Episode 1: Tackling tax issues and investment funds - Untangling the complexity of Pillar Two for investment funds

Patricia:

Hello, and welcome to the Ashurst Tax Department podcast on Pillar Two and its impact on investment funds. I am Patricia Allen and I'm joined here in London by my fellow tax specialist, Alistair Ladkin.

Alistair:

Hi, Patricia. I'm looking forward to the discussion.

Patricia:

And in Luxembourg by Alex Clouté.

Alex:

Hello, nice to be here. Thank you for the opportunity.

Patricia:

And Adnand Sulejmani.

Adnand:

Hi, Patricia. Thank you for having me on this podcast.

Patricia:

Huge thanks, Alistair, Alex, and Adnand for being part of our podcast today.

Why did we want to do a podcast about Pillar Two? Well, I think it is fair to say that when one picks up the Pillar Two legislation it is incredibly complicated and it can apply in some unexpected scenarios, and that is worrying. So we thought it would be helpful to give some practical guidance to fund managers as to when they really need to focus in Pillar Two and when they can sleep easy and completely forget about the topic. We also thought it would be helpful to chat through what we think a pragmatic approach is to dealing with Pillar Two in fund documentation. Bearing in mind of course that one does not want to scare off the potential investors.

Just to set the scene, Adnand, can you please remind us what the Pillar Two legislation is trying to achieve, and indeed is it actually fully enforced in Luxembourg?

Adnand:

Thank you, Patricia. Pillar Two applies to constituent entities that are part of an MNE group or large-scale domestic group, which has an annual revenue of at least 750 million euro in its ultimate parent entities consolidated financial statements in at least two of the four fiscal years immediately preceding the tested fiscal year. That is the so-called two-out-of-four-years-consolidated-revenue threshold.
The objective of Pillar Two is to ensure that MNE groups or large-scale domestic groups that meet that consolidated revenue threshold pay a global minimum effective tax of 15% on income arising in each jurisdiction where they operate. The objective of Pillar Two is achieved through the introduction of top-up taxes. The first type of top-up tax that might apply is the qualified domestic minimum top-up tax, which allows a jurisdiction to levy an additional tax to bring the effective tax rate of the MNE group within that jurisdiction up to the minimum 15%.

Second, under the income inclusion rule, the top-up tax might be levied at the level of the ultimate parent entity of the group to bring the effective tax rate on the profits in each country where the MNE group operates up to the minimum 15%. And finally, under the undertaxed profit rule, which somehow acts as a backstop where the under-taxation of the constituent entity of the MNE group has not been taken into account by the application of the income inclusion rule, which might be the case where, for instance, the ultimate parent entity or any intermediate parent entity is not in a jurisdiction that has implemented Pillar Two rules, by denying tax deductions or making other adjustments in relation to other constituent entities of the MNE group in jurisdictions which have adopted the undertaxed profit rule to achieve the 15% effective taxation rate.

In Luxembourg, Pillar Two has already entered into force and is applicable for fiscal years starting on or after the 31st December 2023. So fiscal year 2024 should be the first year where MNE groups falling within the scope of Pillar Two might be subject to such top-up taxes in Luxembourg.

Patricia:

Okay, Adnand, so this is something that we should be worrying about today and thinking about today because it's already in force. Look, it would be really helpful if you could just explain in broad terms in the context of a Luxembourg fund set up as a special limited partnership, what is the process we go through to actually determine in practice whether that fund might fall within the scope of Pillar Two?

Adnand:

That's a good question. In practice, with respect to a fund taking the form of a Luxembourg special limited partnership and assuming that the consolidated revenue threshold is met, a certain number of questions have to be analysed to determine whether that fund actually falls within the scope of Pillar Two.

The first question is whether the fund might qualify as a constituent entity of an MNE group. To be able to determine this, one would first have to identify the ultimate parent entity of the group. An ultimate parent entity is an entity that is required to consolidate one or more entities held by it on the line-by-line basis, or even under the equity method for joint ventures for instance, in accordance with an acceptable financial accounting standard; and, such entity should itself not be consolidated on a line-by-line basis or under the equity method by another entity which holds any capital or profit rights in it.

