The Grand Duchy of Luxembourg has developed over the past decades into an important financial centre that is nowadays perceived as a brand by professionals across the financial industry. This is particularly true for the investment funds industry where Luxembourg has become the second largest domicile for investment funds worldwide and the first one in Europe in terms of assets under management. Assets under management in Luxembourg have increased by nearly 30 per cent over the last three years, reaching 4,159 billion Euro in regulated entities (as at 31 December 2017), and even more if non-supervised entities were to be included in the statistics released by the Luxembourg regulator.
Of course, Luxembourg has had to compete with other key financial centres to gain this leadership position. In particular, Luxembourg has proven, by coming through the latest financial turmoil, that the pillars on which it has built its financial industry are robust and reliable. These pillars are (i) tax neutrality; (ii) structuring flexibility in a stable legal environment; and (iii) investors’ protection. Luxembourg has managed to achieve a balanced combination of these three elements to gain credibility from investors, managers and major multinational companies.The question is whether current international changes are likely to affect this situation. Indeed, the OECD’s initiative to tackle base erosion and profit shifting (BEPS) as well as Brexit are likely to adversely affect the position of Luxembourg as a major financial centre in the future.
Paradigm shift in the tax environment
Clearly, a competitive tax framework is a key feature of the success of Luxembourg domicile. However, the OECD initiative tends to tackle tax avoidance and tax planning strategies that artificially shift profits to lower tax locations. For example, the so-called ’Multilateral Instrument’ (“MLI”) should oblige economic operators to justify the creation of a structure in a specific jurisdiction and put them in a position where they have to demonstrate that such structure is not set up to avoid taxation: this is the ‘principal purpose test’ introduced by the MLI.
Although this may be a challenge for the Luxembourg market place going forward, the OECD rules should also empower the country as it already has the infrastructure in place to offer and support the creation of a true fund management business in Luxembourg. Reliance on the fund infrastructure in place in Luxembourg should offer fund managers, in particular in the alternative investment fund industry, the possibility to use the regulatory framework to create a Luxembourg-based fund management activity that may help to support the analysis under the BEPS environment. Consequently, Luxembourg, through its current legal and regulatory framework, remains a first-choice domicile as it allows joining both tax and regulatory substance in an investment fund environment.
Uncertainties and opportunities in relation to Brexit
Luxembourg is very often listed as a first-choice jurisdiction when discussing options with UK-based fund managers due to its reputation as an onshore financial centre and the existence of a fund industry dedicated infrastructure. One of the first blows of the UK’s decision to leave the EU was felt in Luxembourg shortly after the vote: some managers of open-ended investment structures or funds, the offering period of which would not be closed by the effective Brexit date, took the decision to relocate their funds to ensure ongoing compliance with AIFMD and the related EU passport benefits. Although some private equity / real estate managers have taken the decision to relocate part of their fund management activities to Luxembourg, a vast majority prefer to wait until they receive more certainty on the divorce terms. With the deadline approaching, a second wave of managers is now moving to Luxembourg to be able to address the European market going forward. M&G, AIG, Blackstone, and Carlyle are among those important players.
The European Supervisory Market Authority (“ESMA”) has indicated in its opinion on investment management in the context of Brexit published on 13 July 2017 that “(…) relocating UK entities should undergo the same authorisation procedure and be subject to the same standards as other applicants (…)”. Having this in mind, operators have relied on the experience, expertise and pragmatism of the Luxembourg supervisory authority of the financial sector, the CSSF, to carry out such regulatory approval processes in a timely and business-oriented manner, in particular when it comes to the appreciation of the calibration of the governance structures and internal control mechanisms put in place in Luxembourg, in light of the ‘no letter-box entity’ and proportionality principles. In this regard, the CSSF’s position seems to ensure that the substance and organisation put in place in Luxembourg is proportionate to the size of the business of the relocating entity.
True management structure
In addition, ESMA, in the above opinion, also indicated that management companies located in one jurisdiction that intend to outsource the asset management function to another place, within or outside the EU, should (i) justify to their EU national competent authority the objective reasons underlying such delegation decision and (ii) carry out an initial and ongoing thorough due diligence on the proposed delegate, be it within the same group. This should certainly push towards the creation of a true management structure in Luxembourg with substance and business activity in order to meet the above ESMA requirements.
ESMA also seized the opportunity presented by Brexit to try to hold up additional competences to the national authorities and in particular the CSSF. Indeed, in its opinion, ESMA also indicates that it intends to be in charge of authorisation of cross-border delegations, which power should not be in the hands of the national regulators. At this stage, this is only ESMA’s opinion, and one should wait until the European Commission issues its opinion to see if such a transfer will indeed become a reality. Luxembourg and other countries are clearly pushing back ESMA’s proposition, as such a transfer would, in their view, be detrimental to market players since such an additional mechanism would result in a longer authorisation timeframe, additional costs and a heavier regulatory burden. Furthermore, as the current regulatory practice of national competent authorities works in a very satisfactory way in a UCITS or AIFMD European context, one fails to understand why ESMA suddenly barges in with this claim.
In light of the above, does Brexit present a clear opportunity for Luxembourg? At this stage, it looks like it does; however, no one knows at this stage what form Brexit will take with respect to the financial sector, as the question of mutual recognition has not yet been clarified. If one considers that there should be some kind of agreement to allow reciprocal access to EU and UK markets, it is not clear yet which type of equivalence of rules should be required: similar rules, substantially equivalent rules, common principles. So political uncertainty is clearly at the moment delaying strategical decisions for industry players as to their relocation to Luxembourg, but for how long?
To conclude: Luxembourg has already started to modernise its economy to provide high-quality services and infrastructure from a legal, professional and technical standpoint to the financial industry and to ensure that, whatever the situation is in the future, it is able to compete with other EU or international domiciles. But until there is unambiguous political certainty about Brexit, market players will certainly prefer to wait until the last minute before finalising their decision on relocation of their fund management activities to Luxembourg.
Edouard D’Anterroches is lawyer and partner at AKD Luxembourg’s investment funds practice specialising in a wide range of investment funds with a focus on private investment structures dedicated to private equity, real estate, debt, infrastructure and impact finance strategies. He advises on compliance with Luxembourg obligations under the AIFMD and related contractual arrangements. Prior to joining AKD, he worked for Arendt & Medernach S.A.