AGEFI Luxembourg - juin 2025

Juin 2025 13 AGEFI Luxembourg Conseil / RSE I n the evolving landscape of transfer pricing, it appears increasingly important to analyze the debt capacity of a relatedpartyborrower by assessingwhether a comparable independent entity couldhave secured similar debt and reasonably serviced it, taking into account fac- tors such asmarket conditions, capital structure, andpro- jected cash flows. As the distinctions among guid- ance, market trends, and adminis- trativetolerancecontinuetoshift,the responsibility of ensuring compli- ance-reflectingboththelendingand the borrowing perspectives and how this applies inpractice -maybe a relevant consideration for multinational groups operating in Luxembourg. Debt Classification and ThinCapitalizationRisks The 2022 OECD Transfer Pricing Guidelines aim to clarifyhowtodifferentiatedebt fromequity incross- borderfinancing. Incaseswhereaborrower’sfinan- cial profile or market comparables suggest that a third party might not have extended the full inter- company loan, the excessive portion could poten- tially be reclassified as equity. Only the amount of debt that can be supported by a debt capacity anal- ysis may be considered as debt, with interest on the excess portion likely being non-deductible. However, recent Luxembourg case law appears to deviate fromthisprinciple,withcourts rejectingpar- tial recharacterization of debt, and opting instead to fully requalify the loan as equity based on its true economic substance and not only on its terms and conditions. As outlined below, the debt-to-equity ratio is one of the key indicators to assess the overall qualification of the financial instrument but is not consideredby theLuxembourgadministrative court of appeal to allowpartial requalification. Highly leveragedgroupstructuresmayattract atten- tion from tax authorities, especially when interest is deducted in a high-tax jurisdiction, while the interest incomeisrecordedinalow-taxjurisdiction.Unlikein other European countries such as Germany or the Netherlands, Luxembourg has not yet seen any leg- islative changes or formal guidance on the necessity to document debt capacity. In light of the absence of binding rules, taxpayers are adoptingmore cautious approaches, as tax authorities appear to be increas- ingly anticipating thorough debt capacity analyses, whichmaybeindicatedbyariseinauditactivityand judicial trends. Commercial Rationality andBusiness Purpose: ScrutinyBeyondPricing Tax authorities are increasingly encouraged to look beyondpricing and considerwhether an intercom- pany transactiondemonstrates a genuine commer- cial rationale. The 2022 OECD Transfer Pricing Guidelines aim to consolidate and clarify the prin- ciples established in the 2020 OECD Guidance on financial transactions, highlighting a substance- over-form approach. Recent Luxembourg court cases, including those related to loans grantedprior to 2020, suggest a growingwillingness to retrospec- tively evaluate whether the borrower had the capacity to service the debt andwhether documen- tation was prepared contemporaneously. The loan needs to have a commercial purpose and should be viewed in a broader context than solely a quantitativeanalysis.Afundamentalquestiontocon- sider iswhether an independent party in a compara- blepositionwouldhavereasonablyenteredintosuch an arrangement. For example, a Luxembourg com- pany that fully finances the acquisition of another companywith debt - without a revenue plan or cash flow projections, or without security – might fail the test and see the loan recharacterized as a capital con- tribution, making the interest non-deductible and leading to withholding tax considerations. A third- party lender would typically expect the company to partially finance the acquisition with its own capital, ensurethatthereisabusinessplantoultimatelyrepay the debt, anddiscuss terms and conditions that align withtherealitiesoftheacquisition(e.g.pledges,repay- ment terms in linewith cashflowexpectations, etc.). This principle was recently reaffirmed by the Luxembourg Administrative Court in a decision dated 17 April 2025 (Cour administrative, 17 Avril 2025, n° 50602C), which addressed the qualification ofinterest-freeloanpayables(IFLs)grantedtothetax- payer by its indirect shareholder. In its reasoning, the Court emphasized the importance of evaluating the broader context in which a financial transaction occurs.Amongotherelementsoftheruling,theCourt noted that “it is necessary to assess in a more global manner how the loan fits into the ‘life’ of the compa- ny,” particularly in cases where a loan follows other shareholder-relatedoperations suchas capital repay- ments. The Court stressed that the relationship between the lender and the borrower - especially wherethelenderisadirectorindirectshare- holder - is a key element in assessing whether the provision of funds consti- tutes a genuine loan or a disguised equity contribution. In practice, it is suggested that tax- payers consider not only the form ofatransactionbutalsoitsbroader economic substance. Factors such as the sequencing of sharehold- er-related events, the commer- cial rationale, and alignment withmarkettermsmaywarrant careful examination. Ensuring proper documentation, main- taining consistent