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When the EU Commission introduced the Anti-Tax Avoidance Directives in 2019 and 2020, it included provisions dealing with the taxation of reverse hybrid entities. The purpose of these rules is to tackle situations where investors treat tax-transparent partnerships as corporations (“blockers”).
In that setting and since 2022, Luxembourg tax-transparent partnerships (such as a SCS or SCSp – referred to as SCSp only for the purpose of this article), which are otherwise tax-free vehicles, may become subject to Luxembourg corporate income tax (at a rate of c. 18%) if certain conditions are fulfilled.
These conditions would broadly be met if the foreign investors that regard the SCSp as a corporation (creating a reverse hybrid) hold in aggregate at least 50% of the political or economic rights thereof.
Luxembourg is home to many alternative investment funds – regulated or not – which are set-up as Luxembourg tax-transparent partnerships. These alternative investment funds attract investment from limited partners scattered across the world. As a result, it’s no surprise that certain investors may have a different legal classification system, and treat Luxembourg partnerships as blockers rather than transparent entities.
The reverse hybrid rules may therefore have direct adverse tax consequences impacting the investors’ returns.
Like for the ordinary anti-hybrid rules, the reverse hybrid rules foresee that, in the case of investment funds, small-stakes investors (those holding less than 10% in the investment fund SCSp) should not be considered for the aforementioned 50% test (so-called “de minimis rule”).
In addition, the reverse hybrid rules are not supposed to apply to collective investment vehicles (“CIVs”). This CIV exemption applies if the investment fund is (i) widely held, (ii) holds a diversified portfolio of securities and (iii) is subject to investor-protection regulation in the country in which it is established. In practice, the CIV exemption and its three conditions would be expected to be met by most Luxembourg tax-transparent partnerships covered by the SIF Law, the RAIF Law or the AIFMD Law.
Whilst the CIV exemption has been welcomed by fund managers, its interpretation may, in certain cases, result in undesired consequences.
The purpose of this brief note is to highlight how the CIV exemption plays out and possible interpretation conflicts.
Concept of “widely held”
The notion of “widely held” is not defined in the Luxembourg law. Further, authoritative sources (such as the OECD) do not specify what constitutes a minimum number of investors for this classification.
The market practice therefore takes a pragmatic approach when considering this concept. For instance, in ramp-up periods, only few investors may have entered the fund. However, if the investment fund is designed to be marketed to a number of unrelated investors during the investment cycle, practitioners generally consider this concept as being met.
Similarly, if sponsors intend to claim the application of the de minimis rule (where there are investors below 10%), this would generally imply that the fund should be sufficiently widely held.
On the contrary, investment funds exclusively dedicated exclusively to big ticket investors would generally fail that test and the CIV exemption would not be applicable.
Diversified portfolio of securities
Much like the "widely held" test, there is no explicit definition in the tax law.
A similarly pragmatic approach should be followed. For instance, one may refer to the relevant Luxembourg product laws to determine whether the diversification test could be considered as met.
Both the SIF Law and RAIF Law have a risk-spreading requirement which provides that one investment should not represent more than 30% of the portfolio. Luxembourg AIF partnerships which are not subject to these product laws do not have to comply with those diversification requirements. Nonetheless, for the purposes of this test, one may look at the number of investments held by the partnership and by way of comparison determine if the 30% would be met. It’s worth noting that, like the product laws foresee, this test should be appreciated on a look-through basis.
The restrictive terminology of this test – referring to a portfolio of “securities” rather than the broader notion of “assets” – may lead to uncertainty. In our view, one should refer to the concept of the investment policy adopted by Luxembourg AIFs, traditionally encompassing a broader scope, involving the collective investment of funds in assets. On that basis, it could be considered that the notion of a portfolio of securities extends to other types of assets.
Overall, the diversification test should rely on an intentional component as much as on a factual component.
Investor protection criterion
In today’s alternative investment fund framework (i.e., the AIFMD), investor protection is the responsibility of the managers. The supervision of the AIFM by its home state regulator means that the fund vehicle is subject to investor protection regulation. Luxembourg AIFs managed by authorized Luxembourg AIFMs fall under the supervision of the CSSF (at manager level). In that case, it means that safeguards are in place to ensure that investors are well-informed and adequately protected. Under that setting, this criterion should naturally be fulfilled.
The question remains whether a registered AIFM - an AIFM that manages an AIF partnership with sub-threshold investments that is not fully authorized - would provide sufficient level of transparency and protection to investors. Uncertainty remains in that respect.
In addition, it’s not rare that Luxembourg investment funds are managed by an EU AIFM, for instance in Ireland. The wording of the law suggests that the AIFM must be subject to investor protection in the country in which the investment fund is established. A restrictive view may therefore lead to the conclusion that a Luxembourg AIF managed by an Irish (or other EU country) AIFM should not meet the investor protection test.
In our perspective, this restrictive view cannot prevail as EU AIFMs duly authorized and supervised in their home states have to comply with the same requirements (under the AIFM Directive as transposed in each EU Member State) as a duly authorized/supervised AIFM based in Luxembourg.
Such view would also be contrary to the spirit of the AIFMD which foresees that an EU AIF can be managed by any other EU country AIFM. It is noteworthy that imposing a requirement for a Luxembourg SCSp to be managed by a Luxembourg AIFM to qualify for the CIV exemption would be at odds with the freedom of establishment enshrined in the Treaty on the Functioning of the European Union.
In conclusion, two years after its implementation, the CIV exemption applies by and large to most Luxembourg alternative investment funds set up as partnerships. In certain cases, the CIV exemption may however not be applicable (fund of one) or still subject to uncertainty.
This article was written by Vincent Remy and François Manset, with contributions from Paul Prince, Senior, EY Luxembourg.
Summary
When the EU Commission introduced the Anti-Tax Avoidance Directives in 2019 and 2020, it included provisions dealing with the taxation of reverse hybrid entities. The purpose of these rules is to tackle situations where investors treat tax-transparent partnerships as corporations (“blockers”).
In that setting and since 2022, Luxembourg tax-transparent partnerships (such as a SCS or SCSp – referred to as SCSp only for the purpose of this article), which are otherwise tax-free vehicles, may become subject to Luxembourg corporate income tax (at a rate of c. 18%) if certain conditions are fulfilled.