In this context, it's worth mentioning that if the entity is located in a jurisdiction where the local generally acceptable accounting principles do not qualify as an acceptable financial accounting standard under Pillar Two, for instance, or even in the case where the jurisdiction does not have any laws at all which provides for the obligation to prepare consolidated financial accounts, the entity might nevertheless be considered as the ultimate parent entity under a so-called deemed consolidation rule. Under this deemed consolidation rule, one would have to look in the situations that we just mentioned, whether the entity would have been required to prepare consolidated financial statements under an acceptable financial accounting standard under Pillar Two.

So, a fund might therefore be considered as a constituent entity of an MNE group with an investor as its ultimate parent entity if the investor is required or deemed required under this deemed consolidation rule to consolidate the fund on the line-by-line basis or under the equity method under an acceptable financial accounting standard. If the fund qualifies as a constituent entity of an MNE group, it may be subject to registration and reporting obligations for Pillar Two purpose, and it might potentially also be liable to a top-up tax.

In Luxembourg, a constituent entity qualifying as an investment fund as defined under Pillar Two, is not subject to the undertaxed profit rule or the qualified domestic top-up tax, but may still be subject to the income inclusion rule and therefore such fund would be exposed to a potential top-up tax thereunder.

If the fund is not a constituent entity of an MNE group, the next question is whether the fund itself is the ultimate parent entity of an MNE group. So, here, a fund taking the form of a Luxembourg special limited partnership is not required to prepare consolidated accounts in Luxembourg. Therefore, such a fund should not be considered as the ultimate parent entity of an MNE group.

If the fund qualifies however as a constituent entity of an MNE group, the final question then is whether the fund might benefit from an exemption from Pillar Two and hence qualify as an excluded entity.

There are two exemptions which are worth mentioning in this context. The first one targets an investment fund as defined under Pillar Two that is the ultimate parent entity of an MNE group, this is the so-called investment fund exemption. Then the second exemption concerns constituent entities that satisfy certain ownership or activity conditions which are themselves owned by excluded entities. This is the excluded entity contamination group.

A fund in the form of a Luxembourg special limited partnership cannot be considered as the ultimate parent entity of an MNE group, as we just saw, and therefore the investment fund exemption might not be relied by the fund directly. However, in the presence of an investor of the fund, which is considered as the ultimate parent entity of the fund and which qualifies as an investment fund under Pillar Two, the fund might qualify under certain circumstances as an excluded entity under the excluded entity contamination rule and hence fall out of the scope of Pillar Two.

Patricia:

Adnand, that's so helpful in just setting the background as to how you work through the questions that need to be answered for us to see whether we think we've got an issue or not. Alex, do you think you could just focus in a little bit more about then how those tests, when run in the context of a widely held fund, might apply?

Alex:

Yes, thank you, Patricia. Absolutely. I think the question that everyone has been asking is how is Pillar Two having implications for a widely held investment fund? To determine whether Pillar Two is likely to be an issue for a widely held Luxembourg fund, we first need to look at whether the investors would consolidate or be deemed to consolidate the fund, as explained by Adnand.

In other words, it means that the question is, is there any investor that could be having a significant control over the fund from an accounting point of view. The question of control always varies from the accounting standard at stake. But in the context of a widely held fund, it is unlikely, I think that's the expectation, that any individual investor would have enough control to require consolidation. Typically, the expectation is that no investor holds a significant enough stake to exert such influence. I think it is improbable that any investor would consolidate the fund on a line-by-line basis in their financial statement in the context of a widely held fund. This also makes the concept of the Pillar Two joint venture rules irrelevant because none of the investor would hold 50% or more in the fund.

Having said that, and to your question, it is unlikely that the fund would be a constituent entity for Pillar Two. And we move to the next question, can the fund be the UPE of its own Pillar Two group? As we said, if looking at the regulatory landscape in Luxembourg, an alternative investment fund structured as a special limited partnership, or a RAIF, or a SIF, or a SICAR, are not required to prepare consolidated accounts under the Luxembourg accounting law. So they are therefore not supposed to be considered as UPE by nature, based on our regulations.

