Substance: Juggling with tax, TP, regulatory and operational requirements

“Substance” is a key topic in the setup of investment structures. However, the concept of substance is generic and could encompass various and potentially different items. It could also be interpreted differently between tax authorities and regulators. From a tax perspective, it usually describes beneficial ownership requirements and tax treaty access. From a regulatory perspective, decision-making functions are key areas of attention by regulators for Alternative Investment Funds (AIFs) managed by an Investment Fund Manager (IFM).

From a tax perspective, the evolution of substance requirements is being placed more and more in the spotlight, both from a direct tax and transfer pricing perspective.

The complexities of ensuring substance in investment structures

From a direct tax perspective, the European Commission published a draft Directive on 22 December 2021, known as the Anti-Tax Avoidance Directive III ("ATAD III"), which aims to prevent the misuse of shell companies for tax evasion and avoidance in the European Union. As part of the Directive, an entity should not outsource its day-to-day administration and decision-making to professional third-party service providers. This means that the entity should ensure it has the relevant substance for carrying out its activities, otherwise access to a double tax treaty1 could be jeopardized.

Substance also plays an important role when looking at beneficial ownership and principal purpose tests (as per BEPS2 Action 6). Different investments and jurisdictions might require a different type and quality of substance, which creates additional complexity in setting up the investment structure.

It is possible to see a common denominator when talking about substance and access to a double tax treaty. A recent EU tax case law in Denmark3 concluded that, in relation to withholding tax exemption, an EU Member State must refuse to grant the benefit of EU Directives in case of fraud or “abuse of rights”. In the case under review, the “abuse of rights” was related to a holding company which did not qualify as beneficial owner since it was a mere conduit.

In addition, another tax case law in Spain4 also related to withholding tax, concluded that if there is no real business activity and substance in the holding company, the latter is not considered to be the beneficial owner, therefore the withholding tax exemption should be denied. In this case, the beneficial ownership assessment was based on transfer pricing considerations.

The concept of substance is also crucial from a transfer pricing perspective

The main references to substance from a transfer pricing perspective can be found in Chapter 1 of the OECD5 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (“OECD TP Guidelines”) and BEPS Actions 8-10. As per OECD TP Guidelines, an entity performing intragroup transactions can perform the risk control functions when it has the capabilities to accept and manage the risk related to the transaction but also to take the necessary measures in case the risk materializes. This entity should also have the financial capacity to assume the risk.

It is interesting to note that BEPS Actions 8-10 do not speak about employees. The board of the company or a committee sitting at its level could be able to perform full or part of the risk control functions or its oversight. In Luxembourg, companies performing intragroup financing activities should perform the risk control functions in relation to the origination and the management of the transaction. Not meeting the requirements from a functional or economic standpoint could have an impact from a beneficial ownership perspective in foreign jurisdictions.

Circular CSSF 18/6986 as a main reference in Luxembourg

From a regulatory standpoint in Luxembourg, one of the main references for substance-related matters is Circular CSSF 18/698 related to the IFM. To get the authorization to operate as an IFM, the IFM must maintain a sufficient level of substance in Luxembourg. Any delegation of functions which is of such a large scale that the IFM could no longer be considered as an IFM in substance must be considered as contravening the conditions which the IFM is required to meet in order to obtain and maintain its authorization. However, such level of substance merely depends on the decision-making functions in relation to investment management, distribution and oversight activities that are different to the ones typically expected by tax authorities.

How to implement substance requirements

To face those increased and diverse substance requirements, market players use different types of models to comply with the rules formulated by the regulator and by tax authorities. When employees are providing services to several Luxembourg companies, a global employment contract (GEC) is often used in practice since it is considered as an efficient way to allocate costs and resources to the relevant entities. The GEC allows companies to allocate the employee costs directly in their income statements without having VAT implications. Nevertheless, market players can find it challenging to establish the correct balance between the number of employees included in the GEC and the number of companies for which the employees are working. Before implementing a GEC in a structure with an IFM, a deep review should be performed to align with the CSSF requirements. Lastly, it is recommended that a review of the companies and employees involved in the GEC is performed every six months to one year.

Another model used by market players involves having a “master” company employing the personnel providing the services and recharging their costs to the relevant Luxembourg entities. This model does not require a specific employment contract. However, there could be VAT implications on the cost recharged, as the assignment of employees by one company to another qualify as a supply of services for VAT purpose. Also, as the salary costs of the employees will not be directly disclosed in the income statements of the companies receiving the services, this could trigger beneficial ownership questions by foreign tax authorities.

Lastly, a group could set up a dedicated “service” company to provide the services to the relevant companies; this set-up has the same limitations as the “master” company mentioned above, and it allows for centralization of costs in one entity.

Of course, depending on the needs of the group, it is possible to envisage a combination of the above solutions in order to tackle specific issues.

Finding the best way to organize substance in the structure can be challenging

In case of queries from local or foreign tax authorities, it can be hard to find a one-size-fits-all approach. Tax authorities could focus on different requirements which could increase the difficulty in replying in an efficient and timely manner to various requests.

In addition, following the COVID-19 outbreak, more and more companies are envisaging a work-from-home policy. However, the functions performed by the employee working from home, but from another country, could play a role in the determination of substance in Luxembourg and on the allocation of the profit derived from the employee’s activities.

In light of the above, to implement the most appropriate level of substance for the operation in place, it is advisable to perform a review of the type of substance already present at the level of each structure. Furthermore, the appropriate quality of substance should be implemented considering the different requirements per jurisdiction but also per type of investment. Lastly, the substance in place should be properly documented in the corporate governance processes to be able to answer swiftly to any request from the competent authority.

It is therefore key to have a holistic view of the various regulations in place, as the intent of the legislator to tackle artificial arrangements is reflected in various actions including more tax and TP related legislations but also financial regulations, Directives and circulars issued by the regulator.