Economic Substance, Beneficial Ownership and Transfer Pricing under Scrutiny

Article published by A GEFI 15.09.2025

In today’s international tax landscape, substance, beneficial ownership and transfer pricing (TP) have converged into the same question: do tax outcomes reflect genuine business reality?

Luxembourg, the world’s second-largest investment fund centre and a leading hub for cross-border investment, multinational headquarters, and international ﬁnancing, beneﬁts from a network of over 85 double tax treaties. These treaties are vital for international investors, as they allocate taxing rights, reduce or eliminate withholding taxes on dividends, interest, and royalties, and prevent double taxation, without which cross-border investment would be extremely diﬃcult. Beyond lowering tax burdens, treaties also provide legal certainty and predictability, making access to treaties and EU Directives one of the key factors in choosing Luxembourg as a jurisdiction for an invest- ment platform.

However, the treaty beneﬁts are not automatic. To access treaty beneﬁts, companies must demonstrate genuine economic substance and prove they are the beneﬁcial owner of the income received. For Luxembourg, where investment and ﬁnancing structures rely on treaties and EU Directives access, these requirements are now at the core of international tax planning and a frequent source of litigation.

The Rise of Substance in International Tax and Transfer Pricing

The term “substance” has been central in international tax since the launch of the OECD/G20 Base Erosion and Proﬁt Shifting (BEPS) project in 2013. A core objective of the BEPS Action Plan was to “realign taxation with economic substance and value creation, while avoiding double taxation”. The guiding principle is clear: proﬁts should be taxed where value is created.

In this sense, the OECD TP Guidelines (TPG) were updated in 2017 to reﬂect the implementation of the BEPS Action Plan and nearly doubled in length, emphasising thorough fact-ﬁnding, accurate delineation, correct qualiﬁcation of intercompany transactions, and alignment between contractual terms and actual conduct of the parties. A proper TP analysis in line with the TPG is therefore instrumental for assessing substance, identifying potential gaps, and demonstrating both arm’s length pricing and economic substance.

Tax administrations now scrutinise treaty claims and TP outcomes through the lens of substance. In practice, this means assessing whether management and decision-making occur where the entity has its registered seat, whether it performs substantive functions, and whether it has adequate people, premises, and capital to support those functions. Authorities also examine whether the entity assumes genuine ﬁnancial risks and retains an appropriate share of proﬁts rather than simply passing income upstream.

Luxembourg has translated these international principles into domestic requirements. Under the 2016 TP Circular on intragroup ﬁnancing, a ﬁnancing company must demonstrate organisational substance: key decisions taken in Luxembourg by resident or locally taxable skilled directors, board meetings held domestically, and qualiﬁed staﬀ overseeing activities, even if some tasks are outsourced. Beyond this, it must demonstrate economic substance, which depends on the business purpose and economic reality of the activity, its commercial viability, and the ﬁnancial and operational risks attached to it. The level of equity “at risk” should be consistent with the risks eﬀectively borne. Failure to comply may lead to denial of residency certiﬁcates or reclassiﬁcation as an agent, thereby undermining treaty beneﬁts.

The substance requirements of the Circular represent a minimum standard. Additional indicators include local oﬃce space, a bank account, records kept in Luxembourg, and proof that the income recipient carries out genuine activity and authority rather than acting as a conduit. Foreign tax jurisdictions may also impose further requirements through domestic anti-abuse rules or based on case law, so assessments should be made on a case-by-case basis.

Beneﬁcial Ownership: The Treaty Gatekeeper

Parallel to substance, the concept of beneﬁcial ownership serves as the gatekeeper to treaty relief. It was ﬁrst introduced in Articles 10, 11 and 12 of the OECD Model Tax Convention in 1977 to allocate taxing rights on dividends, interest and royalties. The concept was meant to prevent abuse of treaties through “conduit companies”, and it has since been incorporated into most tax treaties worldwide, including the double tax treaties signed by Luxembourg. In addition, beneﬁcial ownership was also added as a criterion in the EU Interest and Royalties Directive. Despite its importance, beneﬁcial ownership has never been precisely deﬁned, but OECD commentary clariﬁes that the beneﬁcial owner must have the right to use and enjoy the income, unconstrained by legal or contractual obligations to pass it on. In other words, the company must not just hold the title to income, but be free to decide how it is used.

