In a noteworthy decision issued 22 July 2026, the Luxembourg Administrative Court provided welcome guidance on the application of the arm’s length principle where a related party borrower’s financial condition has materially deteriorated after a financing arrangement is put in place.
The case focused on whether a Luxembourg lender’s decision to waive interest as part of a distressed-debt restructuring was consistent with the arm’s length principle or whether the lender was required to continue recognising interest income under the original loan terms, despite the borrower’s weakened financial position and a broader financial restructuring involving other stakeholders. The decision is significant because it treats a later waiver, amendment or restructuring of financial terms as a separate transfer pricing event that must be assessed based on the facts and circumstances at the time the decision is made. Rather than looking at only whether the original interest rate was arm’s length when the loan was granted, the court considered whether the lender’s response to the borrower’s subsequent financial distress was commercially supportable.
For taxpayers, the court’s decision reinforces several important points:
A Luxembourg company (LuxCo) made a EUR-denominated loan to its French subsidiary with a 12% annual interest rate. The loan was funded through USD-denominated bonds issued to LuxCo’s Luxembourg parent company. At the time the financing was put in place, a transfer pricing analysis supported both the 12% rate and a 0.147% net financing margin for LuxCo.
The French borrower later experienced severe operational and financial pressures, prompting a broader financial restructuring that was finalised in 2018. Under the restructuring arrangement, LuxCo waived interest for a short period in 2017 (i.e., 16 October to 31 December), and the restructuring also included a partial debt-to-equity conversion, new financing with a reduced interest rate of 6%, additional guarantees and concessions from other third-party stakeholders.
The Luxembourg tax authorities challenged the partial waiver of accrued interest, taking the position that LuxCo failed to recognise arm’s length interest income on the loan. The authorities treated the waived interest as a hidden capital contribution to the French borrower. They also disallowed a portion of LuxCo’s interest expense on the bonds issued to its parent and recalculated the deductible interest by reference to the depreciated market value of the bonds instead of their nominal value. The taxpayer appealed to the Administrative Tribunal, which upheld both adjustments. The taxpayer then appealed to the Administrative Court.
On appeal, the Administrative Court ruled in favour of LuxCo, reversing the decision of the Administrative Tribunal.
Although the Luxembourg tax authorities, and initially the tribunal, took the position that LuxCo should have continued to recognise interest at the 12% rate, the Administrative Court held that the interest waiver and reduced interest rate were consistent with the arm’s length principle. In reaching that conclusion, the court considered the borrower’s deteriorated financial position, LuxCo’s realistically available options and the broader restructuring context, including the involvement of an unrelated third party in the negotiations.
The Administrative Court also rejected the tax authorities’ attempt to calculate deductible interest by reference to the impaired value of LuxCo’s funding instruments. Based on the facts of the case, the court confirmed that the contractual principal remained the relevant basis for the interest calculation.
The decision is a useful reminder that related-party financing arrangements should not be evaluated in isolation from later commercial developments. Where a borrower’s financial condition has materially weakened, the arm’s length analysis should consider whether an independent lender, facing the same facts and realistic alternatives, would have agreed to a waiver, amendment or refinancing.
In fact, if an entity is characterised as bearing credit risk on its lending, it should also be capable of absorbing the consequences when that risk materialises, including where its own funding costs continue to accrue. The transfer pricing position will generally be strongest where the documented risk profile and the treatment of the eventual outcome are consistent both at inception and when circumstances later change.
Daniel Ortega
Gerdy Roose
BDO in Luxembourg
The case focused on whether a Luxembourg lender’s decision to waive interest as part of a distressed-debt restructuring was consistent with the arm’s length principle or whether the lender was required to continue recognising interest income under the original loan terms, despite the borrower’s weakened financial position and a broader financial restructuring involving other stakeholders. The decision is significant because it treats a later waiver, amendment or restructuring of financial terms as a separate transfer pricing event that must be assessed based on the facts and circumstances at the time the decision is made. Rather than looking at only whether the original interest rate was arm’s length when the loan was granted, the court considered whether the lender’s response to the borrower’s subsequent financial distress was commercially supportable.
For taxpayers, the court’s decision reinforces several important points:
- Changes to related party financing terms should be supported by a contemporaneous arm’s length analysis.
- The materialisation of credit risk may affect the return an independent lender would realistically expect to earn.
- The parties’ realistically available options should be evaluated based on the facts existing at the time of the restructuring.
- Contemporaneous documentation is critical where financial conditions change after the original financing is implemented.
- An accounting impairment does not necessarily reduce the contractual principal amount on which interest is assessed.
Background
A Luxembourg company (LuxCo) made a EUR-denominated loan to its French subsidiary with a 12% annual interest rate. The loan was funded through USD-denominated bonds issued to LuxCo’s Luxembourg parent company. At the time the financing was put in place, a transfer pricing analysis supported both the 12% rate and a 0.147% net financing margin for LuxCo. The French borrower later experienced severe operational and financial pressures, prompting a broader financial restructuring that was finalised in 2018. Under the restructuring arrangement, LuxCo waived interest for a short period in 2017 (i.e., 16 October to 31 December), and the restructuring also included a partial debt-to-equity conversion, new financing with a reduced interest rate of 6%, additional guarantees and concessions from other third-party stakeholders.
The Luxembourg tax authorities challenged the partial waiver of accrued interest, taking the position that LuxCo failed to recognise arm’s length interest income on the loan. The authorities treated the waived interest as a hidden capital contribution to the French borrower. They also disallowed a portion of LuxCo’s interest expense on the bonds issued to its parent and recalculated the deductible interest by reference to the depreciated market value of the bonds instead of their nominal value. The taxpayer appealed to the Administrative Tribunal, which upheld both adjustments. The taxpayer then appealed to the Administrative Court.
Decision of the Court
On appeal, the Administrative Court ruled in favour of LuxCo, reversing the decision of the Administrative Tribunal. Although the Luxembourg tax authorities, and initially the tribunal, took the position that LuxCo should have continued to recognise interest at the 12% rate, the Administrative Court held that the interest waiver and reduced interest rate were consistent with the arm’s length principle. In reaching that conclusion, the court considered the borrower’s deteriorated financial position, LuxCo’s realistically available options and the broader restructuring context, including the involvement of an unrelated third party in the negotiations.
The Administrative Court also rejected the tax authorities’ attempt to calculate deductible interest by reference to the impaired value of LuxCo’s funding instruments. Based on the facts of the case, the court confirmed that the contractual principal remained the relevant basis for the interest calculation.
BDO Perspective
The decision is a useful reminder that related-party financing arrangements should not be evaluated in isolation from later commercial developments. Where a borrower’s financial condition has materially weakened, the arm’s length analysis should consider whether an independent lender, facing the same facts and realistic alternatives, would have agreed to a waiver, amendment or refinancing.In fact, if an entity is characterised as bearing credit risk on its lending, it should also be capable of absorbing the consequences when that risk materialises, including where its own funding costs continue to accrue. The transfer pricing position will generally be strongest where the documented risk profile and the treatment of the eventual outcome are consistent both at inception and when circumstances later change.
Daniel Ortega
Gerdy Roose
BDO in Luxembourg