The Luxembourg government clarified its application of the reverse hybrid rule in the EU’s second anti-tax avoidance directive (ATAD-2) last November, in 2022. It made clear that tax-exempt investors are exempt from the application of the reverse hybrid rules and clarified when they do apply to other investors. With the “quite helpful” clarification bringing simplification in one area, the quest for certainty has moved to related issues, such as allocating the potential tax burden if a given investor triggers it.
The second anti-tax avoidance directive (ATAD-2), which contains the “reverse hybrid rules”, “by now has or plays a major role in every fund structuring or fundraising,” said Andrius Bielinis, a Frankfurt-based Clifford Chance counsel focussing on tax law and investment funds. “I think the biggest risk is for a fund to be treated as a hybrid entity.”
A reverse hybrid is a transparent fund in its country of incorporation which is considered as tax opaque in the investor’s country. This would happen if one country treated the fund as “transparent” – no tax is imposed because the taxation is supposed to apply to the investor.
Qualification conflict
But then the overseas investor’s country says that it doesn’t tax the investor until there’s a distribution, because for them, the fund is “opaque”, meaning the home of the investment is to tax it. This creates a “qualification conflict”, which could lead to double non-taxation. That’s what the reverse hybrid rules prevent by imposing Luxembourg corporate taxation, seen as very unfavourable by many in the financial sector.
If the reverse hybrid rules are triggered, “Then the fund would become taxable on part of its income, which is a bit of an issue because traditionally a fund vehicle is supposed to be tax neutral,” said Maxime Budzin, a Luxembourg-based Clifford Chance counsel, speaking at a Clifford Chance event in March.
“This can be seen as a reputational risk for the fund – drawing the line between good investors and bad investors is someone difficult from a commercial perspective,” said Budzin. However, “one could say from a commercial perspective, there is no distinction between good and bad investors, but you have to address those issues,” responded Bielinis.
More checking
Given the hybrid entity risk, it has become standard practice to ask investors to confirm how the fund is treated in their jurisdiction, for example in subscription documents, he continued. He explained the fund managers were becoming more cautious when establishing funds, especially in the partnership or contractual form.
On the issue of how to deal with tax costs if this happens, “the goal is to allocate the taxes that have been triggered by one investor, and that cause this hybrid status, only to that investor and not to be borne by the entire fund or all the investors,” said Bielinis. “In that case, the cost allocation rules have to be properly drafted in the fund documents.”
The clarification also has important implications for the German market. Prior to the clarification, a German FCP fund that historically would have been generally considered a hybrid entity, would now be exempt if the investors are tax exempt. “That could make it once more attractive for German tax exempt investors because they would fall under that clarification under Luxembourg law.”
Portfolio application
A third point relates to the growing realisation among fund sponsors that ATAD-2 is not only relevant on the fund level, but also on the portfolio level. Bielinis explained that having a hybrid entity status prohibits you to a certain extent from deducting interest expenses at the portfolio level.
This is especially relevant when a portfolio company is financed by shareholder loans, he explained. “Tax advisers, responsible for the tax compliance of these companies wonder to what extent they’re able to file and declare the tax expenses in their tax files.” This is because, he explained, they have to consider the ATAD rules. “They don’t know the entire structure, especially the investor base above the fund.” He described it as “a challenge,” saying that it mostly affected older funds that were established prior to ATAD-2, or “at least before it became common to address those issues.”