Luxembourg corporate tax regime saves companies cash

Transactions can be seen as loans in one country and dividend payments in another

The corporate tax structures involving Luxembourg can seem nightmarishly convoluted, but in essence they are quite simple.

They save groups of companies tax by creating contrived “costs” that can be used to reduce the group’s taxable profits, but have little or no effect on its real profits.

The best way to understand the system is to think of a simplified example. In this example an Irish business sets up a new group company in Luxembourg and gives it an interest-free loan of €1 billion.

The Luxembourg company then loans the money, at interest, back to another new company, this one back in Ireland. This company then uses the money to invest in a new, and profitable, aspect of the group’s overall business.

The interest payments the new Irish company makes to its sister company back in Luxembourg, are a cost that reduces the Irish company’s taxable profits. So if the Irish company is being charged, say, 5 per cent, or €50 million, a year, it is saving €7.5 million a year in Irish corporation tax (12.5 per cent of €50 million).

There would be little point in the whole exercise if the profit the Luxembourg company was making (it borrows at zero interest and lends on at 5 per cent) was being taxed there.

But Luxembourg practice allows companies charge what is called “deemed interest” on interest-free loans. This imaginary interest charge, which can be thought of as the charge that might apply if the loan was a normal, commercial one, has the effect of reducing the Luxembourg company’s profits to close to zero.

Because it is close to zero, rather than actually zero, Luxembourg’s exchequer gets a small cut from the overall transaction. Luxembourg has a 29 per cent corporation tax rate.

In some of the tax structures contained in the PwC documents seen by The Irish Times, use is made of controversial financial products called hybrid instruments. They are called hybrid because the transactions can be seen as loans in one country, and dividend payments in another.

So in the example above, the €1 billion the Luxembourg company gives to the new Irish company, would be considered a loan in Ireland, and the interest it pays on it, chargeable against Irish tax. However, in Luxembourg the same payments, from the Irish company to the Luxembourg company, would be considered dividends paid on an equity investment, and would be exempt from tax under Luxembourg’s tax rules.

Hybrid financial instruments and their use in tax structures such as the one described above, have been strongly criticised by the Organisation for Economic Cooperation and Development.