Real Deals - EY Luxembourg private equity tax partner Olivier Bertrand discusses the changing international tax landscape in Luxembourg and what PE funds need to know about it.
ase erosion and profit shifting (BEPS) has rapidly moved to the implementation phase. What does this require PE funds to do exactly and how can EY help?
There has certainly been a couple of developments including BEPS, ATAD I and ATAD II. BEPS has led to the signature of the Multi Lateral Instrument (MLI) with one of the main impacts on private equity being the Principal Purpose Test, an anti-abuse measure under which the benefit of a double tax treaty can be denied to a company if it has been established with the main purpose of deriving a tax benefit.
In addition to withholding tax on dividend and interest, asset managers should also consider potential non-resident capital gain tax when they exit an underlying asset. With year-end coming close, some of those risks might even lead to tax accruals in the scope of the 2020 audit; the first year of effectiveness of the PPT.
Asset managers are also impacted by ATAD I, introducing an interest limitation rule under which the tax deduction of interest expense is generally capped at 30% of the EBITDA.
In practice, asset managers investing into distressed assets should consider a particular risk of non-deduction of interest expense if the income they realize does not qualify as interest income for tax purposes as this would trigger the application of the interest limitation rules, i.e. taxation of a larger portion of capital gain.
Whether fair or not, everyone has a view, but taxation is generally happening at the level of the portfolio companies and underlying asset and such taxation is most probably already embedding the new tax restrictions and anti-abuse measures (ATAD, BEPS, etc..).
My view is that in the alternative investment world, the investment structure should remain tax neutral in order to mitigate any exposure in terms of double / triple taxation.
With the recent implementation of ATAD II, what should alternatives managers be aware of? What more does the ATAD II outline that GPs should consider and when?
For asset managers and PE houses, two particular measures are of particular importance: the hybrid instrument mismatch and the hybrid entity mismatch.
While the hybrid instrument mismatch refers to instruments that have different qualifications in 2 different jurisdictions, the hybrid entity mismatch is more difficult to address and relates to the difference in qualification of entities, but both measures aim for the same result - the non deductibility of payments that are not taxed in a timely manner at the level of the investor.
For example, if an intermediate holding company makes a payment to a fund that it considers to be tax transparent, such payment might not be deductible if it is received by an investor (through the transparent fund) which considers the same fund as opaque and therefore does not include the payment in its taxable basis (so-called deduction non inclusion outcome).
The Luxembourg Ministry of Finance has called for a draft law introducing a six-month deferral to the MDR Law (Law of 25 March 2020). Why and what does this mean for funds domiciled in Luxembourg? What does the Law require?
Under the MDR Law, cross border arrangements should be reported if they contain at least one of the indicators (called “hallmarks”) set out by the Directive.
For private equity houses, the most likely hallmarks to consider would be transactions with low tax jurisdictions, and transactions where income might be turned into capital, both of these hallmarks being subject to an additional main benefit test where it should be assessed if one of the main purposes of the transaction is to derive a tax advantage. Missing a filing obligation may lead to penalties which are likely to be around €250,000.
In July 2020, Luxembourg introduced a six-month deferral with respect to the MDR filing obligations. In difficult times, reducing the administrative burden on taxpayers is very welcome by the industry!
Interestingly enough, this postponement was very timely and enabled managers to avoid the burden of reporting transactions in the Cayman Islands without additional main benefit test, as Cayman was black-listed until very recently.
Overall, what are the key risks that have to be considered by private equity when reviewing a company following the changes in the international tax landscape?
Since 2019, the additional tax risks we just discussed have to be taken into consideration, if not accrued in the scope of the audit.
But let’s rather address the very positive answer that over the last few years, asset managers have been massively hiring in Luxembourg and setting-up high standard infrastructure with skilled backoffice, middle-office and front-office employees strongly substantiating the use of intermediate holdings with solid commercial rationale (risk fencing, external lending, exit strategy, co-investment, management incentive plan, etc.).
We have also seen an exponential increase in the number of Luxembourg funds and alternative investment fund managers, giving even more purpose to the Luxembourg tax operations as it makes it more obvious to set-up your holding entities in the country where your fund is established!