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The tax agenda has kept private equity firms busy during the past three years, with significant changes in the landscape, and more are on the way. In this article, Laurent Capolaghi, Partner, Private Equity Leader, and Claire Goachet, Associate Partner in Private Equity Tax at EY Luxembourg review some of the most important tax hot topics that may influence the European private equity market.
Anti-Tax Avoidance Directive 2 (“ATAD 2”) – reverse hybrid rules
In 2019, the Luxembourg legislator introduced provisions addressing intra-EU hybrid mismatches with effect from 1st January 2019. Since then, this provision has been replaced by the broader anti-hybrid provisions of the ATAD 2 applicable since 1st January 2020, and added a new provision addressing the taxation of “reverse hybrids”, which is applicable since 1st January 2022.
The anti-hybrid mismatch requirements of the ATAD 2 are designed to ensure that deductions or credits are only taken in one jurisdiction and that there are no scenarios where a payment is deducted in one jurisdiction without the equivalent income being taxed in the other. The regulations usually apply only to mismatches caused by hybridity and have no bearing on the allocation of taxation rights under a tax treaty.
One of the aims of the ATAD 2 rules is to tackle situations where a tax transparent partnership is treated as a corporation by certain investors, which results in avoiding taxation at both partnership and investors level. In a nutshell, if a Luxembourg partnership that is treated as transparent for Luxembourg tax purposes is considered as opaque by certain investors (under certain conditions outlined below), such partnership would become subject to corporate income tax in Luxembourg.
Because private equity managers frequently choose to set up their Luxembourg funds as tax transparent partnerships (i.e., the common limited partnership or société en commandite simple or special limited partnership or société en commandite spéciale), a closer look at these rules would be required to mitigate any potential adverse tax consequences.
First, it is worth mentioning that the reverse hybrid entity rules do not apply to Luxembourg undertakings for collective investment which is defined as an investment fund that is widely held, holds a diversified portfolio of securities and is subject to investor-protection regulation in the country in which it is established. Along these lines, this carve-out covers Specialized Investment Funds (SIF) or Reserved Alternative Investment Funds (RAIF) which are legally set-up as partnerships. This exception also applies to unsupervised partnerships qualifying as Alternative Investment Funds (AIFs) as per the Luxembourg 2013 law on AIF Managers to the extent they are widely held, hold a diversified portfolio of securities and are subject to investor protection requirements. Given that many Luxembourg funds are covered by these three regimes, the reverse hybrid rules should not impact them.
Other Luxembourg private equity funds will not necessarily be impacted either. Indeed, the rules will only apply if the non-resident associated enterprises looking at the Luxembourg partnership as tax opaque hold, in aggregate, a direct or indirect interest of at least 50% of the voting rights, capital interests or rights to profit thereof.
In this regard, it is worth noting that the anti-hybrid provisions apply only to “associated enterprises” and Luxembourg law included the following carve out: an investor who, directly or indirectly, owns less than 10% of an investment fund and is entitled to less than 10% of the profits of such investment fund will, unless there is proof to the contrary, not be considered “acting together” with another person participating in the fund. Such de minimis rule would help to limit the impact of the reverse hybrid rules for widely held funds.
Although the above exclusions and carve-out would result in limiting the implications of reverse hybrid rules in a private equity fund context, fund managers must continue to keep a tight eye on particular set-up (for instance with a sole investor and where the partnership would not fall into the exclusions) to ensure that the current rules would not adversely impact their structures.
Anti-Tax Avoidance Directive 3 (“ATAD 3”) – shell entities on the radar
In December 2021, the European Commission released its proposal for a new Directive that targets so-called “shell” entities, i.e., undertakings with no or minimal economic activity, used as instruments of tax evasion or tax avoidance. Whilst the draft Directive may still be subject to further amendments, ATAD 3 will ultimately have to be transposed into Member States’ national laws by 30 June 2023 for the rules to come into effect as of 1 January 2024.
