Background

Various other European jurisdictions are reforming their carried interest regimes and other tax incentives for asset managers – either to tighten them, like the UK, or to become more attractive, like various southern European countries. To remain competitive in this environment and with a view to further growing the asset management industry in Luxembourg by also attracting “front office” roles, the government continues to act decisively.

The bill of law seeks to tackle shortcomings of the current carried interest tax regimes: one was no longer open to new entrants and applied only to individuals who moved to Luxembourg between 2013 and 2018; the other one was reserved to employees of the AIF manager (“AIFM”) and lacked clarity and alignment with market practices.

Key features of the new carried interest regimes

A revised definition of carried interest

Carried interest is no longer limited to capital gains but would encompass any right to participate in the “outperformance” of an AIF, and thus also covers income type of returns. This accommodates performance fees and incentive fees, as well as the waterfall type of carried model as applied by many closed-ended funds. Under the latter model, carried interest is distributed after the AIF has returned a minimum yield to investors (the hurdle), which is usually set at 8%. The proposal accommodates both waterfall models with the hurdle applied over the whole fund (more typical for EU fund products) and a hurdle model applied on a deal-by-deal basis (more typical for US fund products).

A broader array of beneficiaries

The bill of law also amends the eligible beneficiaries of carried interest regimes, by removing the requirement to be employee of the AIFM or the AIF. The commentaries clarify that regime now expands to all individuals who are managers or are directly or indirectly at the service of managers or companies managing AIFs. The text of the law does not impose any relationship with the sponsor as a condition (i.e., only a contractual arrangement or indirect or indirect participation in the management of the AIF is required). For example, board members, shareholders of management companies and people who (indirectly) provide services to fund managers such as employees of an investment adviser may now all benefit from a carried interest regime. The explanatory statements do state that the regime shall not be abused by transforming a fixed income or a standard bonus into a non-genuine carried interest. 

Going forward, it will also be possible to apply a special carried interest regime even if the payment is made via the AIF’s general partner or the AIFM, as long as that entity receives the carried interest for the account of the individual beneficiaries and on-pays the carried interest directly to them. Carried interest received through a tax transparent vehicle such as a Carry SCSp continues being deemed received directly from the AIF.

Non-residents who receive carried interest paid by a Luxembourg entity might fall in scope of the new regimes as well, depending on their individual circumstances, taking into account rules on non-resident capital gains taxation and the applicable tax treaty gives taxing rights to Luxembourg. Individuals migrating to Luxembourg and who already have an accrued entitlement to carried interest would also be able to qualify for the new tax regimes. 

Carried interest paid on a purely contractual basis

This regime will cover carried interest that does not specifically take the form of an interest or shareholding in the AIF giving right to a share in the profits exceeding a certain hurdle. This type of carried interest would be subject to a special tax rate of a quarter of the regular rate (i.e., maximum approx. 11.45%, if the highest marginal rate applies).

Typically, this bucket will cover carried interest acquired for free, without mandatory participation in the AIF and paid (directly or indirectly) by the AIF once the hurdle return rate is met. The absence of mandatory acquisition of shares/interests next to the carry entitlement is the key distinguishing feature. Certain incentive or performance fees could thus be considered to fall into that bucket.

The fact that a carry holder acquires an interest or shareholding in the AIF on a voluntary basis would not change the qualification.

Carried interest inseparably linked to a participation or represented by a participation

Carried interest that is inseparably linked to a direct or indirect participation in the AIF or that is represented by a participation in the AIF to which the carry entitlement is attached would fall into a second bucket. The regime would only apply to the portion of return that represents carried interest and not to the regular return as investor (e.g., return as a co-investor). Here as well, to avoid abuse, there should be a close enough link with the participation in the AIF as regards volume and duration.

For now, it seems this form of carried interest would be taxed at the regular rate (i.e., up to 45.78%) unless the payment is made on a participation held for more than 6 months (except if the participation represents more than 10% in the share capital of the AIF, which would typically not be the case in a genuine fund and carried interest structure), in which case the payment would be tax exempt. It is somewhat unclear whether each payment of carried interest would need to be structured as a (partial) disposal of the interest in the AIF in order to benefit from this tax exemption or if regular distributions of carried interest would qualify for the exemption as long as the participation to which they relate is maintained for more than six months.

The fact that the carried interest portion of an investment is allocated on a no-consideration basis does not prevent falling in scope of this second bucket, as long as it is inseparably linked to the acquisition of the participation. However, as is already currently the case, the free allocation of carry shares/interests to employees (without asking them to acquire those at fair market value) may in itself be requalified into a benefit in kind taxable as employment income on the value of the carried interest at the time of the allocation.

Finally, and very importantly, the tax transparency of an AIF taking the form of an SCSp, an SCS or an FCP is turned off for the sole purpose of this rule. This removes a key uncertainty of the current legislation and allows looking through a Carry SCSp without having to also look through the AIF.  

Practical actions

The new regimes will give new opportunities to fund managers seeking to increase their footprint in Luxembourg and offer competitive remuneration packages to attract and retain talents. It will be key, however, to ensure that carried interest is properly structured to fall in the desired bucket and to mitigate the risk of potential challenges under the abuse of law doctrine.  

Next steps

Parliament will discuss the proposal and may amend it in the coming months. The State council will also need to give a non-binding opinion.  A vote is expected to take place in November or December. In view of the government’s parliamentary majority, the bill of law stands very good chances of being adopted.

Our experts look forward to discussing the topic with you and will keep you informed of further developments.