The current geopolitical instability, spiraling inflation and energy prices, looming recession and massive supply chain issues, lead to an increasing risk of defaults, insolvencies and volatility. These notions are expected to become even more prevalent in the months to come.
Distressed debt funds typically flourish under such circumstances. Looking back at the global financial crisis over a decade ago, the likes of credit opportunities funds offered competitive mid-teen net internal rate of return (IRR). Fast-forward to more than a decade later, the same recipe is now on the menu again. According to the May 2022 special report of Private Debt Investor1, distressed funds have raised more than $44 billion in 2021 (up 21% from 2020) with comparable promised returns.
Given the current macro-economic environment, the EU secondary market to purchase debt at attractive discount is expected to present an important opportunity for investors in search of high yield. This is further compounded by continuous deleveraging of non-performing loans (NPLs) from bank balance sheets and the fact that the European economy is by and large driven by the small- and medium-sized companies which are the first ones exposed to possible default.
In this context, sponsors of EU distressed funds often look towards the Grand Duchy to establish their platform. The speed, flexibility and breadth of fund solutions proposed by Luxembourg are well-known to investors and managers, making Luxembourg the number one jurisdiction for managers of EU-oriented credit funds across all strategies. That said, the road to a performing fund structure is often encumbered by various pitfalls which may prove problematic for unwary managers.
Laurent Capolaghi, Assurance Partner and Private Equity Leader at EY Luxembourg, and Vincent Rémy, Tax Partner and Private Debt Leader at EY Luxembourg, shed some light on the main advantages presented by Luxembourg and the main (tax) structuring aspects of which NPL managers should be aware.
A two-layered structure: what should you know?
On the fund level, managers of distressed platforms often structure their funds with an onshore (Luxembourg) platform to freely market their product across institutional investors in the EU, using the AIFMD passport. As far as the legal wrapper is used, the choice boils down to whether the fund itself should avail of legally segregated compartments or not, whether risk-spreading requirements would need to be complied with to satisfy investors risk aversion and if the fund structure should be tax transparent or opaque. Luxembourg is flexible enough to accommodate any of these situations.
On an investment company level, the main common denominator for all Luxembourg-based funds is the use of local investment companies (so-called “holdcos”) to effectively package the acquisition of NPLs. These holdcos are used for different commercial reasons, such as the availability of a legal framework which is widely recognized as flexible and giving certainty in key aspects. The most prominent are, for example, the collateral law on the creation and enforcement of financial collateral arrangements, or the securitization law for compartmentalization and bankruptcy remoteness.
Luxembourg investment vehicles are generally financed with a debt instrument whose return tracks the performance of the underlying NPL and is tax deductible.
Why does tax structuring matter?
Since the adoption of the EU Anti-Tax Avoidance Directives in 2019/2020, the tax landscape has changed dramatically to tackle base erosion arrangements. Every debt sponsor should be mindful of the following measures that may ultimately have an impact on the IRR.
Holdcos investing in NPLs make the bulk of their profits when the value pulls back to the par or when award rights are transferred under foreclosure proceedings (e.g., the Spanish Real Estate Owned Companies (ReoCo) market). The resulting gain realized by the holdco is sheltered by a tracking yield, leaving a taxable margin that complies with generally applicable transfer pricing (TP) rules.
The interest limitation rules (ILR) can effectively limit the deductibility of exceeding borrowing costs incurred by such holdcos to 30% of the gains or EUR 3 million. In the context of distressed debt, the gain realized may therefore be taxable on a 70% tax base which is an unrealistic option for sponsors wary to maintain competitive net IRR.
To address the ILR adequately, sponsors generally take great care in the design of the financing instruments issued by the holdcos to make their investments, with the aim of not recognizing (exceeding) borrowing costs while complying with TP’s arm’s length principles. Another option to deal with the ILR consists in factoring in the change in economic reality since the issuance of NPL with the possibility to reassess the interest rate based on a reasonable repayment price of such NPLs – the resulting income being economically equivalent to interest income.
The aim of hybrid rules is to tackle situations where the fund being established as a tax transparent partnership is treated as a corporation by certain investors and might result in hybrid mismatches. These mismatches are corrected at the holdco level (with the limitation of deductibility of the expenses incurred) and/or at the partnership level itself (with the effective taxation thereof). Given the diverse origin of investors, the hybrid rules pose a real threat to their IRR. Nevertheless, taking a closer look at these rules as they apply in Luxembourg offers a more positive outlook.
These rules for instance should not apply to Luxembourg alternative investment funds which are widely held, have a diversified portfolio and are subject to investor-protection regulation. As the vast majority of Luxembourg funds comply with these features, the hybrid rules should not have an impact for most structures.
More attention should be paid to funds of one: Separately Managed Accounts (SMAs) where the investor would be located in a jurisdiction where partnerships are regarded as corporate blockers.
Access to double tax treaties (DTT) is generally reserved to taxable residents of the relevant State. Over the years, different concepts have emerged to deny such access, for example, to holdcos that lack sufficient economic and organizational substance, i.e., those that do not have meaningful resources on ground to conduct the activity and remunerate the functions in line with risks taken.
The concept of “beneficial ownership” also denies DTT benefits where the holdco simply acts as a conduit for another person who in fact receives the benefit of the income concerned. Making sure that the holdco does not act as a mere fiduciary or administrator acting on behalf of the interested parties is therefore key.
Structures can also be under scrutiny under a mix of existing/developing local general anti-abuse rules (GAAR) and the scope of the principal purpose test (PPT) that aims at tackling structures being set-up only for tax purposes.
Finally, the EU Commission’s last proposed directive to tackle shell entities with no own resources (the ATAD 3) has generated great interest.
All in all, it is therefore necessary that sponsors keep these concepts in check to ensure that the holdco has sufficient own resources and does not lack business reasons.
In a nutshell
Luxembourg remains the top EU jurisdiction to accommodate distressed debt and other special sits funds for several commercial, legal and regulatory reasons. The number of tax traps that a sponsor of such funds faces is already important and keeps growing – also in terms of complexity. Credit fund managers should stay close to their Luxembourg advisors to navigate this tax maze and ensure the viability of their structures.