VAT and AIFs: how AIF structures can safely navigate VAT rules

Compared to traditional funds, alternative investment funds (AIFs) often use complex structures that require an in-depth VAT analysis. This is especially true for non-EU promoters setting up their first funds in EU jurisdictions.

Article 135.1.g of the EU VAT Directive exempts from VAT the management of investment funds “as defined by Member States” without any further details. Both the Court of Justice of the European Union (CJEU) and the Luxembourg VAT authorities have interpreted and developed this exemption primarily in a UCITS context. It is thus interesting to consider the extent to which the exemption also applies to AIFs.

Even if Luxembourg has the lowest VAT rate in the EU (17% compared with an average of 20%) and applies the fund management VAT exemption in a comprehensive manner, the VAT rules applicable to complex investment structures must be carefully considered, as most investment structures cannot recover VAT on their costs. VAT is therefore generally a final cost for the sector.

Usually, the main actors in AIF structures are the alternative investment fund managers (AIFMs), the AIFs, usually set up as special limited partnerships (société en commandite spéciale – SCSp), their general partner(s) (GPs), and the special purpose vehicles (SPVs) owned by the funds to structure their investments. The main VAT issues are: qualification as a VAT taxable person with the related obligation to pay VAT on services received from foreign services providers; application of the fund management VAT exemption; and the possibility of recovering VAT on costs. A final issue is the possibility of benefiting from the new Luxembourg VAT grouping regime.

The AIFM

The corner stone of the AIFM Directive and Luxembourg implementing Law of 12 July 2013 is the AIFM. With the exception of self-managed AIFs, all AIFs must designate an AIFM. The AIFM has two main functions: the investment management function and the risk management function. The first function undoubtedly benefits from the VAT exemption for fund management. The Luxembourg VAT authorities lifted any doubts regarding the VAT treatment of the second function (risk management) when they issued their circular 723 ter of 7 November 2013, confirming that risk management services could be exempt as management services of investment funds. AIFMs providing exempt services are VAT taxable persons without the right to recover VAT on their costs and obliged to pay Luxembourg VAT on services received from foreign services providers if these services cannot benefit from the fund management VAT exemption (or another exemption).

The funds

Article 44.1.d of the Luxembourg VAT law (implementing Article 135.1.g of the VAT Directive) provides a list of funds and entities that may benefit from VAT exempt management services. This list includes alternative investment funds as defined in Article 1.39 of the AIFM Law of 12 July 2013 relating to managers of alternative investment funds. The Luxembourg VAT law thus treats AIFs and UCITs in the same way. Both qualify as VAT taxable persons and are obliged to pay Luxembourg VAT on services received from foreign providers unless an exemption applies. They have no right to recover VAT on costs, except in rare cases such as investments in real estate, works of art, or other tangible goods.

The VAT status of SCSp

The AIFM Law of 12 July 2013 introduced a new form of company: the SCSp. This new legal form is available to any type of activity, but is especially suited to the private equity and real estate sectors. The SCSp is composed of two categories of partners: one or several limited partner(s) (LP) and one or several GPs. It has no legal personality and allows for more flexible structuring when compared with other corporate entities, which must comply with stricter corporate law requirements.

When the law was published, the VAT status of the SCSp was unclear. After an in-depth analysis of their legal nature, the VAT working group of the Luxembourg Private Equity Association (LPEA) concluded that the GP and the SCSp should be seen as two separate persons for VAT purposes, and that the VAT status of the GP and SCSp should be separately considered based on the nature of their activities.

In practice, we may face different situations. For example, a GP with activities limited to the passive ownership of associated interests in the SCSp without direct or indirect intervention in its management would qualify as a “passive holding” and, therefore, not as a VAT taxable person; it would qualify as a VAT taxable person if it were to invoice services to the SCSp. These services would be VAT exempt if the SCSp qualifies as an AIF and if the services qualify as management services for VAT, which will not always be the case. The SCSp would not qualify as a VAT taxable person if it does not qualify as an AIF and if its activities are limited to the passive holding of shares, whereas it would be a VAT taxable person if it qualifies as an AIF. These distinctions have direct and concrete implications in terms of VAT registration, deduction of VAT, exemption of services received, etc. (see summary table). The most important consequence of qualifying as a VAT taxable person is the payment of Luxembourg VAT on services received from foreign services providers when these services do not benefit from the fund management VAT exemption or another exemption. Typical costs that are subject to VAT are transaction costs such as due diligence services relating to the target investments by lawyers and financial experts.

Investment structures

In the traditional UCITS world, setting up SPVs as intermediate investment structures is rather exceptional. One well-known example is the creation of SPVs in Mauritius to invest in Indian shares. On the contrary, in the AIF world, and especially in the private equity and real estate sectors, the use of such intermediate entities is systematic.