The Draft Directive requires companies that, during the last two tax years, predominantly derived passive income (e.g., interest, dividends, royalties) or predominantly held real estate and/or shares, and that meet some other tests to report substance-related information to the tax authorities of their residence state. If a company meets the minimum substance requirements (as outlined in the Draft Directive) it will not be considered as a shell company and the tax consequences foreseen in the Draft Directive will not apply.
The Draft Directive outlines three cumulative “gateway” criteria to identify whether an entity is at risk of being a shell: (i) the entity mainly derives passive income (e.g. interest, dividend) or predominantly holds real estate and/or shares, (ii) the entity is engaged in “cross-border activities”, and (iii) the entity (partly) outsources its own administration and decision making. The entity meeting those criteria will be considered “at risk” and will be required to disclose and document its substance in its annual tax returns by providing information on its premises, bank accounts, local director(s) or employees.
If the substance is not properly demonstrated, the entity at risk will be deemed to be a shell company and will therefore not be entitled to receive a tax residency certificate (or to receive it but with a warning statement). As a result, the entity may not be entitled anymore to double tax treaties and/or EU Directives, which may result in a higher tax burden, particularly if the company derives income from the EU or pays income to EU investors.
The companies would be able to refute the presumption of being a shell company by submitting more evidence on substance and commercial rationale, or by obtaining a reporting exemption on the grounds that the company's existence does not provide a tax benefit to the group. The successful rebuttal or the exemption from reporting is valid for one tax year and may be extended by five years. The Draft Directive also foresees automatic exchange of information received by the residence state of the company with other EU Member States and into a Central EU Directory.
A few exclusions will apply, for instance to regulated / indirectly regulated financial undertakings (which includes AIFs and entities that are covered by the EU 2017 Securitization Regulation), holding companies in the same jurisdiction as the ultimate parent entity and companies that have a transferable security admitted to trading or listed on a regulated market or qualifying multilateral trading facility.
Alternative asset managers are well-advised to consider the draft Directive already carefully and to carry out a first impact assessment on their corporate structures this year, given that the gateway criteria will refer to the preceding two tax years.
“Pillar Two” – What impact for Luxembourg private equity funds?
The Pillar Two proposal, also referred to as the Global Anti-Base Erosion (GloBE) rules, consists in a set of minimum taxation rules for large multinational groups (MNG). On 20 December 2021, the OECD published model rules on a global minimum level of taxation for MNG in the EU, for implementation as from 1st January 2023. On 22 December 2021, the European Commission published a draft Directive on a global minimum level of taxation for MNG in the EU.
The draft Directive would apply to entities forming part of a MNG that is defined as a collection of entities included in consolidated accounts drawn up by an Ultimate Parent Entity where the overall turnover of the consolidated group during the last two years exceeds 750 million euros. The draft Directive, amongst other measures, notably provides that MNGs falling within the scope should pay an income tax at a minimum effective tax rate of 15%.
In absence of line-by-line consolidation at the level of the investment fund, the rules would, generally, not apply. Where the fund does consolidate line-by-line, the revenue thresholds would still need to be met.
Moreover, the draft Directive 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 a certain number (seven) of cumulative criteria.
The above conditions and exclusions suggest that Pillar II would have a limited impact on Luxembourg private equity funds. However, it remains to be seen how the Luxembourg law will transpose the draft Directive to confirm to which extent they would effectively be affected by these rules.
Conclusion
The preceding tax themes do not, as stated in the introduction, constitute an exhaustive list of key tax concerns. For instance, other aspects, such as transfer pricing and Mandatory Disclosure Regime (DAC 6), remain key topics for 2022 and need to be kept on the "tax" radar of PE tax directors. Being fully aware of the key tax challenges and continuous increase of tax pressure, private equity fund managers should keep factoring in all those tax aspects when structuring their funds.
Summary
The tax agenda has kept private equity firms busy during the past three years, with significant changes in the landscape, and more are on the way. In this article, Laurent Capolaghi, Partner, Private Equity Leader, and Claire Goachet, Associate Partner in Private Equity Tax at EY Luxembourg review some of the most important tax hot topics that may influence the European private equity market.