“Pillar Two”: What impact for Luxembourg debt funds?

The EU adoption of Pillar Two (or global minimum corporate tax rate) has already been commented intensively for a number of sectors.

What is Pillar Two?

Extending the 2015 Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project, the OECD/G20 came up with the BEPS 2.0 project. The first aim of it was to address tax challenges arising from the globalization and digitalization of the economy. Two workstreams spawned from BEPS 2.0: Pillar One proposes a partial reallocation of taxing rights towards market jurisdictions. Pillar Two, also referred to as the Global Anti-Base Erosion (GloBE), provides for a set of minimum taxation rules for large multinational groups (MNG). 

On 20 December 2021, the OECD published the GloBE Model Rules for implementation from 1 January 2023.

Pillar Two applies to MNG that have a combined annual group turnover of at least 750 million euro based on consolidated financial statements of the so-called Ultimate Parent Entity (the 750 million and consolidation requirement is in line with the Country-by-Country Reporting rules). It provides that MNG should pay an income tax at a minimum effective tax rate (ETR) of 15%.

Pillar Two introduces two rules into domestic legislation (the GloBE Model Rules) and one treaty-based rule.

The two domestic rules are (i) the top-up tax rule and (ii) the back-stop rule. The first one – officially known as the Income Inclusion Rule – applies to the entity that is at the top, or near the top, of the MNG (the so-called Ultimate Parent Entity). Similar to controlled foreign corporation (CFC) rules, it will give the jurisdiction of that top entity the right to levy top-up taxes to increase the ETR up to 15%. The back-stop rule – as known as the Undertaxed Payments Rule – allocates top-up taxes among the countries in which the group has operations in case the first rule doesn’t apply.

The treaty-based rule – or Subject to Tax Rule – allows source jurisdictions to tax related-party payments. 

Proposed EU Directive on Pillar Two

To ensure that Pillar Two is implemented in a coherent and consistent way in the EU, the Commission published on 22 December 2021 a draft Directive on a global minimum level of taxation for MNG in the EU.

The draft Directive largely follows the GloBE Model Rules mentioned above: each EU Member State would have to implement the Income Inclusion Rule as from 1 January 2023 whilst the Undertaxed Payments Rule would be deferred to one year later.

The draft Directive does not address, however, the Subject to Tax Rule as it will be up to each jurisdiction to implement in respective tax treaties. 

What is the impact for Luxembourg’s private debt funds?

Luxembourg is one of the top jurisdictions worldwide for asset managers overall and surely for EU-focused credit strategies. Managers of such credit funds often design their fund structure using a Luxembourg platform which allows relying on the EU Alternative Investment Funds Manager Directive (AIFMD) passport with the tradeoff that the Luxembourg AIFM (or the Luxembourg fund in certain cases) is subject to supervision in Luxembourg. This Luxembourg fund, generally in the legal form of a (tax transparent) partnership is either lending directly to EU borrowers or via a fully owned investment entity, generally based in Luxembourg.

Consolidation requirement under the draft Directive

The draft Directive applies to an Ultimate Parent Entity that is required to prepare consolidated accounts where the overall revenue of all constituent entities tallies 750 million.

Generally, investors and the investment fund do not consolidate with one another. Same for the investment fund and the underlying Luxembourg investment entity. Absent the consolidation requirement at the level of the investment fund, the rules would, generally, not apply. In the unlikely case consolidation would be applicable, the 750 million threshold of revenues should first be met.

Excluded entities

The draft Directive also provides that certain entities should be excluded from its scope based on their purpose and status. This is the case for “investment funds” (when they are at the top of the ownership chain i.e., an Ultimate Parent Entity) that meet seven cumulative criteria. Of particular relevance are those that (i) require investors to be unrelated and (ii) the fund or its manager to be subject to investment fund regulations in the country where the fund is established. As mentioned above, the majority of Luxembourg debt funds pool money from several different investors and their AIFM is supervised in Luxembourg (transposition of the AIFMD). On that basis, most Luxembourg debt funds should be considered as excluded entities. Interestingly, the exclusion should also apply to their (Luxembourg) investment entities.

A number of investment funds are owned by one or connected investors such as fund of one or fund for family offices. In that case, credit fund managers would look into relying on the absence of consolidation requirements / not meeting the 750 million threshold.

It remains to be seen how the Luxembourg law will transpose the draft Directive, but it appears that Luxembourg private debt funds should, by and large, be outside the scope of these rules.