The basic idea behind an investment fund, is a tool to provide investors with exposure to assets they would not regularly have access to individually. Either the price of a specific asset exceeds their financial capacity, or a direct investment would limit their possibility to achieve a further level of diversification.
This thought, combined with the idea that specialised teams are better positioned to find the right assets over the investor, form the fund industry’s business model. To be specific: a fund is a collection of carefully selected assets that offer participants diversified exposure that they could not anticipate on their own.
Is there any need to tax the collection of assets?
Profit taxes usually apply if a business is conducted. Whether a collection of assets is a business can give rise to a heated technical debate amongst tax lawyers. The outcome of that debate is: “it depends, it can go either way”. Some will argue that a fund is a passive tool to route pooled capital into the economy, others will argue that a fund conducts a business. The conclusion: “it depends, it can go either way”, is of little use for the investment management industry.
Settling the debate on the need for taxation at fund level
Luxembourg has also recognised that “it depends…” is of little use for the fund industry. Investors are happy to run risk in relation to assets, but not in relation to the tax position of the fund. Luxembourg enacted a variety of laws and regulations that apply to investment funds and provide for a quasi-tax exemption. In fact, Luxembourg takes a clear stance: taxing a fund does not make any sense.
Then the reverse hybrid rules came along…
A lot has changed since the beginning of this year. The idea that funds should operate tax neutral no longer firmly stands in Luxembourg. In contrast to the past, the notorious reverse hybrid rules now apply. Certain funds suffer taxation (headline rate of 18.19%) to the extent tax savings are the presumed driver behind the structuring of the investment in the fund. These rules kick in if certain tax savings are achieved by a majority of investors.
Certain tax savings, what does that mean?
The reverse hybrid rules counter tax savings triggered by tax hybridity. If a fund is tax transparent in the country where it is established, then its home jurisdiction in fact says:
“We do not tax the fund as we take the view that the fund’s income accrues directly to investors and should be taxed there, the fund is tax transparent”
The investor jurisdictions may however say:
“We do not tax the investors as the fund’s income accrues to the fund and will only be taxed at investor level when it is distributed by the fund, the fund is tax opaque”
A possible end-result: no taxation is due to a qualification conflict in respect of the fund. Investors in jurisdictions that view the fund as “opaque” are labelled “bad” investors. That term is totally off when discussing with fund managers; from a business perspective, any investor is good. Tax experts and the fund managers’ business units; world apart.
Are the reverse hybrid rules relevant for all type of funds?
As the rules only apply in respect of funds that are transparent in Luxembourg, the rules are relevant for Luxembourg limited partnerships (SCS/SCSp) but not funds organised as limited liability companies. Most Luxembourg funds are organised as limited partnerships because that legal form can count on global recognition with fund managers and investors. Hence, the reverse hybrid rules need to be looked at for most funds set ups in Luxembourg.
When are the tax savings the driver for the investment in the fund?
Why does an investor commit capital to a fund? Is it to achieve tax savings or to get exposure to certain assets? Or is it a mix? Intentions are difficult to clarify, so legislators try to objectify them: if certain conditions are met, the intentions are presumed. The reverse hybrid rules effectively do so by assuming tax saving intentions if “bad” investors have some form of control over the fund. Such control is presumed if the pool of associated “bad” investors own at least 50% of the fund.
Associated investors, what does that mean?
An associated investor is an investor that holds 50% or more in the fund. This is not the standard position as funds are typically more diversified when it comes to their investor base. If this association test is rarely met, then why all the fuss about the reverse hybrid rules? It all boils down to the dark magic of “acting together”.
Investors that “act together” are considered to hold each other’s interest to test the association threshold. So, if investor A, B and C each holds 20%, but act together, they are all considered associated to the fund, as they are each deemed to hold 60%. Acting together can thus trigger association and association can trigger the application of the reverse hybrid rules. Unfortunately, there is no clear guidance on the acting together concept.
Whether independent investors are acting together in respect of their interest in the fund can give rise to a heated technical debate amongst tax lawyers. Again, the likely outcome of that debate is : “it depends, it can go either way”. The only thing that is certain is that <10% investors in a Luxemburg fund are presumed not to act together with other investors in that same fund.
As such, fund managers tend to follow a prudent approach and typically assume that all investors that hold 10% or more, are associated to the fund, as they may arguably be caught by the acting together concept. This approach may technically be over-prudent, but at least it feels like a firm protection against any disaster.
So now what? Monitoring, monitoring, and monitoring….
To monitor whether the reverse hybrid rules kick in, fund managers typically require investors to disclose whether their jurisdictions of residence treat the fund as opaque or transparent. Obviously, fund managers can monitor the stake that each investor holds in the fund. As such, the manager has all the tools to determine whether the pool of associated “bad” investors own at least 50% of the fund. It may not be the ideal vision of the fund managers’ legal in-house counsel but monitoring the pool of bad investors is what must be done nowadays.
To anticipate on the risk that the 50% threshold is crossed, limited partnership agreements provide for clauses that can direct those bad investors to separate fund sleeves or blocker vehicles. Limited partnership agreements also provide for clauses allocating reverse hybrid tax leakage to the investors that cause it. Fund managers tend to avoid relying on the latter clauses, not only because the tax allocation is a challenge, but also because of reputational reasons: distributing a fund that suffers taxes is not living up to what is assured.
Is there an exemption to the reverse hybrid rules?
Yes, there is an exemption for widely held funds investing in a diversified portfolio of securities subject to investor protection rules imposed by the fund jurisdiction. Especially the widely held concept, in the context of a non-retail fund, can give rise to a heated technical debate amongst tax lawyers focusing on how many investors is enough. By now, we know the outcome of that debate: “it depends, it can go either way”. There are very few fund managers that choose to rely on the exemption, as guidance on the key concepts is lacking.
Lessons learned and a call for guidance
The reverse hybrid rules may render a fund taxable and may therefore keep fund managers awake at night if they do not closely monitor their investor base. A taxable fund is a recipe for reputational damage for any fund manager. A reasonable interpretation of the acting together concept and the exemption would protect most funds against the impact of reverse hybrid rules. Lacking meaningful guidance, funds do not tend to rely on such reasonable interpretation. While the industry is anxiously awaiting further guidance from the tax authorities, closely monitoring the investor base and smart clauses in limited partnership agreements is, for the moment, the recipe to manage the reverse hybrid rules.