged effectively to ensure the stability of the insti- tution. These riskmanagement activities are tied to the capital that is allocated to the PE. Some key functions related to risk management include: - The credit riskmanagement: If aPE is responsible for monitoring and mitigating the credit risk of loans or investments it has originated, then this risk is attributed to the PE. - The market risk management: PEs involved in managing assets may handle market risks associ- atedwithfluctuations in asset prices. If the PE is ac- tively involved inmanaging thesemarket risks, the assets are attributed to the PE, and sufficient capital must be allocated to mitigate potential losses. Quantification of Risks For the quantification of risks, the Basel framework is commonly applied to banks to measure credit, market, and operational risks. The internal models of the bank, such asValue at Risk (VaR)models, are also commonlyusedwhen approvedby regulatory authorities. These models provide a precise meas- urement of risk compared to standardized ap- proaches, as they account for correlations between different risk categories. Allocation of Free Capital The allocation of capital is crucial for ensuring that a PE has sufficient resources to cover the risks it as- sumes. Below are the most common methods of capital allocation for banks: - Capital Allocation Approach: This method allo- cates capital based on the proportion of the Risk- Weighted Assets (RWA) attributed to the PE. It directly ties the allocation of capital to the PE’s risk profile, following the same principles that are used for the overall bank under the Basel framework. - Economic CapitalApproach: This approach allo- cates capital based on the economic risks the PE is exposed to, rather than simply on regulatory min- imums or external comparables. - Thin Capitalization Approach: The thin capital- ization approach compares the capital allocated to the PEwith that of similar independent enterprises. - Quasi-Thin Capitalization Approach : This method involves allocating capital to a PEbasedon minimum regulatory capital requirements. Allocation of Debt financing The allocation of debt is also a key consideration, with three mainmethods used: - FungibilityApproach: Thismethod assumes that debt is not specifically tied to any single entity or branch and is allocated to the PE proportionally based on the share of total assets or the RWA attributed to the PE. - TracingApproach: Under the trac- ing approach, specific debt liabilities are traced directly to the assets or transactions that they finance. - Dealing Approach: In this ap- proach, the allocation of debt is based on the terms of internal dealings between the PE and the HO, treating the internal transactions as if they were third- party transactions. Pricing of the Dealing The transfer pricing of intra- group transactions between the HO and the PEmust follow the arm’s length prin- ciple. This ensures that the PE is properly compen- sated for any functions performed or services provided to other parts of the enterprise. The ap- propriate transfer pricing method depends on the specific circumstances of the transaction and the functions performed by the PE. Points of attention When considering profit allocation between the HOand a PE in Luxembourg from tax and TP per- spective, several critical aspectsmust be addressed: The influence on Corporate Income Tax (CIT) in Luxembourg: Proper allocation of profits directly affects the CIT base in Luxembourg. Incorrect al- location of profits, particularly underestimating the contribution of the foreign PE, can result in overestimation of CIT, increasing the tax burden on the entity in Luxembourg. Ensuring profits are allocated accurately is essential to avoid misallo- cation and excessive taxation. Proper TP docu- mentation should be prepared to avoid potential double taxation. The influence on Net Wealth Tax (NWT): The allo- cation methodology should not only address the al- location of profit between a HO and its PEs, but also address the allocation of assets, which ultimately wouldimpacttheNWTbaseoftheLuxembourgHO. TheinfluenceonExitTaxation: Reallocationofassets between jurisdictions should be performed on a fair valuebasisand,consequently,couldpotentiallycreate situationsofexittaxation.Whenassetsaremovedout ofLuxembourg,anyunrealizedcapitalgainsonthose assetsmaybetaxed,asLuxembourglosestherightto taxfuturegains.Properanalysisshouldbeperformed upfront to avoidunexpected tax liabilities. The tax Balance Sheet and Equity Requirements: Thetaxbalancesheetmustaccuratelyreflectassetand debt values for bothCIT andNWTpurposes. Equity levelsofthePEsofbanksshouldalignwithregulatory requirements, suchasBasel rules forfinancial institu- tions.Whileregulatoryequityrequirementssetamin- imum, the equity attributed for tax purposes can be higherbutshouldnotfallbelowregulatorystandards. This ensures that equity anddebt ratios complywith both tax and regulatory obligations. Conclusion The profit allocation between a HO and its PEs is a complex process and a major source of tax contro- versy around the globe. Due to the development of the number of PEs in the financial sector, Luxem- bourgisexposedtothischange,whichcreatesachal- lenge for the taxpayers and the Luxembourg Tax Authorities. As inmany instances, the fact of having a robust TP documentation is recommended for the financialinstitutionsasapreventivemeasuretoavoid potential controversy. Nicolas GILLET EY Luxembourg Partner, Transfer Pricing Leader Illia KOZINETS EY Luxembourg Senior, Transfer Pricing Profit allocation between Head Offices and branches: What is the methodology used by financial institutions? L’assuranc pour le e vie luxembo s luxembourg urgeoise eois. la ebinair Vraiment ? Notre w e de 30minute accessible en rep y s