Luxembourg funds lose German tax exemption

Luxembourg, a popular fund domicile for GPs worldwide, has signed a double tax treaty with Germany that could introduce withholding tax on hybrid debt instruments used to help acquire German targets.

No longer will private equity or real estate funds based in Luxembourg escape a 26 percent withholding tax when using hybrid debt instruments to help finance German acquisitions. Last month the two countries signed a new double tax treaty, subjecting GPs worldwide that use Luxembourg as a tax efficient jurisdiction for German inbound investment to new tax concerns. 

German target companies are often capitalised through hybrid debt instruments (such as profit participating loans) by which a certain portion of German derived profits is repatriated, according to a client memo from Dechert, a law firm. 

Currently an investment in a German portfolio company using a combination of equity and profit contingency element debt is being granted full tax relief under the 1958 treaty. 

The updated treaty means that this exemption no longer applies and interest payments from hybrid instruments will be treated as debt from a tax perspective and charged the full withholding tax rate.

This German specific provision ensures Germany does not lose out from repatriated profits from foreign investors, according to sources. 

“It’s here to make sure that these investors leave a certain amount of tax at the German table,” said Hans Stamm, partner at law firm Dechert, in an interview with PE Manager.

However, Luxembourg investment funds in the legal form of a SICAV, SIVAF or SICAR are to be able to claim certain treaty benefits, leading to a reduction of German withholding tax from 26.4 percent to 15 percent on portfolio dividends and to 0 percent for interest payments, the memo said.  

Currently these funds benefited from a reduction or exemption in tax due to a mere administrative procedure in Germany and Luxembourg but now they can claim the benefit in their own names.

“It has been administrative practice for many years and I would guess that Luxembourg as a jurisdiction was extremely interested to set the benefits in stone and have an explicit provision which makes it crystal clear,” said Stamm. “It’s definitely positive for Luxembourg as a fund centre.”

The Treaty is expected to be ratified by the two parliaments and will in principle apply from start of 2013.