What explains the booming success of credit funds in Luxembourg?

This significant growth is driven by various converging factors, including:

Regulatory changes:

in the aftermath of the 2008 financial crisis, the increased regulations caused a contraction of lending offers from traditional banks. Non-bank lenders, such as private credit funds, have thus filled that gap in providing financing to businesses that faced challenges in obtaining loans from traditional banks.

Low interest rate environment:

this asset class is often considered more resilient during economic downturns compared to other asset classes, thanks mainly to its traditional floating rate exposure providing a hedge against inflation. 

Demand for institutional investors:

these investors are boosting their exposure to private credit assets, as this asset class provides for diversification opportunities, higher yields, fixed income streams and risk-adjusted returns.

During that same decade, Luxembourg has emerged as a key player in the alternative investment funds industry, including the credit industry, notably thanks to its unique toolkit that provides well-known and tailored products to managers to set up a private debt fund. Luxembourg has established itself as number one jurisdiction for credit funds with an EU investment strategy and oriented to EU investors. 

How is a debt fund typically structured?

A debt fund has multiple layers. At the upper level, there are one or several investor-facing vehicles. The number and type of vehicle (legal form, regulatory regime) depends on:

•  The nature and residence of the investors, i.e., whether they are taxable or tax exempt, have certain U.S. tax sensitivities, are resident in a jurisdiction that sees a Luxembourg limited partnership as tax transparent or tax opaque (separate taxpayer), and
• Commercial considerations such as the need for compartments to invest in different asset classes or the desire to raise capital in multiple currencies.

The most favoured vehicle undoubtedly remains the special limited partnership (SCSp), but if investors cause tax issues to arise for the SCSp under the reverse hybrid rules, a popular alternative is the SCA RAIF, i.e., a corporate fund subject to a product law that comes with a special tax regime (subscription tax on the net asset value instead of standard corporate income taxes).

Below the fund, for European investments, the platform company is typically a Luxembourg private limited liability company (SARL) which often concentrates a certain degree of substance. The platform may in turn may hold SPVs to segregate different asset classes or different deals, e.g., to leverage only certain investments or exclude certain assets from the scope of the security package granted to external lenders. However, sometimes the fund will have to directly lend to the underlying borrower for regulatory reasons and thanks to its alternative investment fund (AIF) status.

What are the main tax attention points in the structuring of the fund?

At the level of the fund, it is important to monitor the investor base’s evolution during the fundraising period and the related risk that the reverse hybrid rules may apply to the fund, which could result in the fund becoming liable to corporate income tax on part of its income. The manager and the general partner typically have rights to (i) request information from investors, (ii) allocate tax leakage caused by the participation of certain investors in the fund to these investors, and (iii) restructure the fund or transfer investors to structurally resolve a reverse hybrid (or other material tax) issue.

Below the fund, the funding of the platform and any additional underlying special purpose vehicle is influenced by various Luxembourg and foreign tax considerations. The impact of several interest deduction limitation rules depends on;

•  the credit asset class (es) targeted,
• the type of funding instruments used and the tax qualification of the return both for Luxembourg tax and the jurisdictions of residence of the fund and/or of the investors, and transfer pricing considerations. One should furthermore not forget source country tax aspects, e.g., the requirement for the platform company (or an underlying intermediary company) to qualify as beneficial owner of payments on the credit assets in order to benefit from tax treaties and thus from potentially reduced withholding tax rates.

This article was first published by Paperjam.