financial flows, and establishing a clearly demonstrable business purpose could be important for withstand- ing scrutiny fromtax authorities. It is beneficial to Luxembourg taxpayers to demon- strate that transactions are commercially rational, economically defensible, and reflect arm’s length conduct. Luxembourg’s Positionon Intercompany Financing: Evolving Practice and Judicial Clarification Luxembourghas not enacted legislation that defines fixed limits on the debt-to-equity ratio in intercom- pany financing. Historically, an informal 85:15 debt- to-equity ratio has been referenced, particularly for holdingcompanies,asanon-bindingbutcommonly acceptedadministrativepractice.While this ratiohas never been legally binding, it has been followed by many taxpayers. Rather than relying on specific ratios, tax authorities are increasingly assessing whether intercompany financing arrangements reflect realistic economic behavior and whether the borrower couldhaveobtainedsimilar terms froman independent lender under comparable circum- stances. This approach underscores the importance of conducting a debt capacity analysis and a com- mercial rationality test at the time the loan is issued. Theoutcomeoftheseconsiderationssuggestsaneed for robust transfer pricing governance. Forexistingloansthatlackthistypeofanalysis,itmay bebeneficialfortaxpayerstoreviewtheircapitalstruc- tures, scrutinize board minutes and internal docu- ments, andprepare to demonstrate retroactively that theborrowerwascapableofservicingthedebt.Courts are likely to expect managerial diligence, placing greaterresponsibilityondirectorstoensurefinancing decisionsalignmorecloselywitheconomicsubstance. The Luxembourg Administrative Court’s 17 April 2025 decision (n° 50602C) appears to confirm this approachbyrejectingtherelianceonthe85:15ratioas standard market practice, ruling that it was neither legallybindingnor adequatelyevidenced. TheCourt also dismissed the partial recharacterization of inter- est-free-loans(IFLs),emphasizingthatfinancialinstru- mentsmust be fully classifiedas either debt or equity based on their true economic substance andnot only their terms and conditions. This judgment suggests that vague references to market norms or historical practices may no longer be sufficient, raising the stakessignificantlyforanygroupfinancingstructures thatlacksolidcontemporaneousdocumentationand, fundamentally, a commercial rationale. Conclusion AsLuxembourgseeks toalignmore closelywith the 2022 OECD Transfer Pricing Guidelines, the debt capacity analysis appears to have become an essen- tial component of intercompany financial arrange- ments. While the absence of formal thin capitaliza- tion rules might imply some flexibility, recent jurisprudence, particularly the Luxembourg Administrative Court’s 17 April 2025 decision (n° 50602C),suggeststhatthismaynolongerbethecase. The Court emphasized that the debt capacity of a borrower shouldbeassessed in light of the complete economic context, particularly in transactions linked to shareholders. By rejecting reliance on lump-sum market practice and partial recharacterizations, the Court indicated that only financial arrangements with well-substantiated debt capacity and a clear commercialrationalearelikelytowithstandscrutiny. This rulingconveys a significantmessage: intercom- pany loans shouldnot onlybepricedat arm’s length but should also be supported by a credible analysis demonstrating that a third-party lenderwouldhave issued the loan under similar terms. Formultinational groupsoperating inLuxembourg, the path forward is clear: the foundational evidence that a financial transaction reflects market behavior and economic substance is centered on the debt capacity analysis and is no longer merely a compo- nent of a technical compliance exercise. The chal- lenge extends beyond new transactions, historical intercompany loans that were not supported by a contemporaneousdebtcapacityassessmentmaynot be considered protected under previously accepted marketnorms.Groupsmayneedtoreviewhistorical positions, evaluate documentation, and, where appropriate, demonstrate retroactively that the bor- rower had the capacity to service the debt. This is a critical part of responsible transfer pricing gover- nance and a core responsibility of directors of Luxembourg companies. More broadly, this shift also reflects an increasing expectation that transfer pricing governance should evolve beyond mere pricing, encompassing the entirelifecycleoffinancialarrangements-frominitial structuring and documentation to ongoing moni- toring andalignmentwith commercial realities. The recent court decisions serve as a clear indication that substance, purpose, and proactive oversight are more critical than ever. SophieBOULANGER Partner,HeadofTransferPricing,TransferPricingServices, XanthippiKLADOU Manager,TransferPricingServices, KPMGLuxembourg Understanding Debt CapacityAnalysis in Transfer Pricing: ALuxembourg Perspective d a s y towar Lead the industr eputation engthen r Str Reduce emissions Op Lead. . ly Comp sustainability goals and contrib tion Stra and Decarbonisa e bring you long-standing exp W e ustainable futur timise. s net-zero ambitions. uting to Europe’ y to support you in achieving your teg Assessment ootprint ertise in Carbon F