Luxembourg: What Does Substance Really Mean For Alternative Investments?

Last Updated: 4 July 2017
Article by Christophe Diricks

Most Read Contributor in Luxembourg, September 2018

Some may be under the impression that substance is a widely known tax concept and that there is not much to say.

From a tax point of view, however, substance remains a changing concept, evolving with tax laws, jurisprudence and doctrine. Since the Organisation for Economic Co-operation and Development (OECD) presented their action plan on base erosion and profit shifting (BEPS), the concept of substance has reached another level with the principal purpose test (PPT) introduced in Action 6.

The PPT is an anti-treaty abuse clause that "allow[s] contracting states to deny the application of treaty provisions when transactions or arrangements (such as the setting up of a SPV in Luxembourg) are entered into in order to obtain the benefits of these provisions in inappropriate circumstances." Private equity, real estate, and hedge/debt funds (so called "AIFs") are quite worried about the potential consequences of a broad interpretation of the PPT concept, which may disqualify them (and their SPVs) for double tax treaty benefits.

AIFs in light of BEPS Action 6

AIFs are nothing else than arrangements between multiple investors aiming at diversifying their risks and benefiting from an increased scale of investment in addition to the expertise of an asset manager. However, this risk-spreading and economy of scale will remain inefficient if we cannot put, tax-wise, the investor in a situation equal to one of direct investing. This is why AIFs are usually set up under tax transparent funds with a tiered SPV structure, i.e. to benefit from double tax treaties and hence minimise tax leakages on distribution from the portfolio to the final investor.

Is the objective of tax neutrality sufficient to qualify for treaty benefits within the meaning of Action 6? We have little guidance on how to determine when a particular tax consideration may be considered "principal purpose," particularly when there are multiple purposes. The three draft examples (aiming at clarifying the PPT for AIFs) published, for guidance, early in 2017 by the OECD acknowledge that a specific provision under a tax treaty (e.g. the reduced withholding tax rate) cannot be denied even if it was taken into account in structuring the relevant investment.

Further features required

To secure treaty benefits, the set-up of a regional holding platform for PE, RE and other AIFs will, however, require additional features such as the competence of a local management team to review/approve/monitor investments, carry on treasury functions, maintain books and records, and ensure compliance with regulatory requirements in the states where it invests.

This requirement of an experienced management team to review/approve/monitor investments is also one of the key functions of the Alternative Investment Fund Manager (AIFM). Having an AIFM in Luxembourg means that strategic decision-making abilities and management have to be performed in Luxembourg, with sufficient substance, people and systems to effectively manage the overall operations.

We can therefore see a convergence between the AIFM Directive and OECD BEPS Action 6 in the level of substance, responsibility and activity required. An AIFM is however not a prerequisite to get treaty benefits.

Asset managers: from London to Luxembourg

With Brexit obliging managers of AIFs to reconsider their operating models in order to continue to market their AIFs in the EU, various EU countries see tremendous opportunities to attract alternative asset managers. The Grand Duchy is the front runner for this competition with 65% of world's cross-border funds being Luxembourg funds, an efficient and experienced regulator, major service providers in this asset class, a skilled and multilingual workforce, efficient fund vehicles for EU investors and a wide double tax treaty network to ensure tax neutrality for investors.

For the very large number of PE, RE and other AIFs that already have an infrastructure in Luxembourg (office space, personnel, IT, and so on), there is only one step left, which is to become both AIFM- and BEPS-compliant.

Key players have already set the pace, and we are confident that the trend will continue.

Time for action

On 7 June, Luxembourg signed the Multilateral Instrument which means that all 81 treaties will be amended to include some of the BEPS provisions, notably with PPT clauses. This will affect substance and treaty access.

Therefore, it's time to perform a substance health check of your existing Luxembourg platform to secure treaty access. KPMG Luxembourg can help with identifying substance risks and assessing their overall impacts in anticipation of challenges by foreign tax authorities.

Such a health check can also be used as an assurance service for stakeholders and can help provide the next steps to strengthening your substance in tax matters.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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