The country is poised to become an even more attractive fund domicile given emerging geopolitical conflicts, new and changing regulations promoting financial transparency, a desire on the part of fund managers outside the EU to market to European investors, and other factors.
Fund managers based in North America, Asia and elsewhere with no previous experience operating in Europe, however, must be aware that domiciling a fund in Luxembourg can be a very different process than domiciling one in Delaware, Singapore or many other popular destinations, including some other EU countries.
This article provides fund managers outside the EU with some important factors to consider before domiciling a fund in Luxembourg — from marketing strategy development through to fund setup and launch.
Promoter marketing strategy
This article explores Luxembourg fund domiciliation considerations, so it’s worth briefly summarising some of the reasons for the jurisdiction’s popularity as a fund choice when marketing to European investors.
Probably the most important reason is EU-based investors themselves. Many European investors prefer Luxembourg due to its proximity, largely familiar regulatory regime and culture, and blue-chip reputation as a secure, trusted and reputable funds domicile.
For fund managers, Luxembourg has other significant advantages besides its investor appeal. It provides access to European investor capital, along with a robust network of local experts, including lawyers, auditors, fund administrators and alternative investment fund managers, most of whom are fluent in four languages. (It should be noted that not all of a Luxembourg fund’s assets must be invested in Europe.)
Moreover, Luxembourg regulatory authorities have consistently tried to strike a balance between promoting compliance with EU tax, economic substance and other rules, while also working directly with businesses to promote a business-friendly regulatory environment. The country has an extensive network of double tax treaties and in general the funds tax regime promotes transparency. As with virtually all tax regimes, the risks and benefits of funds taxation in Luxembourg depends on the specific fund structures and other factors and is best negotiated with the help of third-party experts.
Luxembourg is also widely known for its fund “toolkit,” consisting of a variety of fund structures to suit virtually every investment situation. Whatever the fund type, fund distribution requires a local fund manager with an Alternative Investment Fund Manager Directive (AIFMD) distribution licence.
Luxembourg and the AIFMD
The EU’s AIFMD was implemented following the 2008 financial crisis and is designed to protect both investors and the EU’s financial stability. As its name implies, the directive regulates fund managers rather than the funds themselves.
Under the directive, alternative investment fund managers, or AIFMs, must report certain fund information to local authorities and fulfil other compliance requirements, which typically include retaining conducting officers, maintaining substance structure, and developing policies and practices related to valuation, oversight, risk management, compliance, auditing and conflicts of interest.
With these responsibilities come significant privileges. An authorised or registered AIFM in an EU member state has passporting rights, meaning they can market and distribute to, and raise capital from, investors across the European Economic Area (EEA), including of course Luxembourg itself.
For firms based outside the bloc who want to domicile and market funds in the EU, it often makes sense to outsource AIFM duties from the start rather than hire and develop an in-house expert. Domiciling a fund in Luxembourg and hiring a local AIFM has many advantages. Luxembourg was the first EU member state to transpose the AIFMD into law, and authorities there have made a concerted effort to work with industry leaders, lawyers and other stakeholders to create an AIFMD framework that promotes both transparency and flexibility. For example, Luxembourg law allows for both AIFM and independent director services, whereas some popular EU fund domiciles do not.
Other regulatory considerations
There are other important regulatory considerations besides the AIFMD when domiciling a fund in an EU member state, including of course Luxembourg. EU compliance rules governing funds tend to be strict, especially at the asset level, and will in any case be unfamiliar to fund managers new to the market.
As mentioned, Luxembourg authorities — in this case the Commission de Surveillance du Secteur Financier (CSSF) — have worked to create a business-friendly compliance regime within the bounds of EU directives. Here are some of the most significant compliance considerations when domiciling a fund in Luxembourg:
The EU Sustainable Finance Disclosure Regulation (SFDR)
The SFDR is the EU’s most prominent ESG-related regulation. It has been designed to promote clarity and standardisation, and includes requirements related to classifying funds as sustainable (or not). Under the regulation, and according to the European Commission’s regulatory technical standards (RTS), firms must disclose information on the product and entity levels.
It should be noted that Luxembourg’s CSSF has published SFDR guidance, including an FAQ, to complement the EC’s guidance. The CSSF guidance has information on how to complete a prospectus or issuing document, and on how to make website, precontractual and periodic disclosures.
While EC and CSSF guidance are important and clarifying, it should be stressed that the SFDR and other ESG reporting requirements are part of an evolving regulatory area that must be monitored, typically with the help of third-party compliance experts.
Virtually all fund managers inside and outside the EU are by now aware that there are different iterations of the EU’s Anti-Tax Avoidance Directive (ATAD), its Directive on administrative cooperation in the field of taxation (DAC), and other rules promoting EU substance and targeting tax avoidance.
These ongoing efforts increase transparency and in part discourage the use of EU-resident entities that have no or minimal economic activity but benefit from tax advantages. An entity may be at risk under any of the rules.
Here are some important items to consider in the area of anti-abuse provisions:
- Luxembourg corporate taxpayers are taxed on the undistributed net income of a controlled foreign company (CFC) if the company has been put in place essentially for the purpose of obtaining a tax advantage. The income is taxed in proportion to the taxpayer’s ownership or control of the entity and to the extent that the income is related to significant functions carried out by the taxpayer.
