Luxembourg’s government is proposing to simplify the corporate income tax process for investment funds which have overseas investors or subsidiaries by reducing their risk of being subjected to full Luxembourg anti-tax avoidance corporation tax. The changes will remove doubt from how to deal with tax exempt entities.
A proposal in this month’s 2023 Luxembourg budget bill will narrow the focus of a tax rule aimed at preventing the non-taxation of certain Luxembourg partnerships (ie SCSp structures) due to an overseas investor absolving itself from paying tax when Luxembourg expects it to pay tax. It will also end the application of this tax rule when the investor considers itself tax-exempt, making the tax process for many Luxembourg-based investment funds easier.
The anti-tax avoidance rule, known as the “reverse hybrid rule”, as it stands, imposes Luxembourg corporate taxation of 18.19% on investment funds organised as certain types of partnerships when their overseas investors’ income is not taxed when Luxembourg considers that it should be. There are various ways this could happen, including when the overseas investor has a “tax-exempt” status.
Another important way this can happen is through what’s termed in tax-speak as a “mismatch”: the overseas investor might consider the Luxembourg partnership as a shareholder-owned company paying its own taxes as opposed to what Luxembourg considers to be a partnership. Partnerships don’t pay tax directly, because their partners are expected to pay tax though their personal income tax.
The rule is subject to conditions limiting its application to large (>50%) owners or shareholders in the partnership relationship.
If passed, the bill would clarify going forward that this anti-tax-avoidance rule will only apply if the non-taxation of income stems from such “mismatches” in the treatment of a Luxembourg-based partnership.
Reverse hybrid rules explained
“A Luxembourg fund organized as an SCS(p) becomes a Luxembourg taxpayer if it qualifies as reverse hybrid entity,” Frank van Kuijk, a New York City-based Loyens & Loeff (USA) investment management partner, wrote in a LinkedIn post. “It qualifies as such if its associated investors represent a pool of “bad” investors that control together 50% of the fund.” If it becomes considered a reverse hybrid entity, any income flowing to the SCS(p) or any other partnership structure not taxed elsewhere would become subject to Luxembourg corporate taxation, he explained. This is considered a highly unpleasant outcome in such circles.
According to Van Kuijk, a “bad” investor is a tax concept meaning that the investor views the partnership as a structure that pays tax itself (known in tax circles as “opaque”) while the home country of the partnership views it one where the partners pay (“transparent”). “In such a case the partnership’s home country in fact takes the view that the overseas investor country should tax the partnership income while the overseas investor country takes the view that the partnership country should tax the income,” he explained. “The result is no taxation at all.”
EY Partner Olivier Bertrand explained that one of the conditions triggering the reverse hybrid rule is that investors must be associated to the partnership. This means that any one single entity holding at least 50% of the partnership or a group of individuals holding over 10% shares who are considered to be “acting together” who together meet that threshold. Investors holding positions of less than 10% are never considered associated without proof to the contrary. This means that funds with a sufficiently diversified investor base – SIFs, RAIFs or SCSps – benefit from a “specific carve-out”.
Exempting the tax-exempt
In his LinkedIn post, Van Kuijk discussed how the proposed rule would change the treatment of “tax-exempt investors”. “The draft Budget Law now clarifies that income allocable to such investors, even if they qualify as “bad” investors (for how they classify the partnership in their tax filings), would not be taxed under the reverse hybrid rules,” he wrote. The proposal further suggests that such investors may even be treated as “good” instead of “bad” investors for the 50% “associated” test, he explained.
Van Kuijk said that the proposed change aligns the existing reverse hybrid rules with the ordinary anti-hybrid rules defined by ATAD-2, the European Union’s second anti-tax avoidance directive, which don’t apply if the non-taxation is simply a consequence of a tax exemption.
He explained that this change “makes total sense as the current rules provide for overkill.” Government institutions are an example of tax-exempt investors, he said. “Government institutions are typically big investors in fund entities,” he said. “They have to invest, for example, pension payments or public wealth generated for example by the sale of fossil fuels” to be able to fulfil their society’s needs, he argued. “It doesn’t make sense to ask a government institution to pay tax, because we pay tax to the government.”
Benefiting the investment fund industry
Bertrand agreed that the budget proposal will have special relevance for the investment fund industry “because you have a lot of institutional investors which are exempt, where the status of a partnership is largely irrelevant in certain jurisdictions or potentially unknown. Some offshore jurisdictions do not have the concept of a “transparent” entity or an “opaque entity”, but are a hub for investment funds as well,” some of which are sold in Luxembourg.
Bertrand explained the background of the rules by referring to the EU’s anti-tax avoidance directives, ATAD 1 and 2, and a new one ATAD 3 aimed at the use of shell companies. “Those rules, if you go back in time, historically, those ATAD etc were mainly aiming at avoiding tax avoidance from multinationals,” he said. “And when drafting it, they ended up in a situation where investment funds were hit by those regulations.” He pointed out that in investment areas like private equity and real estate, income for such funds is usually already taxed.
“These rules anticipated structures that have as an aim to plan on non-taxation,” said Van Kuijk. “And there is no investor … that invests in the funds to achieve a tax benefit.” He went on to say that fund investors do so because they trust that a fund manager will generate a yield for the investor.
Van Kuijk acknowledged that exempting the fund industry from anti-tax avoidance rules would be “politically very difficult” and would probably trigger state aid rules. “But you clearly see that Luxembourg and the Commission have tried to make certain exceptions which are geared toward the fund industry.”
If adopted by Luxembourg’s parliament, the changes to the reverse hybrid rules would apply for the current 2022 tax year.