Substance has always been a matter of concern for Luxembourg entities particularly due to recent anti-tax avoidance developments (e.g. fight against base erosion and profit shifting (so-called “BEPS”) developed within the Organisation for Economic Co-operation and Development (OECD), as well as movements towards more tax transparency).
In order for a company to qualify as a Luxembourg company and maintain Luxembourg nationality, it is necessary that the company has its central administration in Luxembourg. Luxembourg law applies the “real seat theory” (i.e. the theory pursuant to which the corporate laws applicable to a company are the laws of the place of its central administration) as opposed to the “incorporation theory” (i.e. the theory pursuant to which the corporate laws applicable to a company are the laws of the state of its incorporation regardless of the place where its central administration is located).
From a Luxembourg domestic tax perspective, a company is resident of Luxembourg if its registered office or its central management (place of effective management) is in Luxembourg. In tax treaties contexts, the central administration criterion generally applies to determine the residency of a company.
Substance may be a condition to securing tax benefits (e.g. exemption or reduction of withholding taxes or exemption of capital gain taxation) notably in the jurisdictions where a company’s income originates from, granted under tax treaties, directives or by pure domestic rules. Substance also helps mitigate the risk that the tax authorities of other countries consider a Luxembourg company as being tax resident in their jurisdiction and consequently tax it accordingly on its worldwide income (i.e. leading to a double taxation situation). Finally, general robustness of the corporate structure as a whole is relevant in light of current developments on anti-abuse provisions, measures against aggressive tax planning and reporting relating to tax transparency. It should be noted that substance alone may not be sufficient to ensure favourable tax treatment of a given transaction. Certain anti-abuse rules may require companies to be able to justify their existence by reference to non-tax driven reasons (only).
Except in the context of Luxembourg companies involved in intra-group financing activities, there are no specific Luxembourg substance requirements in Luxembourg but so-called “best practice recommendations”. It should be noted that there are no global rules either and that, instead, each country has their own practices and/or substance rules. In fact, the relevant level of substance for a Luxembourg company is generally not a Luxembourg question, i.e. it is typically the source/foreign country’s perspective which is the most relevant (in other words, what is considered acceptable from a pure Luxembourg domestic tax perspective may be impacted by foreign tax substance considerations). No factor or aspect is decisive by itself but the overall picture must be considered. Generally, the level of actual presence is measured not only in terms of office space and employees but also and foremost in terms of place where decisions are taken, assets are managed and risks are borne. Economic substance (a.o. concept of beneficial ownership of income, level of margin realised by an entity) is more and more important, especially in an international context.
In accordance with said “best practice recommendations”, the following can be advised:
1. Management
The usual management structure of a Luxembourg company includes Luxembourg local managers to facilitate compliance with the substance requirements and the organisation of the maintenance and the decision-taking process in Luxembourg. It is recommended that the majority of the members of the board be Luxembourg resident and that their signature be required to bind the company in its relationship with third parties. The Luxembourg resident managers should preferably have a authority to bind, alone, the company for day-to-day matters.
The Luxembourg managers should be actively involved in all matters concerning the company, particularly in those relating to the company’s main purpose. The managers should preferably have the relevant knowledge, skills and experience to manage the functions, risks and assets of the company.
2. Economic substance
It is important to be able to justify that the Luxembourg company is the beneficial owner of its income. Failing to be able to demonstrate that the recipient of dividend, interest or royalties payments is the beneficial owner of such payments may lead tax authorities of source countries to consider the relevant company as an agent, nominee or conduit company and therefore to deny certain tax benefits based on their own domestic law or on tax treaties (e.g. a letterbox entity not eligible to a lower withholding tax rate). Luxembourg companies financed with total return tracking instruments may be considered by source countries as not eligible to the right to dispose or to reinvesting income it receives. Theoretically, powers of a recipient over an income should not be constrained and such recipient should not be obliged to pass the entire payment received to another entity. Therefore, it is of utmost importance to have the financing (and the determination of an appropriate margin based on transfer pricing documentation, where applicable) of a Luxembourg company to be reviewed by advisors.
3. Meetings
Meetings of the board of managers (as well as meetings of the shareholders) should as a rule take place in Luxembourg and only exceptionally outside Luxembourg. Although it is preferable for the managers to meet physically in Luxembourg, it is not prohibited for one or the other of the managers to exceptionally attend a meeting via a conference call or a videoconference, which should however be initiated from Luxembourg.
Meetings should be held in person regularly (at least three times a year) and as often as the business requires it and should be documented in detailed and tailor made minutes.
4. Luxembourg bank account
Luxembourg bank accounts should be used for paying ongoing expenses and the invoices of service providers in Luxembourg (day-to-day cash flow). Bypassing Luxembourg (e.g. with the use of payment direction letters should be avoided). There are, however, no Luxembourg rules that invalidate the use of foreign bank accounts.
5. Registered address / office space
Companies must comply with all laws and regulations on the domiciliation of companies, and in particular with the provisions of the Luxembourg law dated 31 May 1999 on the domiciliation of companies, as amended. It must have an address in Luxembourg, where it shall keep its books and records. Companies may or rent office space or enter into domiciliation arrangements.
6. Employees
To the extent relevant for the fulfilment of their corporate purpose, companies should have a sufficient number of full-time and/or part-time Luxembourg-based employees who can carry out tasks for the their business activities. Hiring part-time accountants or legal agents through sub-contracting service providers is also helpful. The payroll expenses with respect to such employees should be included in the company’s annual expenses and liabilities.
Whether a Luxembourg company avails of sufficient substance is something that has to be assessed on a case by case basis on the basis of the entire set of surrounding facts and circumstances. This means that it is not necessary to meet all criteria of the best practice recommendations (this would be a best case scenario).
The COVID-19 pandemic had and still has an impact on the logistics around the organisation and holding of meetings of the board of managers and shareholders of Luxembourg companies, particularly given the limitation of people’s mobility and the restrictions imposed to in-person business meetings. The Luxembourg legislator, known for being agile and flexible, introduced several emergency measures in March 2020 to ensure business continuity. Such measures allow all Luxembourg companies (regardless of what in this respect may be provided in their constitutional documents) to hold meetings of their board of managers and/or shareholders remotely by any appropriate telematics means, without physical presence being required. Although this measures may in principle weaken the substance of companies and negatively affect their corporate residence, the OECD considers that it is unlikely that the COVID-19 pandemic will create any changes to an entity’s residence status under a tax treaty (the OECD’s note on the matter can be retrieved at https://bit.ly/3fXP4Bb). Luxembourg has not taken an official position on this matter but in line with the OECD analysis, the current exceptional circumstances should not lead to an adverse effect on a company’s tax residence.
VANDENBULKE offers domiciliation and other corporate/trust services via our entity VANDENBULKE Corporate and Trust. Our services include, among others, providing Luxembourg companies with a registered office (or dedicated office space), providing Luxembourg resident managers, handling the corporate secretarial tasks, book keeping, preparing annual accounts and corporate tax returns, carrying out the formalities and publications required by law and by the articles of association, conducting the relations with the appropriate public authorities and liaising with Luxembourg banks.
Our Corporate M&A and Tax teams can provide further input and answer any particular question on the above in coordination with our team of experts at VANDENBULKE Corporate and Trust.