- General anti-abuse rules (GAAR) in the EU are designed to catch non-genuine arrangements and counteract aggressive tax planning when other rules don’t apply. Under these rules, certain transactions may be disregarded or requalified as non-genuine by tax authorities.
- Hybrid mismatch rules aim to neutralize the tax effects of hybrid mismatches (that is, companies exploiting national mismatches to avoid taxation) by limiting the deduction of payments or by including the payments in the taxable income of a corporate taxpayer under specific conditions.
- The EU Anti-Tax Avoidance Directive III (ATAD 3, also known as the Unshell Directive) is designed to combat tax avoidance by shell entities, or companies showing a lack of substantial economic activity. As of this writing, ATAD 3 is being implemented by EU member states. Some jurisdictions have expressed concerns about the complexity of the directive and its potential to create administrative burdens for businesses. This disagreement between member states and the European Commission is a good example of how member states in general may interpret laws in their own way and of how many jurisdictions (including Luxembourg) have strived to create business-friendly regulatory landscapes under EU directives.
Anti-money laundering and countering the financing of terrorism (AML/CFT)
No private equity firm anywhere will need to be told about the challenges of gathering and maintaining investor information to fulfil various anti-money laundering and know-your-customer (AML/KYC) requirements, also called AML/CFT requirements. Luxembourg has its own requirements, which are regulated by the CSSF. Its AML/CFT law was passed in 2004, and has been amended from time to time, including in 2022.
The CSSF’s AML/CTF frequently-asked-questions document is a clear introduction to the requirements. At 20 pages, the document’s length gives some indication of the requirements’ complexities.
Bank account establishment
Under the AIFMD, certain licences are required to establish a cash bank account on behalf of a fund, including a depositary licence and a banking licence. A third-party AIFM may have a depositary licence and can generally work with a licenced bank to establish an account on behalf of a new fund. Even when working with an established depositary and bank, it generally takes at least three months to establish a bank account in Luxembourg.
As mentioned, Luxembourg is widely known for its extensive toolbox of investment vehicles. Its structures permit EU passporting and therefore access to investors across the EEA. Luxembourg’s most popular fund structure options include the reserve alternative investment fund (RAIF), the special limited partnership (SCSp), the specialised investment fund (SIF) and the common limited partnership (SCS), among others.
Some fund structures are regulated and others are not. Even unregulated funds, such as the RAIF, are regulated by the AIFMD — that is, at the fund manager level. Unregulated funds do not, however, have to be approved by the CSSF to be established. These tend to be limited partnerships, a flexible, tax-transparent vehicle well known to many in the US and elsewhere. The SCSp is particularly popular, and its success has other popular fund destinations such as Ireland looking to create their own similar vehicles to compete.
Regulated fund structures, such as SIFs, must be approved and monitored by the CSSF. Not surprisingly, these structures have more compliance requirements and tend to be attractive to larger investors (including pension funds) that demand the highest transparency and risk-mitigation controls.
Many Luxembourg funds, it should be added, can be set up either as a standalone fund or as an umbrella fund. An umbrella fund is comprised of sub-funds to allow for flexibility and reduced costs and administrative burdens in certain situations.
Perhaps most critically when establishing a fund structure, the fund manager must avoid hybrid-mismatch arrangements. Due diligence in this area, especially for those new to the EU market, will almost certainly include obtaining local third-party guidance to avoid non-compliance with ATAD and other rules.
Luxembourg’s various fund vehicle options provide flexibility for fund managers, but it’s essential for a fund manager to understand each structure’s benefits and drawbacks — from tax advantages to reporting requirements to investor appeal to compliance risks — before making decisions about structuring. The various options mean that due diligence can, and indeed should, be an involved process.
Finally, once a fund is established, Luxembourg has many available entity options, each of which (like fund structures) has benefits and limitations. For example, a manager may decide to use a simple holding company, such as an SPV, which typically provides double tax treaty benefits. To take another common example, a manager may choose a financing company, which is a limited liability company in the form of an SARL. Banks like to provide services to these because SARLs make it easy to enforce the securities granted by the Luxembourg company.
These are just two examples of the many Luxembourg company types, which can facilitate strategies involving co-investment vehicles, management equity plans in the form of partnerships, and more.
Fund setup and launch
For fund managers based in the Americas and Asia, one of the most surprising elements of domiciling a fund in Luxembourg — or in any EU member state — is the time it takes to establish the fund. In Luxembourg, it typically takes three to six months, which is in sharp contrast to some other popular fund domiciles outside Europe. A fund in Delaware in the US, for example, can typically be established in a day or two.
For a fund manager based outside Luxembourg, fund setup involves establishing a local bank account, registering as a manager and applying for authorisation as an AIFM or engaging a local third-party AIFM with passporting rights, among other steps. Again, engaging third-party AIFMs and other local experts, such as lawyers, is the most common, least risky and generally quickest way to set up and launch a Luxembourg fund.
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The contents of this article are intended for informational purposes only. The article should not be relied on as legal or other professional advice. Neither Vistra Group Holding S.A. nor any of its group companies, subsidiaries or affiliates accept responsibility for any loss occasioned by actions taken or refrained from as a result of reading or otherwise consuming this article. For details, read our Legal and Regulatory notice at: http://www.vistra.com/notices . Copyright © 2024 by Vistra Group Holdings SA. All Rights Reserved.
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