Reverse hybrid entity exemption for investment funds - New clarifications and their significance

The Luxembourg tax authorities’ Circular provides pivotal clarifications on the application of the reverse hybrid entity exemption for collective investment vehicles. This article outlines the key items and their far-reaching implications, aiming to provide clarity and guidance for all stakeholders involved. 

Through Circular LIR n°168quater/2 dated 12 August 2025, the Luxembourg tax authorities have provided long-awaited clarifications on the requirements that an investment fund qualifying as collective investment vehicle (CIV) must meet to be exempt from the reverse hybrid entity (RHE) rule. 

This rule, introduced in Luxembourg by the law implementing Council Directive 2017/952 (known as ATAD 2) and effective since tax year 2022, treats Luxembourg partnerships (typically a Luxembourg limited partnership (SCS) or Luxembourg special limited partnership (SCSp)) as RHE if certain conditions are met. Where a Luxembourg investment fund established as a partnership is characterized as RHE, its net income, which is not otherwise taxed under Luxembourg tax law or the law of any other jurisdiction (e.g., the jurisdictions where the investors are located), is subject to Luxembourg corporate income tax. 

In line with ATAD 2, the Luxembourg law foresees a specific carve-out for CIVs meeting cumulatively three conditions, i.e., being “widely held”, holding a diversified portfolio of securities and being subject to investor-protection regulations in the country in which they are established. 

However, since the adoption of the law, asset managers have faced some uncertainty around the practical application of this exemption due to a lack of guidance on the interpretation of these criteria.

Scope of eligibility 

The first question that the Circular answers is the scope of eligibility for the CIV carve-out. In line with the parliamentary documents of the ATAD 2 implementation law, the Circular confirms that i) undertakings for collective investment within the meaning of the amended law of 17 December 2010 concerning undertakings for collective investments, ii) specialized investment funds within the meaning of the amended law of 13 February 2007 relating to specialized investment funds, and iii) reserved alternative investment funds within the meaning of the amended law of 23 July 2016 relating to reserved alternative investment funds, always qualify for the CIV carve-out. This is welcome news as the Circular clarifies, once and for all, that a RAIF SCS or a RAIF SCSp will benefit from the exemption, regardless of whether the three conditions mentioned above are met or not. 

As a result, only other types of Luxembourg CIVs (i.e., those not covered by one of the aforementioned product laws) such as Luxembourg investments funds established as SCS or SCSp and qualifying as alternative investment funds (AIF) managed by a Luxembourg or EU-based AIF manager (AIFM), would have to meet the three conditions set forth by the law and for which the Circular provides useful guidance.

Criterion of widely held

A CIV is widely held if its shares or units are marketed for distribution to multiple unrelated investors. A look-through approach is adopted in a master-feeder fund structure; the criterion must consequently be assessed at the level of the feeder fund.

The Circular clarifies that factual and intentional elements should be considered and that a limited number of investors does not necessarily constitute a breach of the condition of widely held. This confirmation introduces a welcome flexibility in assessing the multiplicity of investors. Notably during the launch phase of a fund the number of investors may be very limited, which in the past raised the concern that this could jeopardize the application of the CIV carve-out. This is no longer the case as the Circular confirms that the condition of widely held is not breached if it is reasonable to consider that it will be met within 36 months from the date of authorization or establishment of the CIV. The Circular also acknowledges an exception to the presence of multiple investors during the wind-down phase of the fund.

As mentioned above, the widely held criterion does not only require the presence of multiple investors but also requires them to be unrelated. The Circular considers two investors to be related if one holds, directly or indirectly, a participation of 50 percent or more of the voting rights or capital of the other. The same applies when two investors have a common shareholder, i.e., if an individual or another entity holds, directly or indirectly, a participation of 50 percent or more of the voting rights or capital of both investors. Members of the same family are also considered to be related. Finally, the Circular also considers two investors not to be unrelated if, considering all relevant facts and circumstances, one controls the other or both are under the control of the same individuals or entities.

It should be noted that the definition of related investors as provided by the Circular only applies to assessing the widely held criterion and should not be confused with the concept of related enterprise as used for transfer pricing purposes or the concept of associated enterprises as used for applying e.g., the hybrid mismatch rules. The clarifications on the concept of CIV provided in the Circular exclusively relate to the application of the exemption from the RHE rule and do not affect interpretations under other prudential or regulatory laws. 

The Circular also introduces a helpful widely held presumption. A CIV is deemed to be widely held if no individual investor ultimately owns or controls, directly or indirectly, more than 25 percent of the vehicle’s capital or voting rights or controls it by other means. The Circular also innovates as regards verifying the absence of such investor, insofar as it foresees the possibility for the relevant taxation office to rely on the information from the Register of Beneficial Owners. As a reminder, investment funds must, where relevant, file the details of their beneficial owners with the Luxembourg Register of Beneficial Owners to comply with anti-money laundering regulations.

Diversification of securities portfolio

The Circular clarifies that the concept of “securities” should be understood in the broadest sense, so as to include not only the obvious, such as shares and other securities giving or capable of giving access to the capital of a legal entity, but also assets such as debts (e.g., loans) for which the classification as “securities” appeared less evident. According to the Circular, this concept also encompasses derivative financial instruments, provided that the underlying consists of securities, as well as beneficiary shares, bonds, units in other collective investment vehicles and deposits with credit institutions.

The diversified nature of the securities portfolio is assessed based on the investment policy as set out in the management regulations or constitutive documents and the exposure to market risk (including direct and indirect counterparty risk), taking into account the investment policy followed. Asset managers should therefore pay particular attention to the legal documentation and to the global exposure to risk of the investment entity or fund to ensure that this condition is met. Additionally, the diversification should align with the requirements for specialized investment funds within the meaning of the 2007 law. As an example of non-compliance the Circular provides the case of a fund that invests more than 30 percent of its assets or subscription commitments in securities issued by the same issuer, unless there is adequate justification allowing for a higher proportion of investments in securities issued by the same issuer. Derivative financial instruments not involving a comparable risk distribution, meaning an appropriate diversification of the underlying assets, does not, in principle, constitute a portfolio of diversified securities.

Compliance with investor-protection regulations

The Circular notably removes one uncertainty that existed in the market, being the application of the exemption to AIFs managed by an AIF manager located outside Luxembourg. The Circular confirms that the condition for a CIV to be subject to investor protection regulation in their country of establishment is deemed to be met where the AIF is managed by a duly authorized AIFM in accordance with the provisions of Directive 2011/61/EU and of the Council of 8 June 2011 on AIFM. In other words, an AIF managed by a manager approved by the Luxembourg Commission des Surveillance du Secteur Financier or by another regulator in the European Economic Area is considered to meet the investor protection requirement.

The carve-out going forward

After nearly three years of application of the RHE rule, the Circular allows asset managers to plan future investments and structures with greater certainty. It is now clear that Luxembourg investment funds covered by their respective product laws qualify as CIVs for the purpose of the carve-out from the RHE rule. For the other investment funds, the Circular provides helpful guidance on each of the three conditions to be met to benefit from the exemption. Notably in taking the approach to rely on circumstantial elements rather than on a determined (minimum) number of investors for assessing the condition of being widely held, the Luxembourg tax authorities provide asset managers with a certain flexibility in times where the raising of funds may not be achieved as fast as it may have been a couple of years ago. Existing structures, including fund documentation, should be reviewed considering the clarifications that are now available to ensure that they meet the requirements.