A deep dive into Alternatives

New opportunities and areas of doubt have emerged in recent years with the rise of the alternative investments industry. This article is the first of three, which will give details on the concept of alternative investment funds (AIFs) and investment platforms from a Luxembourg direct tax perspective, the VAT aspects requiring consideration when dealing with AIFs and acquisition vehicles and transfer pricing issues in connection with the AIF and its organs and service providers.

Part I – AIFs and regional investment platforms from a Luxembourg direct tax perspective

The terms such as “MLI”, “PPT”, “substance”, “purpose”, “treaty benefits”, “AIF” and “AIFM” are familiar to some, but it is important to understand how these actually interact one with another, and how one could serve another.

Below, we describe what we believe may be a suitable investment platform in the future in this ever changing regulatory and tax environment, especially with the introduction of the concept of “purpose” as a condition to access treaty benefits.

The AIF and the “regulatory nexus”

The SCSp (société en commandite spéciale) is an entity without legal personality whose investors are limited partners (associés commanditaires) and which is managed by a general partner (associé commandité). The SCSp is not subject to corporate income tax (levied at a rate of 18.19% including the solidarity surcharge) nor to net wealth tax (levied at a rate of 0.5%). The SCSp is not subject to municipal business tax (MBT) (levied at a rate of 6.75% in Luxembourg-city) unless it has a commercial activity, or has as its general partner a Luxembourg commercial entity which holds an interest of 5% or more in the SCSp. It is assumed that SCSp that are AIFs never have a commercial activity and therefore cannot be subject to MBT on the grounds of a commercial activity. However, they can be subject to MBT if they have as general partner, a Luxembourg commercial entity that holds an interest of 5% or more in them.

Due to the appetite for raising capital from European investors, the number of Luxembourg AIFs in the form of SCSp is constantly growing. This growth was expected as Luxembourg has always been a prime location in which to establish fund structures, and a similar entity to a US or UK limited partnership was missing from the Luxembourg tool box until 2013, and this gap has now been plugged with the creation of the SCSp.

It is worth noting, however, the increasing trend of relocating or establishing AIFM in Luxembourg. One reason for this is the uncertainty created by Brexit and its potential negative impact on operating models. At the same time, the requirement to justify a genuine purpose (see below) and to a certain extent, cost rationalisation, are also factors.

One of the strongest reasons for relocating to a jurisdiction is the regulatory motive.

The so-called “regulatory nexus” is a strong, valid reason to establish a complete investment structure in one jurisdiction rather than another, and this is of particular importance in the context of the entry into force of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) and the related “purpose” concept that it introduces.

In other words, we are moving from “how?” to “why?”, and this is where having the fund (AIF), the AIFM, the investment platform and the SPVs in one single jurisdiction makes sense.

The MLI and the principal purpose test (PPT), a shift from “how?” to “why?”, where grouping the investment structure in one single jurisdiction makes sense

As at 11 March 2020, 94 countries had signed, and 4 others¹  had announced their intention to sign, the MLI that was part of the recommended actions of the BEPS project (Action 15)²  of the Organisation for Economic Co-operation and Development (OECD).

The principal aim of the MLI was to implement the recommendations of BEPS Action 6 on treaty abuse, introducing minimum standards to prevent the granting of double tax agreement (DTA) benefits in unintended circumstances. According to such minimum standards, DTAs should include at least a PPT, or a PPT plus either a simplified or detailed limitation on benefits (LOB) test, or a detailed LOB provision supplemented by a mechanism to deal with conduit arrangements. Indeed, it felt that developing such a mechanism was necessary not only to tackle BEPS, but also to ensure the sustainability of the consensual framework to eliminate double taxation.

JJurisdictions were given the choice of signing the MLI and if they decided to become signatories³, could choose which DTAs should be considered as amended by the MLI (then referred to as Covered Tax Agreements). The MLI operates to modify DTAs between two or more parties to the MLI. However, unlike an amending protocol to a single existing DTA that would directly amend the text of the DTA, the MLI will be applied alongside existing DTAs, thus modifying their application in order to implement the BEPS measures.

Luxembourg signed the MLI on 7 June 2017, indicating its intention to apply it to all its DTAs (provided the other party is also a signatory of the MLI) and opting to apply solely the PPT, whose details and philosophy are described in more detail below. The law transposing MLI into Luxembourg legislation was voted on 7 March 2019 and took effect on 1 August 2019⁴.

