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Debt funds – Beware of the reverse entity hybrid rules…or not?

Debt funds – Beware of the reverse entity hybrid rules…or not?

With ATAD2 being enforced as of tax year 2022, Luxembourg’s reverse hybrid entity rules will kick in, gathering much attention from taxpayers in Debt funds.
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 What will the actual consequences be in practice? Some hints with Vincent Remy, Partner and Private Debt Sector Leader at EY Luxembourg.

The aim of the Anti-Tax Avoidance Directive 2 (commonly called ATAD2) rules is to tackle situations where a tax transparent partnership is treated as a corporation by certain investors which results in the same item of income avoiding taxation at both partnership and investors level.  

Such double non-taxation scenario will be corrected by subjecting the otherwise tax transparent partnership to corporate taxes in the jurisdiction of its establishment. As such, this rule is really a groundbreaking departure from the well-established tax transparency principle of partnerships.

Managers often choose to set up their Luxembourg debt funds – regulated or unregulated, as tax transparent partnerships (i.e., the common limited partnership or société en commandite simple or special limited partnership or société en commandite spéciale). This is, among other things, due to their operational flexibility and their familiarity to institutional investors. At first glance, these rules could thus be considered as a threat to the governing principle of tax neutrality (between direct and indirect investment through a Lux fund) and impacting the internal rate of return (IRR) of investors. Nevertheless, a closer look at these rules offers a more positive outlook.

First off, the reverse hybrid entity rules do not apply to Luxembourg undertakings for collective investment which include an investment fund that is widely held, holds a diversified portfolio of securities and is subject to investor-protection regulation in the country in which it is established. Along these lines, this carve-out covers debt funds established as products – such as the Specialised Investment Funds (SIF) or the Reserved Alternative Investment Fund (RAIF) – which are legally set-up as partnerships. This exception also applies to unsupervised partnerships qualifying as Alternative Investment Funds (AIFs) as per the Luxembourg 2013 law on AIF Managers to the extent they are widely held, hold a diversified portfolio of securities and are subject to investor protection requirements. Given that many Luxembourg debt funds are covered by these three regimes, the reverse hybrid rules should virtually not impact them. 

Other Luxembourg debt funds (i.e., those which are not carved-out as per the above) will not necessarily be impacted either. Indeed, the rules will only apply if the investors looking at the Luxembourg partnership as tax opaque hold, in aggregate, a direct or indirect interest of at least 50% of the voting rights, capital interests or rights to profit thereof. When investors get into in a partnership, they are generally considered as “acting together” such that this 50% is in principle deemed to be met. However, recognizing that investors in an investment fund do not have practically effective control over the investments made by the fund, the Luxembourg legislator has provided for a de minimis rule: an investor who, directly or indirectly, owns less than 10% of an investment fund and is entitled to less than 10% of the profits thereof will not be considered as acting together with another investor participating in the same fund, unless proven otherwise. For this purpose, an investment fund is defined as a collective investment undertaking that raises capital from multiple investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors. On that basis, the reverse hybrid rules should eventually have limited application for widely held Luxembourg debt funds.

More attention should be paid to Funds of One in case the sole investor is in a jurisdiction where foreign (and Luxembourg) partnerships are regarded as corporate blockers.

All in all, the 2022 reverse hybrid rules should generally have limited implications for credit fund managers. It is however important for them to keep close check on certain set-ups (Fund of One, big ticket investor) and to continue monitoring any future developments.