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Luxembourg: Non-taxation of U.S. multinational corporation not illegal state aid

Luxembourg's tax ruling

The European Commission today announced the findings of its investigation that the non-taxation of certain profits of a U.S. multinational corporation in Luxembourg did not lead to illegal state aid because the treatment was in line with national tax laws and the Luxembourg-United States income tax treaty.

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The investigation examined whether Luxembourg might have misapplied its income tax treaty with the United States. However, the EC concluded that Luxembourg's tax treatment of the taxpayer’s Europe franchising entity did not violate the income tax treaty with the United States and, on that basis, the tax rulings granted by Luxembourg to the taxpayer did not infringe the EU state aid rules.

The investigation under the EU state aid rules focused on whether the double non-taxation of certain profits of the U.S. corporation was the result of Luxembourg misapplying its national laws and the Luxembourg-United States income tax treaty in favor of the taxpayer. EU state aid rules prevent EU Member States from giving unfair advantages only to selected companies, including through illegal tax benefits. In this case, the investigation showed the reason for double non-taxation was a mismatch between Luxembourg and U.S. tax laws, and not a special treatment by Luxembourg. Therefore, Luxembourg did not break EU state aid rules.

The EC release notes that the EC “…welcomes steps taken by Luxembourg to prevent future double non-taxation.” The statement continues:

Of course, the fact remains that [the taxpayer] did not pay any taxes on these profits – and this is not how it should be from a tax fairness point of view. 

Background

The taxpayer's Europe franchising company is a subsidiary of the U.S. corporation. The company is tax resident in Luxembourg and has two branches—one in the United States and the other in Switzerland. In 2009, the Europe franchising acquired a number of franchise rights from the U.S. corporation which it subsequently allocated internally to the U.S. branch of the Luxembourg company. As a result, the Europe franchising company receives royalties from franchisees operating outlets in Europe, Ukraine and Russia for the right to use the brand. The Europe franchising company also set up a Swiss branch responsible for the licensing of the franchise rights to franchisors and through which royalty payments flowed from Luxembourg to the U.S. branch of the company.

The Luxembourg authorities in 2009 granted the Europe franchising company a first tax ruling—confirming that the company did not need to pay corporate tax in Luxembourg, since the profits would be subject to taxation in the United States. This was justified by reference to the Luxembourg-United States income tax treaty provision that exempts income from corporate taxation in Luxembourg, if it may be taxed in the United States. Under this first ruling, the Europe franchising company was required to submit proof every year to the Luxembourg tax authorities that the royalties transferred to the United States via Switzerland were declared and subject to taxation in the United States and in Switzerland.

Following this first tax ruling, the Luxembourg authorities and the taxpayer engaged in discussions concerning the taxable presence of the Europe franchising company in the United States (a "permanent establishment"). The taxpayer claimed that although the U.S. branch was not a "permanent establishment" according to U.S. tax law, it was a "permanent establishment" according to Luxembourg tax law. As a result, the royalty income would be exempt from taxation under Luxembourg corporate tax law. The Luxembourg authorities ultimately agreed with this interpretation and, in September 2009, issued a second tax ruling according to which the Europe franchising corporation was no longer required to prove that the royalty income was subject to taxation in the United States.

EC’s findings

The EC’s in-depth investigation assessed whether the Luxembourg authorities selectively derogated from the provisions of their national tax law and the Luxembourg-United States income tax treaty and gave the taxpayer an advantage not available to other companies subject to the same tax rules. The EC concluded that this was not the case.

In particular, it could not be established that the interpretation given by the second tax ruling to the Luxembourg-United States income tax treaty was incorrect, although it resulted in the double non-taxation of the royalties attributed to the U.S. branch. Therefore, the EC found that the Luxembourg authorities did not misapply the Luxembourg-United States income tax treaty and that the tax advantage conferred to the Europe franchising company cannot be considered state aid. 

Also, the Europe franchising company's U.S. branch did not fulfil the relevant provisions under the U.S. tax code to be considered a permanent establishment.

At the same time, the EC found that the Luxembourg authorities could exempt the U.S. branch of the Europe franchising company from corporate taxation without violating the income tax treaty because the U.S. branch could be considered a permanent establishment according to Luxembourg tax law. Under the relevant provision in the Luxembourg tax code, the business carried on by the U.S. branch of the Europe franchising company fulfilled all the conditions of a permanent establishment under Luxembourg tax law.

Therefore, the EC concluded that the Luxembourg authorities did not misapply the Luxembourg-United States income tax treaty by exempting the income of the U.S. branch from Luxembourg corporate taxation. This interpretation of the tax treaty resulted in double non-taxation of the franchise income of the Europe franchising company.

BEPS proposals

The Luxembourg government presented on 19 June 2018 draft legislation to amend the tax code to bring the relevant provision into line with the OECD's base erosion and profit shifting (BEPS) project and to avoid similar cases of double non-taxation in the future. This is currently being discussed by the Luxembourg Parliament. Under the proposed BEPS provision, the conditions to determine the existence of a permanent establishment under Luxembourg law would be strengthened. In addition, Luxembourg would be able to, under certain conditions, require companies that claim to have a taxable presence abroad to submit confirmation that they are indeed subject to taxation in the other country.

Read a September 2018 report prepared by KPMG’s EU Tax Centre

Read a September 2018 report prepared by the KPMG member firm in Luxembourg

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