I think the bottom line of that question is at first glance, a widely held fund should not be negatively impacted by the rules under Pillar Two. That's the common expectations. This conclusion holds true regardless of the legal form or regulatory regime of the Luxembourg fund. I think one needs to stress that for the fund to have absolute assurance on this position, it needs to assess the consolidation position from its investor. And we can talk about it in a minute on how to do this in practise, but the message here is that in a favourable scenario, it is still important for the fund managers to perform due diligence and verify consolidation status with their investors to ensure that there are no unforeseen issues with Pillar Two. And I trust this answer meets your expectation, Patricia.

Patricia:

Well, yeah, it's good news and I'm pleased to hear that on a widely held fund, I mean, the likely and hopeful result is widely held fund is subject to confirming the position and consolidation. And Pillar Two are unlikely in practise to be an issue, but obviously as you say, subject to checking consolidation, and going on perhaps in a minute to talk about what we might put into the fund documentation just to make sure that we've covered that off.

And, Alex, is the position different then if we're looking at a closely held fund?

Alex:

Yes, it's a good point because indeed the outcome may be a bit different in this scenario and we would particularly want to watch out. I'll try to make it short and simple. When considering a fund of one or a managed account, the initial step is still the same, it is to determine whether the fund would be included in the accounting group of the investor. And as we said before, the concept of control from an accounting perspective is the key triggering element. The fund will be in the investors group if the investor has controlling interest and must consolidate on a line-by-line basis. And Pillar Two could also be triggered by the application of the joint venture rules if the investor consolidates even on the equity method and hold a stake of 50% or more in the fund.

But let's not dramatise the situation. If the investor were to consolidate the fund, then the practical tax implication under Pillar Two depend on a number of other factors, the status of the investor. For example, there are specific rules for sovereign wealth funds investors. Other type of things we would like to focus on are whether that investor is in a Pillar Two jurisdiction or whether the fund is a flow-through entity itself. And the answer to this question may make variation to the actual application under Pillar Two.

But if the fund becomes a constituent entity, the other question to investigate as we said, and the question to ask, is whether the fund could get an exemption from Pillar Two by the application of the contamination exemption rule. And therefore in practise, I think there are still few things to assess to identify the consequences of Pillar Two, even if the fund is part of a MNE group, I think the exercise doesn't stop here. This is what I mean. If the fund of one or the managed account is however not consolidated by the investor, the next question is the same as the previous example and this I want to stress, can the fund be an UPE, and we saw that the answer is likely to be no from the regulatory landscape in Luxembourg in the accounting rules.

So if I put the conclusion words to all this, I think the structure and classification of a fund of one or a managed account introduce several layers of complexity in determining the implication under Pillar Two. And it's essential to thoroughly analyse the investor status, the fund classification, the applicable tax rules, to really fully grasp the Pillar Two position of that fund.

Patricia:

That's so helpful. Clearly in this scenario where it is, as you say, single investor fund or segregated mandate type scenario, Pillar Two has more potential for applying, so there is more to think about.

And just picking up on that, Alastair, I mean, how do you think a fund manager could potentially deal with this sort of issue in a fund document and fund documentation, subscription agreements, et cetera. And what are the approaches that are being taken and that you've seen in the market?

Alistair:

There are three different issues here. The first is what should the fund be doing to make sure that it's investors are aware of Pillar Two. The point there being that the fund wants to protect itself against investors coming along and saying, "Pillar Two was just something that we were not thinking about."

The next issue that comes up is about information. How is it that fund gets the information that it needs to decide how Pillar Two applies in a particular case? As we've heard, this is maybe more of an issue for a single investor fund, but of course there are Pillar Two obligations to satisfy in terms of due diligence and making sure that the fund can demonstrate that Pillar Two does not apply. So all funds need to be thinking about the information and due diligence points. And then finally, what does the fund do about Pillar Two costs? That could be a tax cost or maybe it could be a compliance cost, like the cost of producing a particular accounting information.