This leads to specific questions. The first question is to determine whether these SPVs qualify as VAT taxable persons or not. As mentioned above, a passive SPV company does not qualify as a VAT taxable person and will not have any obligation to pay VAT on services received from foreign services providers (e.g., lawyers, financial experts, etc.). Should the SPV’s activity go beyond the passive ownership of shares, for example by granting loans or intervening in the management of companies in which it owns shares, such SPVs should be considered as VAT taxable persons and have an obligation to pay Luxembourg VAT on services received from foreign services providers, except if an exemption is applicable. Often, they will have no or limited right to recover VAT on costs, even if an individual analysis is required.

Another question is the possibility of invoking the exemption of Article 44.1.d for management services provided to these SPVs. Indeed, some may argue that SPVs that are wholly owned by a fund (or several funds) are simply a modality of investment of the assets of the fund(s) and should thus benefit from the fund management VAT exemption. Although seductive on paper, such argumentation has never, to the best of our knowledge, been applied in practice, and the Luxembourg VAT authorities would most likely stick to a strict reading of Article 44.1.d of the VAT law, which does not include such SPVs in the list of entities eligible to benefit from the fund management VAT exemption.

Transaction costs

While UCITS invest in readily available classes of assets such as shares and securities listed on the stock markets, AIFs generally invest in specific assets such as the shares of unlisted companies or real estate properties. The acquisition of these assets usually implies the payment of substantial transaction or deal costs. The VAT treatment of these transaction costs will depend on different elements. Assuming that an entity outside the EU, for example the promoter of the fund, pays these costs, they should not be subject to EU VAT. However, legitimate business considerations must justify that this way of invoicing has not been chosen in order to avoid VAT. When a Luxembourg entity pays these costs, we must consider various scenarios. If the entity paying the transaction costs is a passive holding company (i.e. pure and exclusive shareholding activities), this company will have no obligation to pay Luxembourg VAT on these costs, while VAT in the country of the service providers may be applicable at higher rates than in Luxembourg. If the person paying the transaction costs appears to be a VAT taxable person, these costs must be examined to determine if they qualify for a VAT exemption as securities trading services pursuant to Article 44.1.c 9th dash of the Luxembourg VAT law or any other relevant Luxembourg VAT exemption. Finally, if this VAT exemption is not applicable, it must be determined whether the VAT due on these costs is recoverable. Under the conditions defined by the Court of Justice of the European Union, this may be the case if the person paying these costs is an “active” holding involved in the management of the companies in which it owns shares, or a property company renting properties with VAT.

We can summarize the most common situations as follows even if a case-by-case analysis is always advisable:

[1] We assume here that the services effectively qualify as management services of investment funds, which must be checked on a case-by-case basis.

Independent group of persons (IGP) and VAT group  

As mentioned above, the VAT exemption for the management of investment funds is not available for SPVs serving as intermediate structures between the funds and the investments. Similarly it will not be available for investment structures investing in the funds, unless these structures also qualify as funds eligible under Article 44.1.d of the Luxembourg VAT law to receive VAT exempt management services.

All of these structures require appropriate resources. For this, they also need some services that are subject to VAT, such as domiciliation, accounting, and administration. As their activities are limited to investment, this VAT will generally be a final cost. Previously, it was possible, under certain conditions, to apply the VAT exemption for services of an IGP when a service company owned by the promotor of the funds provided these services. However, the benefit of this exemption has been restricted to public interest activities on the basis of three decisions of the CJEU of 21 September 2017.

The introduction of the VAT group regime in Luxembourg as of 31 July 2018 is most likely an opportunity for complex investment structures to consider. Indeed, in a VAT group, the supply of goods and services between members of the group is inexistent for VAT and therefore not subject to VAT. Legally independent persons that are closely bound by financial, economic, and organizational links could set up a VAT group. The new Article 60 ter of the Luxembourg VAT law defines the links in a flexible manner. For example, financial links are deemed to exist if a direct or indirect shareholding of 50% exists, but also if a person is able to designate or revoke the majority of the members of the board of directors or managers (de facto control). Similarly, organizational links are deemed to exist if a legal or de facto common management exists. Economic links are deemed to exist not only if activities are similar or interdependent, but also if members pursue the same economic purpose. These flexible criteria could thus provide for the creation of a VAT group in complex investment structures. In this respect, it is worth noting that passive holding companies, such as SPVs, may be members of a VAT group, which is not the case in most other EU VAT group regimes. This feature and the flexible definitions of the links between members could thus open up opportunities for AIF structures.

After this high-level overview of the VAT challenges for AIFs, we can conclude that current VAT law and principles are compatible with AIFs but certainly imply a customized approach. Often, VAT is a final cost, and applying VAT principles may be complex, but also offers opportunities if appropriately mastered.

^[1] We assume here that the services effectively qualify as management services of investment funds, which must be checked on a case-by-case basis.

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