This article outlines the international tax developments that sponsors of, and investors in, Luxembourg-based private equity funds must take into account — and how the Grand Duchy has successfully addressed some of the concerns and demands of the marketplace.
Two of the most prominent tax measures to have been carried out in domestic legislation in recent years are the Luxembourg law of 23 December 2019 executing the hybrid mismatch measures contained in the EU’s anti-tax avoidance directive (ATAD) and the Luxembourg law of 25 March 2020 implementing the EU directive on mandatory tax disclosure of certain cross-border arrangements (DAC 6). Both laws largely follow the wording of the corresponding EU directives, thereby underlining once again Luxembourg’s stance in the fight against tax fraud and evasion.
The anti-hybrid rules’ overarching aim is to prevent tax mismatches. In particular, the rules broadly seek to disallow tax deductions for interest in structures and arrangements under which an entity or instrument is treated inconsistently in different jurisdictions and this mismatch gives rise to a tax benefit. For private equity managers, this means that they will need to carefully analyse the jurisdiction of their investors in order to avoid additional tax under these rules.
Generally, private equity funds are subject to a number of laws and regulations with a view to protect the integrity of tax systems. Luxembourg has already transposed FATCA and CRS provisions into domestic legislation. With effect from 1 January 2021, DAC 6 imposes certain reporting requirements that have been touted as reducing uncertainty over beneficial ownership and dissuading intermediaries from implementing aggressive tax arrangements.
This article links two seemingly separate discussions. The first is the discourse on international tax avoidance and the measures put in place to combat this. The second is the need for a country such as Luxembourg to maintain its leadership through an attractive tax regime in the private equity industry.
To maintain its competitive edge, the Grand Duchy must bear in mind the key tax objectives that investors share when deciding to invest into a private equity fund, but also the need to prevent aggressive tax schemes.
Luxembourg offers sponsors a comprehensive range of investment vehicles to accommodate different strategies. The type of Luxembourg fund vehicle with which international investors are most familiar is the Luxembourg special limited partnership (société en commandite spéciale or “SCSp”), which is commonly used for fundraising. The latter is a flexible tax transparent entity, which means that non-resident investors, and the investment vehicle itself, are not subject to local Luxembourg taxes. At the same time, however, the SCSp is subject to reporting requirements and must disclose certain information to combat cross-border tax fraud and cross-border tax evasion.
A recent trend is the use of the Luxembourg corporate partnership limited by shares (société en commandite par actions or “SCA”), sometimes in combination with the traditional SCSp. Indeed, an SCA should not in principle create an issue with respect to the new anti-hybrid rules to the extent that it is considered for tax purposes as a corporation (vs a partnership) in Luxembourg and also in the investor countries most of the time, which avoids any tax qualification mismatch. This is not necessarily the case with a SCSp, which qualifies as a partnership in Luxembourg but can sometimes be considered a corporation in certain investor jurisdictions. An SCA with the RAIF regime can still offer investors the corporate tax exemption they benefit with an SCSp in Luxembourg. However, whilst a RAIF vehicle is not strictly regulated, it requires a higher degree of supervision, which usually translates into higher running costs.
The country has a large toolbox of investment vehicles and specific product regimes that provide rigorous investor protection whilst complying with a stringent legal, tax, and regulatory framework. The Grand Duchy has strategically dealt with investor and fund manager requirements. At the same time, the country has implemented each tax legislation with public sentiment in mind in order to prevent fiscal abuse. One of the overarching drivers of private equity fund investment strategies is to increase investor returns by reducing tax leakages and foreign tax-reporting obligations — within the confines of the law. The Grand Duchy has efficiently addressed these contradicting issues. With EUR4.718 trillion of assets under management as at 31 May 2020, Luxembourg remains a strategic location for funds and investors alike — albeit a tax compliant one.
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