So taking those three different issues in turn, the first one, how does a fund make investors aware of Pillar Two? Well, this is an easy one because Pillar Two should be mentioned as a risk factor in the PPM and it should be dealt with in the tax sections, if there are any, so that investors know that Pillar Two is a new regime that they need to be aware of.
The second point, information. As Alexandra was saying, a really important point is for the fund to establish whether an investor is part of a multinational group that includes the fund. And that's not something that the fund can determine on its own, it needs to ask the investors. So how could it do that? Well, it might rely on a general information right in the fund document because fund documents often include that right, for example, to ask investors about their status for the purposes of determining a BEPS issue. It could well be that general information right is wide enough for the fund to rely on, but that's maybe not ideal because that would be to approach investors on an ad hoc basis after the fund is closed.

So what can we do to make things more certain? Well, one option would be to include a statement in the application form that the investor has confirmed that it is not in a group with the fund according to the investor's own consolidation rules. And then another option would be to have an investor questionnaire that includes similar points. That questionnaire would be aimed at establishing whether the investor is part of a multinational group with the fund.

Now, when funds are thinking about which of those options to take, I guess that's a balance, but bearing in mind the particular investors that the fund has. But maybe one thing to bear in mind is that some investors may be in jurisdictions where Pillar Two hasn't yet been introduced, so there needs to be a bit of sensitivity in how the Pillar Two issue is raised. It might be that the investor questionnaire route in a particular case manages to provoke more confusion than might be wanted, and so it could be that in that situation some informal discussions with the investors are better. So the question of information and how you speak to your investors is likely to depend on the investor class.

There's another aspect to the information question and that's, well, what if the investor does form part of a multinational group with the fund? Well, for the investor to comply with its Pillar Two obligations, it may need to ask the fund for information about the fund and its investments. And that information may need to be provided in a particular format that reflects how Pillar Two has been implemented in the investor's jurisdiction. And that could be quite costly. So it's worth the fund considering how that would play out in practise. In particular, it might be sensible to include specific wording somewhere that makes clear that any of those costs that I've mentioned are borne by the investor and not by the fund. Because the investor has asked for that information, so it should be bearing the cost rather than the other investors in the fund.

Finally, what about tax costs that might arise? Well, the practical situation here would be if the investor is part of a multinational group with the fund and the top-up tax arises somewhere within the fund structure. From the perspective of other investors, they're going to say, "Well, that's nothing to do with us because we don't have to consolidate for Pillar Two," but one investor has to. And so those other investors will be keen to know that the top-up tax cost is not going to be economically borne by then.

Now it is worth looking at the particular detail of the agreement, but it's quite likely that the agreement will already have wording in it that allocates the economic burden of taxes caused by particular investors to that investor. If so, that's a neat solution because the fund may not need to change the LPA at all, but just to check that the wording in the particular LPA would apply in a Pillar Two situation to allocate the burden of the top-up tax to the investor who's caused it.

Patricia:

That's all super helpful. And it's interesting, isn't it, that it may be the case that in certain circumstances the fund LPA might actually pick up some of these points.

But in subscription documents, where I think it's fair to say we've seen various approaches being taken, I mean, where do you think the market is at the moment as the approach people are currently taking, as people feel their way towards an answer in all of this?

Alistair:

I think it's fair to say that the market is developing, but what's more common is for the consolidation point to be dealt with in an application form rather than a questionnaire. And for the LPA to, at least at the moment, not specifically deal with Pillar Two. But of course that may well change as investors get more familiar with the issues and may be more amenable to having Pillar Two dealt with expressly in the LPA.

Patricia:

I mean, I totally agree with you. It's a slightly developing market, isn't it? But that approach that you've set out at the moment is sort of a middle ground, where we are hopefully getting the information, but not in a too aggressive stance, for as you say, with the investors taking it back and we cause more problems than we solve by actually asking the questions.

Alistair:

Exactly.

Patricia:

I mean, thank you so much, Adnand, Alex, and Alastair, that's just been super helpful and informative, and thank you so much for sharing your experiences and your insights today. And of course, thank you to everyone who's listening. We very much appreciate all the support.
We hope that you find what we've said in Pillar Two interesting and useful. And of course, if there are any follow up questions that you have on the topic or anything you would like to discuss, please just contact any of us and we'll be delighted to help. This is the first in a series of podcasts that we're going to be doing about tax issues relating to funds. We're really excited about the series that we have planned. There are going to be some really hot topics coming up, particularly with the election, et cetera. So please keep listening and we will notify as and when new podcasts are released. Thank you for listening.