The OECD clarifies⁵  that the benefits of a DTA should not be available where one of the principal purposes of certain transactions or arrangements is to secure a benefit under a DTA⁶  and obtaining that benefit in these circumstances would be contrary to the object and purpose of the relevant provisions of the tax convention.

Although the MLI and PPT approach did not originally target funds and private equity structures, they nevertheless have an impact on these, as they make access to treaty benefits dependent on the principle purpose test i.e., they ask taxpayers to explain why a specific jurisdiction was chosen for establishment. As explained above, the “regulatory nexus” provides strong justification for establishing the acquisition and holding structure in the same jurisdiction as the AIF and the AIFM.

The OECD provided illustrations of how the local tax authorities could assess situations to determine whether the benefit of the DTA should be granted to a non-collective investment vehicle⁷, and of critical relevance to the private equity sector is the example concerning a regional investment platform.

In the regional investment platform example, the OECD describes a structure in which RCo, a company resident in State R, is a wholly-owned subsidiary of an institutional investor, an investment fund established in State T and subject to State T’s regulation. The example indicates that RCo operates exclusively to generate an investment return as the regional investment platform for the acquisition and management of a diversified portfolio of private market investments located in countries in a regional grouping that includes State R. The OECD concludes that in such a situation, based on a certain number of factors⁸, it would not be reasonable to deny the benefit of the DTA concluded between State R and State S to RCo in the absence of other facts or circumstances showing that RCo’s investment is part of an arrangement, or relates to another transaction, undertaken for the principal purpose of obtaining the benefit of the DTA concluded between State R and State S.

This illustration tends to support an investment scheme structure in which all of the following are located in a single jurisdiction: (i) the regional investment platform whose shares are held by the institutional investor i.e. an investment fund or AIF; (ii) the SPVs holding the investments (as subsidiaries of the regional investment platform); and (iii) the service company in which the substance is pooled and the core commercial activities are conducted (i.e., the AIFM) and sub-delegated where appropriate. This contrasts with the old investment scheme structure where each local investment was held by a local SPV whose shares were be held by the fund.

The management of its subsidiaries’ assets by the regional investment platform may be considered as a valid business purpose; and it is the substance and business rationale of the group and, in particular, of the entities located in one specific jurisdiction that must be taken into consideration when analysing the genuineness of an arrangement and, by extension, the purpose of such an arrangement, and not only the situation of one specific isolated entity.

Furthermore, in line with the conclusions of this case law, the German tax authorities issued a circular⁹  indicating that asset management activities of a company constitute a genuine commercial activity to the extent that that company exercises its rights as shareholder in the subsidiaries.

OECD examples, European case law and local legislation in some jurisdictions thus appear to validate the regional investment platform model and substance/function pooling in one single jurisdiction, especially if the fund and the AIFM are located in that jurisdiction.

The regional investment platform – form and direct tax treatment

Very often, the platform is organised as a corporation (société anonyme or société à responsabilité limitée) under the investment company in risk capital (société d'investissement en capital à risque –SICAR) regime set forth by the Law of 15 June 2004.

This is because circular 06/241 of 5 April 2006 issued by the Luxembourg regulator¹⁰  and providing a general description of the concept of risk capital under the SICAR law and the criteria applied by the CSSF to assess the acceptability of the investment policies proposed for SICARs clarifies that the purpose of the SICAR law is to promote the collection, within a vehicle specialised in risk capital, of funds from well-informed investors accepting, with full knowledge and in expectation of a better return, the increased risks most often associated with risk capital, i.e. lower liquidity, higher price volatility and lower credit quality.

The concept of risk capital is defined as the direct or indirect contribution of funds to entities in view of their launch, development or listing on a stock exchange. Generally speaking, risk capital under the SICAR law is characterised by the presence of two elements: a high risk and an intention to develop the target entities. The intention to develop the target entities is deemed to be inherent per se in the contribution of capital to entities with a view to their launch or listing on a stock exchange.

Moreover, the parliamentary work relating to the SICAR law specifies that the concept of risk capital notably refers to venture capital and private equity financing. The concept of private equity is to be construed in the broad sense. Private equity bears an inherent risk, notably the risk due to a lack of liquidity. It may be described, as opposed to an investment in listed securities, as an investment in a non-listed private company, often of a relatively limited size and a significant level of risk. As far as the different forms of investments in risk capital or the objective pursued by these investments are concerned, the parliamentary work specifies that the scope of the law covers all types of private equity investments. 

