ATAD 3: What’s in store for the Luxembourg alternative investment fund industry?

With one of its latest draft directives, the EU Commission aims to tackle the misuse of shell companies in the EU. 

The topic is heating up but what is at stake for the Alternative Investment Fund sector? Vincent Rémy, Partner, Private Debt Leader at EY Luxembourg gives his insights.

In December 2021, the European Commission released its proposal for a new Directive ¹ (referred to as ATAD 3, hereafter the draft Directive) that targets so-called “shell” entities, i.e., undertakings with no or minimal economic activity, used as instruments of tax evasion or tax avoidance.

While the draft Directive may still be subject to further amendments, ATAD 3 will ultimately have to be transposed into Member States’ national laws by 30 June 2023 for the rules to come into effect as of 1 January 2024.

Shell or not shell?

The draft Directive lays down three “gateway” criteria to identify whether an entity is at risk of becoming a shell. The criteria link to relevant (passive) income, engagement in cross-border activities and outsourcing of own administration and decision-making. If the criteria are cumulatively met, the entity “at risk” will be required to disclose and document its substance in its annual tax returns by providing information on its premises, bank accounts, local director(s) or employees. If the substance is not satisfactorily demonstrated, the entity at risk will be deemed to be a shell company and face the tax consequences of the draft Directive: no certificate of tax residence at all or with a with a warning statement, therefore no entitlement to double tax treaties or EU Directives.

Managers of alternative assets (e.g. private equity, private debt, real estate, infrastructure) often structure their funds with a Luxembourg platform in order to benefit from the EU passport, while others still set-up their fund offshore (US, Cayman, etc.). All these funds generally use Luxembourg investment companies to hold their assets. Such holding companies may pass each of the gateways, triggering thus a reporting obligation.

Expected exclusions

Entities with an adequate level of transparency will be considered as not presenting a risk of lack of substance and should therefore be carved out: these exclusions should cover, among others, undertakings with securities traded or listed on a recognized stock exchange, companies established as Alternative Investment Funds (AIF) managed by an AIF Manager as well as entities covered by the EU 2017 Securitization Regulation. The carve-out would also extend to Luxembourg companies which are held by another Luxembourg tax resident shareholder.  

The draft Directive additionally provides for two possibilities to be exempt from the tax consequences of being qualified as a shell company. The first option is that the entity substantiates that it conducts a genuine economic activity and is therefore not a shell company (even if it is not meeting the substance criteria). The second is that the entity substantiates that it does not create a tax benefit, which will make it fall out of the scope of the draft Directive.

Measures to be taken by Alternative Asset Managers

There are numerous non-tax reasons why fund managers use intermediate holding companies (e.g. segregation of assets and risks or investor protection). As a result, it may be possible to rebut the presumption of being a shell.

Alternative asset managers are well-advised to already pay particular attention to the draft Directive and to carry out an initial impact assessment on their corporate structures, given that the gateway criteria will refer to the preceding two tax years.

1 Proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes