Luxembourg reverse hybrid rules – recap and points to look out for

The Luxembourg “reverse hybrid” rules have now been in force for a year. In this post, we recap the effect of the rules, and flag specific practice points to look out for in a fund structuring context.

Overview

The reverse hybrid rules can apply to Luxembourg SCSps or other Luxembourg tax transparent entities (e.g. a Luxembourg SCS). Their effect is to cause the entity, despite its default Luxembourg tax transparency, to become subject to Luxembourg corporate income tax (CIT).

The Luxembourg SCSp is a very popular choice of fund vehicle and so these rules will often be relevant for private funds across various asset classes. Further, the adverse consequences of the rules applying (potentially significant entity level tax arising at the level of the fund vehicle) means that particular focus on these rules is needed as part of structuring discussions and the fundraising process.

Recap of rules

The rules apply to an SCSp (or other Luxembourg tax transparent entity) if, broadly:

• it is considered as a taxable person (i.e. as tax opaque) by one or more investors in their own jurisdiction (an "opaque investor"); and
• those opaque investors hold, in aggregate, at least 50% of the voting rights, capital ownership or profit interest in the entity in question.

In applying the 50% threshold, the interests of investors "acting together" are aggregated. However, helpfully there is a presumption that investors each holding less than 10% of an investment fund are not acting together.

Importantly for funds, there is an exemption within the reverse hybrid rules for collective investment vehicles, meaning an investment fund or vehicle that (i) is widely held, (ii) holds a diversified portfolio of securities and (iii) is subject to investor-protection regulation in the country in which it is established (which includes AIFs subject to AIFMD) (the CIV Exemption).

Points to look out for

In the fund structuring environment, we have seen several areas of difficulty and uncertainty arise in practice since these rules came into force.

• Feeder/parallel fund partnerships:
  • The 50% threshold is generally tested on an entity-by-entity basis. So, while an opaque investor may hold less than 50% of a fund as a whole, it may hold 50%+ of an individual SCSp within the wider fund structure. Issues can arise, for example, where some investors participate through a feeder vehicle, or where the fund is structured as a series of parallel partnerships.
  • Feeder vehicles can also give rise to uncertainty in applying the 10% acting together presumption. In particular, there is a lack of technical consensus within the market as to whether the denominator for the 10% threshold should be (i) total commitments to the fund into which the feeder vehicle invests or (ii) total commitments to the feeder vehicle only - although the conservative view appears to be (ii).
• "Widely held" condition: The CIV Exemption requires that the fund entity in question is "widely held". However, there is no legislative definition of "widely held" and, consequently, there can be (in our experience) difficulty obtaining comfort that a vehicle is widely held for these purposes. This can make it difficult to rely solely on the CIV Exemption, particularly where there is an opaque investor that holds the significant majority of interests in a fund vehicle.
• Tax-exempt investors: Strangely, the original reverse hybrids law did not contain an exception for where an opaque investor is tax-exempt (and therefore obtains no benefit from the tax hybridity of the relevant SCSp). There have been recent changes in the law that have attempted to fix this issue, although there are differing views as to whether the changes that have been made are completely satisfactory. For instance, there is residual uncertainty as to whether a tax-exempt investor "counts" towards the 50%+ threshold in determining whether the SCSp is a reverse hybrid.
• Non-AIF SCSps: A fund structure may contain entities that are not AIFs (and are not otherwise subject to investor protection regulation) and therefore cannot benefit from the CIV Exemption. This issue is often relevant for carry partnerships that are structured as SCSps, given they may not be AIFs from a regulatory perspective. For the same reason, it can also be relevant for SCSps within a deal investment holding structure. Without the CIV Exemption as a backstop, the reverse hybrid analysis for these entities therefore requires more care.

Conclusion

Over the last year, we have found in practice that the reverse hybrid rules can usually be successfully navigated for Luxembourg fund structures. However, the rules need attention due to the areas of complexity and uncertainty in their application, and given their potential adverse impact. Also, the application of the rules depends on the composition of a fund's investor base, which is not known at the outset of a fundraising process. For these reasons, managers are well advised to keep a close eye on these rules during a fundraising.