Private equity risk capital investments may take the form of buy-offs, leveraged buyouts, management buyouts and management buy-ins. The SICAR law does not prescribe risk diversification with respect to the chosen investments. It is thus perfectly conceivable for certain SICARs to restrict their investments to one or several undertakings active in a particularly narrow niche or in extremely specialised sectors.

Additionally, although the SICAR is subject to Luxembourg corporate income tax and municipal business tax¹¹  (levied at an aggregate maximum rate of 24.94% in Luxembourg-city in 2020), it benefits from a wide exemption regime. Indeed, the income resulting from securities as well as income resulting from the transfer, contribution or liquidation of these assets does not constitute taxable income of SICARs, nor does the income arising from funds held pending their investment in risk capital. However, this latter exemption is only applicable for a maximum period of 12 months preceding their investment in risk capital and where it can be established that the funds have effectively been invested in risk capital. The SICAR is also exempt from net wealth tax¹²  and not subject to subscription tax. Finally, dividend distributions made by the SICAR to shareholders are not subject to any withholding tax, irrespective of (i) the quality or residence of such shareholders, (ii) the percentage of the SICAR’s share capital held by such shareholders, or (iii) the period the shares are held.

In practical terms, this means that the income of the SICAR may be exempt from taxation in Luxembourg and repatriated to the AIF without withholding tax, meaning that the SICAR constitutes a neutral¹³  investment platform¹⁴.

Consequently, an investment structure consisting of a fund set-up as an SCSp qualifying as an AIF and holding the shares of a corporate SICAR acting as a regional investment platform with an AIFM located in the same jurisdiction constitutes an efficient, neutral and robust structure which is being increasingly deployed on the market.

In the second of our three articles, we will run you through the VAT aspects to be taken into consideration when structuring such an investment platform and the third article will provide an overview of the main relevant transfer pricing aspects when dealing with such a structure.

¹ http://www.oecd.org/tax/treaties/beps-mli-signatories-and-parties.pdf
² Base Erosion and Profit Shifting (BEPS) refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low-tax or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid.
³ The United States decided not to sign the MLI.
⁴ http://legilux.public.lu/eli/etat/leg/div/2019/04/09/a296/jo.
⁵ Paragraphs 61 and 76 to 80 of the Commentary on Article 1.
⁶ A benefit as targeted by paragraph 9 of Article 29 includes all limitations on taxation imposed on the State of source (e.g. a tax reduction, exemption, deferral or refund) or the relief of double taxation, such as, for example, limitations on the taxing rights of the Contracting State in respect of dividends, interest or royalties arising in that State and paid to the resident of the other State or over a capital gain realized by the alienation of movable property located in that State by a resident of the other State.
⁷ According to the 2010 OECD report related to the granting of treaty benefits to collective investment vehicles (CIVs), CIVs are “funds that are widely held, hold a diversified portfolio of securities and are subject to investor-protection legislation in the country in which they are established”.
⁸ The example further states that the decision for establishing the regional investment platform in State R was driven by (a) the availability of directors with knowledge of regional business practices and regulations, (b) the existence of a skilled multilingual workforce, (c) State R’s membership of a regional grouping and (d) the extensive tax convention network of State R, including its tax convention with State S, which provides for low withholding tax rates. In terms of substance, the OECD notes that (i) RCo employs an experienced local management team to review investment recommendations from the Fund and performs various other functions which, depending on the case, may include approving and monitoring investments, carrying out treasury functions, maintaining RCo’s books and records, and ensuring compliance with regulatory requirements in States where it invests and (ii) the board of directors of RCo is appointed by the Fund and is composed of a majority of State R resident directors with expertise in investment management, as well as members of the Fund’s global management team. RCo pays tax and files tax returns in State R. The OECD further elaborates that the intention of tax treaties is to encourage cross-border investments and that it is necessary to consider the context in which the investment was made, including the reasons for establishing RCo in State R, the investment functions and other activities carried out in State R and concludes that given these facts above, it would not be reasonable to deny the benefit of the State R-State S tax convention to RCo in the absence of other facts or circumstances showing that RCo’s investment is part of an arrangement or relates to another transaction undertaken for a principal purpose of obtaining the benefit of the Convention.
⁹ BMF Rundschreiben v. 04.04.18.
¹⁰ Commission de Surveillance du Secteur Financier (CSSF).
¹¹ When set up as a société anonyme or société à responsabilité limitée.
¹² Save for the minimum NWT amounting to EUR 4,815.
¹³ Except for the minimum NWT.