This article is sponsored by EY.
The current geopolitical instability – comprising spiralling inflation and energy prices, looming recession, and massive supply chain issues – have led to an increased 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 of over a decade ago, credit opportunities funds offered competitive mid-teen net internal rates of return. Fast-forward to today, and the same recipe is now on the menu again. According to affiliate title Private Debt Investor’s 2022 Distressed Debt and Special Situations report, distressed funds raised more than $44 billion in 2021, up 21 percent from 2020, with comparable promised returns.
Given the current macroeconomic environment, the European secondaries market is expected to present an important opportunity for investors in search of high yields. This opportunity is further compounded by continuous deleveraging of non-performing loans from bank balance sheets and the fact that the European economy is, by and large, driven by 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 Luxembourg to establish their platform. The speed, flexibility and breadth of fund solutions proposed by the Grand Duchy are well known, making Luxembourg the number one jurisdiction for managers of EU-orientated credit funds across all strategies.
That said, the road to building a well-performing fund structure is often encumbered by various pitfalls that may prove problematic for unwary managers. Here, we take a look at the main advantages presented by Luxembourg, as well as the main tax structuring aspects of which NPL managers should be aware.
At 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 Alternative Investment Fund Managers Directive passport. As far as this legal wrapper is used, the choice then boils down to whether the fund itself should benefit from legally segregated compartments, whether risk-spreading requirements would need to be complied with to satisfy investors’ risk aversion, and whether 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 legal frameworks that are widely recognised as flexible and giving certainty in key aspects. The most prominent frameworks are, for example, the collateral law on the creation and enforcement of financial collateral arrangements, and the securitisation law for compartmentalisation 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.
Tax structuring implications
Since the adoption of the EU Anti-Tax Avoidance Directives in 2019-20, 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 a fund’s IRR.
Holdcos investing in NPLs make the bulk of their profits when the value pulls to par, or when award rights are transferred under foreclosure proceedings. The resulting gain realised by the holdco is sheltered by a tracking yield, leaving a taxable margin that complies with transfer pricing (TP) rules.
The interest limitation rules (ILR) can limit the deductibility of exceeding borrowing costs incurred by such holdcos to 30 percent of the gains, or €3 million. In the context of distressed debt, the gain realised may therefore be taxable on a 70 percent tax base, which is an unrealistic option for sponsors wary of maintaining competitive net IRR.
To address the ILR adequately, sponsors generally take great care in the design of the financing instruments issued by holdcos to make their investments, with the aim of not exceeding borrowing costs while complying with the TP arm’s length principles. Another option to deal with the ILR is to factor in the change in economic reality since the issuance of the NPL, with the possibility of reassessing 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, 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 that are widely held, have a diversified portfolio, or 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.
Access to double tax treaties (DTT), meanwhile, is generally reserved for taxable residents of the relevant state. Over the years, different concepts have emerged to deny such access to holdcos that lack sufficient economic and organisational substance – for example, those that do not have meaningful resources on the ground to conduct the activity and remunerate the functions in line with risks taken.
The concept of ‘beneficial ownership’ also denies DTT benefits in situations where the holdco simply acts as a conduit for another person who in fact receives the benefit of the income concerned. Making sure 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 as a result of a mix of existing or developing local general anti-abuse rules, or the scope of the principal purpose test, which aims to tackle structures being set up only for tax purposes.
Finally, the European Commission’s last proposed directive to tackle shell entities with no owned resources has generated great interest. All in all, it is necessary for sponsors to keep these concepts in check to ensure that the holdco has sufficient owned resources.
Luxembourg remains the top EU jurisdiction to accommodate distressed debt and other special situations funds. The number of tax traps that a sponsor of such funds faces is already substantial, and keeps growing. The same is also true of their complexity. Credit fund managers should stay close to their Luxembourg advisers to navigate this tax maze and ensure the viability of their structures.
Laurent Capolaghi is a partner and private equity leader, and Vincent Rémy is a partner and private debt leader at EY Luxembourg