Structuring Private Credit Funds
In the closed ended credit space, we see three core strategies: special opportunities, junior credit, and senior secured credit.
Fund Jurisdiction
The general preference for a closed ended credit fund is a limited partnership. The choices for limited partnership jurisdictions are UK; Luxembourg; far offshore (for example, Cayman Islands and BVI); and near offshore (Guernsey and Jersey). Recently, Ireland has revised its limited partnership regime but we have not yet seen this structure used to date. Previously, the choice was principally tax driven, however, now regulatory factors and investor requirements are equally important.
For example, if the fund manager wishes to benefit from the marketing passport under AIFMD, both the fund and the manager will need to be EU based. Furthermore, many European institutional investors are requiring onshore structures for tax, regulatory and/or reputational reasons.
With this increased desire for onshore limited partnership fund structures, and with UK structures posing VAT and remittance issues for the fund manager and any UK resident non-domiciled individual investors respectively, the Luxembourg limited partnership (see below) has become increasingly popular. However, for managers who are less concerned with the European investor market, the Cayman Islands remain the most popular jurisdiction as this is familiar to US and Middle East investors.
Asset Holding Structure
If loans were made and held directly in a limited partnership fund vehicle, the fund would suffer interest withholding tax (WHT) on credit investments in countries such as UK and Spain. Investors will expect the fund to structure its investments to avoid interest WHT at source. Indeed, investors are increasingly requiring underlying withholding tax to be treated as a fund expense.
The usual way for credit funds to avoid interest WHT at source is to make and hold loans through a Luxembourg subsidiary company. Care should be taken in the funding of any such Luxco to ensure that its beneficial ownership of underlying investments is not compromised and to ensure that underlying capital gains are not converted into income for UK tax purposes through the structure.
Luxembourg Limited Partnerships
In addition to the implementation of the AIFMD, the Luxembourg legislator introduced significant changes in the Luxembourg corporate and tax law, in particular with the modernization of the existing common limited partnership (société en commandite simple – CLP) and the creation of a new investment vehicle, the special limited partnership (société en commandite spéciale – SLP). In order to mirror the existing limited partnership regimes in the Anglo-Saxon jurisdictions, the SLP does from a Luxembourg perspective not have legal personality whereas the CLP has legal personality.
Luxembourg Limited Partnership Tax Regime
Even though CLPs have a distinct legal person- ality from their partners for corporate law purposes they are – as the SLP – tax transparent for Luxembourg corporate income tax (impôt sur le revenu des collectivités – CIT) and net wealth tax (impôt sur la fortune – NWT).
A SLP and a CLP may however be subject to municipal business tax (impôt commercial communal – MBT) if it carries out a commercial activity or by virtue of the business-taint theory (Geprägetheorie) if the general partner owns 5% or more of the capital or economic interest in the CLP.
Whereas the Luxembourg AIFM Law had modified the business-taint theory in order to allow an opt-in for or against a business-tainting, the Luxembourg tax law was not directly amended with regard to the definition of a business activity. A “business activity” is generally defined as any independent for profit activity that is exercised in a permanent manner and participates to the economic life in general. In a fund context, the qualification of a CLP/SLP as carrying out a business activity had thus been in certain scenarios doubtful.
In order to address the need for clarification, the Luxembourg tax administration issued on 9 January 2015 a Circular Letter L.I.R. No. 14/4 which confirms that an unregulated CLP/SLP which qualifies as an AIF within the meaning of the AIFM Law is deemed not to be conducting a business activity and will not be subject to MBT, unless its general partner holds 5% or more of the interests in the CLP/SLP.
AIFs/AIFMs Cross-Border Situations
In order to avoid potential double taxation, the AIFM Law provides that AIFs established outside Luxembourg but managed by a Luxembourg AIFM are not subject to Luxembourg tax (i.e., CIT, MBT, and NWT). However, the contrary case of a foreign AIFM managing a Luxembourg resident AIF, is not expressly dealt with. Such case must from a corporate law and VAT perspective be carefully managed in order to ensure the (tax) residency of the AIF in Luxembourg.
VAT Exemption for Management of Investment Funds (C-595/13; Fiscale Eenheid X)
The German legislation transposing the VAT exemption granted by the 6th VAT System Directive (VAT Directive) for the “management of special investment funds as defined by Member States” is limited to UCITS-type “investment funds” within the meaning of the German Investment Tax Act. As a result, management services rendered with respect to German private equity funds as well as other AIFs are not eligible for the VAT exemption, but subject to value added tax (VAT) at a current rate of 19%.
This discrimination of AIFs against certain eligible investment funds not only adversely impacts the attractiveness of Germany as private equity market but also infringes, in our judgment, EU law. This analysis is supported by the opinion of the Advocate General of the Court of Justice of the European Union (CJEU) rendered in the case “Fiscal Eenheid X” (C-595/13) in May 2015.
Questions Referred for Preliminary Ruling
Dutch fiscal authorities and a real estate management company disagreed about whether and to what extent certain fund-related as well as asset- related services rendered by the management company fall under the notion of investment fund “management” and were VAT exempt.
The Dutch court raised doubts as to whether real estate funds are as such eligible for the aforementioned VAT exemption and thus referred the following questions for preliminary ruling to the CJEU:
- May real estate funds be regarded as “special investment funds” within the meaning of the VAT Directive?
- If so, does actual management of real estate fall under the notion of “management”?
- With respect to the first question, the Advocate General concludes as follows:
- Investment vehicles which are subject to investment regulations benefit from the EU VAT exemption, subject to the following differentiation.
- Investment vehicles that are subject to European investment regulation (e.g. UCITS) are automatically eligible for the VAT exemption. This condition was not met in the case at hand with respect to the relevant pre-AIFMD time period. However, the Advocate General makes it very clear that the AIFMD regulation triggers the eligibility of AIFs for the VAT exemption.
- If Member States impose investment regulation under national law on investment vehicles, then the Member States should grant the VAT exemption to such investment vehicles when the rationale of the VAT Directive, in particular the principal of fiscal authority, so requires.
Conclusions
It remains to be seen whether the CJEU follows the opinion of the Advocate General. Assuming so, the conclusions should be unambiguous:
- The discretion of the Member States regarding the definition of the term “special investment funds” is superseded by the European harmonized investment regulatory law.
- All AIFs, including private equity funds, are eligible for the VAT exemption.
- Germany must amend its VAT law accordingly, and expand the VAT exemption for “investment funds” to all AIFs.
