The ATAD 2 directive (as defined below) has been transposed into Luxembourg law with a series of safeguards and carve-outs limiting the impact of these rules beyond the necessary. This has been reflected by the implementation of a de minimis rule applicable to investors in a Luxembourg investment fund.
The de minimis rule is specific to Luxembourg law, and this inconsistency may lead to adverse tax consequences in other Member States via the application of the imported mismatch rule, thus endangering the tax efficiency of private equity/real estate investment structures, which are so relevant to the Luxembourg investment fund industry.
How do the anti-hybrid rules work in Luxembourg in an alternative investment fund context?
The Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries (ATAD 2) has been adopted with the main goal of neutralising hybrid mismatch outcomes (deductions without inclusions and double deductions) that may arise when an entity, a financial instrument or a permanent establishment is characterized differently (i.e. as equity or debt, as tax transparent or tax opaque) in different jurisdictions.
The application of the anti-hybrid rules is limited to hybrid mismatches: - between a taxpayer and associated enterprises (or between associated enterprises);
- between a head office and a permanent establishment (or between permanent establishments of the same entity); or
- under a structured arrangement.
This article will not cover the structured arrangement scenario, which rarely applies in the context of alternative investment structures.
The concept of associated enterprise is defined (with respect to what is relevant to our contribution) as an individual or an entity which holds directly or indirectly a participation of 50% or more in terms of voting rights, capital ownership or profit entitlements of a taxpayer.
In certain cases, an individual or an entity that does not reach the 50% threshold can also become an associated enterprise through the “acting together” rule. Under this rule, an individual or entity that acts together with another individual or entity in respect of the holding of capital or voting rights of an entity, will be considered to also hold the capital or voting rights in that entity of the person it acts together with (i.e. each individual or entity would be considered to hold the aggregated interests of all the other individuals or entities it acts together with).
In an investment fund context, one of the examples of the OECD Action 2 Report1 raised concerns that investors in the same investment fund could be considered as acting together based on the sole fact that their investments are managed under a common investment mandate. Well aware of that, when transposing ATAD 2 with the Luxembourg law of 20 December 20192 the Luxembourg legislator inserted certain provisions to mitigate the impact of these rules in the alternative investment fund sector.
In particular, a de minimis rule was introduced to limit the scope of the acting together rule in an investment fund context. This rule provides that an investor which holds, directly or indirectly, less than 10% of an investment fund’s interests, and is entitled to receive less than 10% of the fund’s profits, is presumed not to act together with other investors unless proven otherwise. Consequently, its interests should not be aggregated with those of other investors of the fund.
For investors holding 10% or more of an investment fund’s interest, even if the rule mentioned above is not applicable, the Luxembourg market currently takes the position that the investor should not automatically be considered to be acting together with other investors of the fund. Rather, investors in this situation should be able to prove (as the de minimis rule does not apply, the burden of proof shifts to the investor) that they are not acting together with other investors in the fund.
Along similar lines, an exemption was introduced for collective investment vehicles (as defined by the Luxembourg income tax law) with respect to the application of the reverse hybrid mismatch rule.
The alternative investment fund sector positively perceived the introduction of said provisions, as well as the current market take on the acting together concept in Luxembourg.
It is important to remember that ATAD 2, as a directive, has not been transposed in other Member States in the same terms. In other words, the fact that Luxembourg does not consider a given investor as an associated enterprise for purposes of the application of the ATAD 2 rules does not mean that all other Member States take the same approach. Furthermore, in the presence of a hybrid mismatch in an investment funds context, Luxembourg will not necessarily apply the anti-hybrid rules to the extent the investors are not considered as associated enterprises, whereas the other Member States involved may not be of the same view, thus triggering the imported hybrid mismatch rule as transposed in said Member States.
When might the imported hybrid mismatch rule be problematic for Luxembourg alternative investment fund structures?
The ATAD 2 directive explains that the goal of the imported hybrid mismatch rule is to avoid structures that can shift the effect of a hybrid mismatch between parties in third countries into the jurisdiction of a Member State through the use of a non-hybrid instrument.3 The imported hybrid mismatch rule will deny the deduction of payments (typically interests or royalties) to the extent that such payments directly or indirectly fund deductible expenditures giving rise to a hybrid mismatch through a transaction between associated enterprises or entered into as part of a structured arrangement. The rule also provides for a carve-out when one of the jurisdictions involved in the transaction has made an equivalent adjustment in respect of a hybrid mismatch.
The following chart depicts a typical Luxembourg private equity fund structure where the imported hybrid mismatch rule could potentially apply in a given TargetCo jurisdiction4:
Typical private equity structures generally require debt being pushed down the chain from the Fund via back-to-back interest bearing loans (IBLs) to the TargetCo, which, in turn, uses the expenses on said IBLs to offset taxable income.
In the structure at hand, investors are unrelated and each investor holds less than 10% of the Fund’s interest/profit entitlements. Under the Luxembourg de minimis rule, the investors would be presumed not to act together (unless proven otherwise) and would therefore not be considered associated enterprises of the Master HoldCo.
Consequently, the Luxembourg anti-hybrid rules would not jeopardize the tax deductibility of the interest at the level of Master HoldCo.
As mentioned above, the de minimis rule is specific to Luxembourg law and other Member States may take the view that investors of the Fund are indeed considered to be associated enterprises of the Master HoldCo. In such cases, deductible interest under the IBLs between Master HoldCo and the Fund may be seen in TargetCo’s jurisdiction as giving rise to a mismatch outcome among associated enterprises. As a result, the local imported hybrid mismatch rule in TargetCo’s jurisdiction may deny the tax deductibility of interest payments under the IBLs between TargetCo and LuxCo, thus increasing the amount of tax slippage at TargetCo level.
In structures involving a Luxembourg fund set-up with a fully taxable subsidiary resident in a Member State, e.g. private equity, real estate or infrastructure, the Luxembourg de minimis rule may unfortunately end up being relatively irrelevant. Tax experts in jurisdictions like France, Germany or Ireland have already raised concerns with regards to the potential application of this rule in their respective jurisdictions in view of the lack of guidance issued by the relevant tax authorities on the interpretation of the acting together concept. The use of Luxembourg funds in corporate form to host problematic investors, be it as master or feeder, may allow for a solution to the current uncertainty.
This article was originally published in Agefi Luxembourg, October 2021 and is reproduced with permission from the publisher.