Over the past two decades, courts across Europe have scrutinised the concept of beneﬁcial ownership with growing rigour. From the landmark Danish cases decided by the Court of Justice of the European Union in 2019, through Danish Supreme Court rulings in 2023 and 2024, to French and Spanish rulings denying relief to holding companies lacking genuine decision-making capacity, and Italian cases on interest and dividend ﬂows, the message is consistent: legal form alone does not suﬃce. Courts consistently require demonstrable economic substance, real risk assumption, and genuine autonomy. This jurisprudence highlights the vulnerability of structures lacking real activity and places the burden on taxpayers to prove that their arrangements reﬂect economic reality rather than mere formality.

Italy’s Supreme Court Raises the Bar

The clearest recent statement of this principle came from the Italian Supreme Court on 20 February 2025 (case n° 4427). The case involved interest paid by an Italian borrower to a Luxembourg ﬁnance company free of withholding tax, claiming exemption based on the Italian legislation. The tax authorities argued Luxembourg entity was a conduit, passing income to its parent with no presence or decision-making power in Luxembourg.

In a landmark ruling, the Court redeﬁned “beneﬁcial owner” for withholding tax exemptions on interest. Adopting a look-through approach, it overturned the traditional stance of the Italian tax authorities and explicitly linked beneﬁcial ownership to substance. The Court set out a three-step framework for assessing beneﬁcial ownership: (i) only a binding contractual or legal obligation to pass on income disqualiﬁes the recipient, group policies or shareholder links are insuﬃcient; (ii) a functional and economic analysis must examine decision-making autonomy, exposure to credit risk, operational substance such as staﬀ and processes, and whether margins align with OECD benchmarks; and (iii) proportionality applies, with no ﬁxed margin, but a contextual assessment based on functions, risks, duration, and regulation. This ensures a holistic, ﬂexible analysis, balancing legal form with economic reality and aligning judicial practice with international standards. For cross-border ﬁnancing, the implication is clear: treaty relief will not be granted without demonstrable economic substance.

Lessons from Luxembourg’s Own Courts

This Italian ruling comes against the backdrop of evolving jurisprudence in Luxembourg itself. On 17 April 2025, the Luxembourg Administrative Court of Appeals (case n° 50602C) ruled on interest-free shareholder loans, rejecting reliance on the traditional “85:15 debt-to-equity” ratio and focusing instead on true economic substance of the ﬁnancing. It held that loans lacking commercial rationale could be requaliﬁed entirely as equity, with all the tax consequences that entails, including loss of interest deductions.

This emphasizes the substance-over-form approach as per the Luxembourg tax law, with a clear message: debt capacity and commercial purpose must be demonstrable, and taxpayers must show genuine activity through local governance, infrastructure, and a clear commercial rationale beyond tax beneﬁts. Without these elements, entities risk denial of treaty beneﬁts and exposure to anti-abuse rules. For ﬁnancing companies, real governance in Luxembourg is essential: decisions taken locally, suﬃcient equity to bear lending risks, and proﬁts aligned with functions performed. Consistency across CbCR, TP documen- tation, and ﬁnancial statements is equally critical, as mismatches signal weak substance and invite challenges from tax authorities.

Conclusion: The Convergence of Substance, Beneﬁcial Ownership and Transfer Pricing

Form without substance cannot secure treaty beneﬁts or defensible TP outcomes. Substance has now gained far greater importance and scrutiny in the context of the application of tax treaties. Beneﬁcial ownership, economic substance, and TP analysis are interdependent tests of the same principle: that tax outcomes must reﬂect genuine business reality. TP analysis has become the practical method for testing substance. A thorough delineation of transactions and functional analysis, covering functions, risks, assets, and governance, is now the main tool for demonstrating both arm’s length pricing and entitlement to treaty or directive beneﬁts.

The era of relying solely on contracts and formal structures has long passed. Today, the focus lies increasingly on verifying actual substance. Courts across Europe have conﬁrmed that beneﬁcial ownership depends on genuine decision-making power and economic reality. The lesson is clear: without demonstrable substance, neither TP arrangements nor treaty protections will withstand scrutiny, and tax beneﬁts must follow business reality, not the other way around.