In a recent decision (No. 42043C dated 17 July 2019), the Higher Administrative Court (Cour Administrative) ruled that the tax administration is entitled to requalify interest payments into a hidden distribution, if a taxpayer is not able to provide sufficient supporting documentation proving that transactions between related parties are taking place according to the arm’s length principle.
In the case at hand, a Luxembourg company held a real estate asset in France and refinanced a bank loan through a shareholder loan granted by its sole shareholder. The activity of the company was limited to the holding of this sole property. The shareholder loan was neither secured nor guaranteed with collateral and carried a fixed interest rate of 12%. The representatives of the Luxembourg company asked two service providers to determine an arm’s length interest rate on said loan. The first expert determined that an arm’s length interest rate would be in the range of 3.21% to 7.88% per year by using the “CUP” method and the second report, prepared during the litigation phase, determined that the arm’s length interest rate would be in a range between 9.95 and 19.61% by using the “Capital Asset Pricing Model” and taking into account the subordination of the shareholder loan to a bank loan.
The tax authorities on the other hand determined the applicable interest rate based on the LIBOR rate increased by a spread linked to the subordination of the lender, which seems to be a “standard spread” ranging between 0.5% and 2%, which lead to a final interest rate of 3.57%. Indeed, in a previous decision (No. 23053C dated 13 June 2007), the same spread was used by the tax authorities, despite the fact that taxpayers in both cases had different activities and probably different risk profiles. In the framework of the litigation, the tax authorities or the government representative had not provided any additional details or insights on the determination of the spread applied on the LIBOR. The Higher Administrative Court nonetheless followed the tax authorities’ position, based on the fact that (i) the first transfer pricing report did not support the interest rate applied by the taxpayer and actually included the interest rate used by the tax authorities in the arm’s length range and (ii) the second transfer pricing report used comparable transactions that were not sufficiently similar to the situation of the company.
In conclusion, while certain taxpayers are still coming to terms with the obligation to maintain proper transfer pricing documentation, the Higher Administrative Court demonstrated that it is not the existence of a transfer pricing study (or two) that is the relevant aspect, but rather the quality and adequacy of the comparable used. The fact that the interest expenses were in any case non-deductible as they were in direct economic relationship with a real estate asset located in a country with which Luxembourg concluded a double tax treaty that prevents Luxembourg from taxing the income deriving therefrom, does not prevent the requalification of the excessive part of the interest into hidden dividend distributions should also not be doubted anymore.