Brief introduction to SCSp and its purpose
A société en commandite spéciale or SCSp is a type of limited partnership structure formed under Luxembourg law. It’s set up for a limited period to hold assets such as real estate and other investments on behalf of its partners.
The SCSp is governed by the terms of a partnership agreement and, provided certain conditions are met, is ‘tax transparent’ for corporate income tax (CIT) and net wealth tax (NWT). Since the SCSp doesn’t carry on a business, it generally won’t pay municipal business tax (MBT) and any distributions to investors won’t be subject to Luxembourg withholding tax.
Importance of tax transparency in investment vehicles
Tax transparency is crucial for investment vehicles like SCSp because it provides a tax-efficient structure, allowing investors to avoid double taxation—first at the entity level and again at the individual level. This efficiency not only maximizes returns but also enhances the attractiveness of SCSp for both domestic and international investors.
Since most investment vehicles are not tax transparent, an investment through them would be taxed twice: once at vehicle level, and once at the investor level. A transparent vehicle means that an investor is only taxed at their own level.
Since the SCSp itself is not subject to tax, any investors are treated as receiving income directly from the underlying assets owned by the partnership with no taxation at the level of the SCSp.
What is Tax Transparency?
Definition and significance
Income tax regimes generally distinguish between physical persons and legal entities such as corporations.
Because of this duality, there’s a danger that income generated by an entity is taxed more than once, first on the entity level (as a tax on corporate income like CIT) and secondly on the individual level when the entity distributes the profits to the investors. This poses a problem for investors and potentially discourages net investment through an entity.
As a result, certain jurisdictions decide to recognize the entity as existing, meaning that it segregates the assets of the entity from the assets of their partners. But they may yet then enact rules that allow any income generated by the assets to accrue directly to the partners. This is known as tax transparency.
How it applies to investment vehicles like SCSps
SCSps are considered tax-transparent entities so they aren’t liable for CIT in Luxembourg, although the partners will be taxed in their countries of residence on any income they receive. The SCSp is also a tax-transparent entity for NWT.
The SCSp may, however, pay MBT under certain circumstances. Though all SCSps that do not have a commercial activity and where the GP holds less than 5% will not be subject to MBT. Most often this is the case for SCSps that are used as investment vehicles.
Because an SCSp is fully tax transparent, it won’t reap the benefits of tax treaties concluded by Luxembourg. Rather, investors can claim the benefit of tax treaties between their country of residence and the country in which the investments are based.
Differences between tax-transparent and non-tax-transparent entities
Because tax systems distinguish between physical and legal persons, they need to decide who to tax when the entity generates income for the benefit of its owners. Either they can tax the entity itself (a non-tax-transparent entity) on that income, or provide for tax transparency in which the income is considered to flow directly from its original source into the hands of the recipients – the investors.
Examples of non-tax-transparent entities
Examples of non-tax-transparent entities are most corporate entities such as corporations and partnerships, in some cases, carrying out commercial activities, as opposed to those purely being investment vehicles.
Tax Treatment of SCSps
Explanation of the tax status of SCSps in various jurisdictions
An SCSp may be treated as non-tax-transparent or tax opaque in certain jurisdictions, even though it’s considered tax-transparent in Luxembourg. This makes it a ‘hybrid entity’ and special ‘anti-hybrid’ rules apply. In this case, the SCSp may become liable for tax in Luxembourg.
Advantages of Tax Transparency for SCSps
Benefits for investors
Enhanced attractiveness to international investors
The attractiveness of SCSps is their tax treatment. Because the SCSp doesn't pay corporation tax, income tax or tax on capital gains, the income is only taxed in the hands of the investor. Therefore, the risk of double taxation (taxation at the level of the SCSp as well as in the country of residence of the international investor) is removed.
Regulatory Framework
Key regulations governing the tax transparency of SCSps
SCSps may become subject to Luxembourg CIT if and when they are deemed a reverse hybrid entity, but only on the part of profits attributable to those investors who trigger such qualification.
Take a group of foreign investors acting together as a group of companies, or perhaps they are family members. If the aggregate percentage of these investors with countries of residence that regard SCSps as being tax opaque amounts to 50% or more of the rights (voting rights, capital ownership rights or dividend rights) in the SCSp, then the SCSp will be taxed. These investors are sometimes called ‘bad investors’ and this rule is known as the ‘reverse hybrid’ rule.
When calculating the 50%, the interests of any investors ‘acting together’ are aggregated, unless they each hold less than 10% of the investment.
There’s also an exemption for collective investment vehicles (CIV) that are widely held, diversified, and subject to investor-protection rules such as AIFs. This is very important for SCSps operating as investment funds and is known as the CIV exemption.
Specific requirements and conditions for maintaining tax transparency
To maintain tax transparency, certain rules need to be kept in mind:
- Make sure that the investors in the SCSp are based in a country which recognizes the SCSp fiscal transparency, or at least that if they do not, they hold less than 50% of the interests in the SCSp.
- For the CIV exemption to apply, the fund must be ‘widely held’. Since this is not legally defined, it can be tricky to determine whether it applies
Challenges and Considerations
Potential challenges in maintaining tax transparency
As we’ve seen, the reverse hybrid rules assume that tax savings are the main goal of investors if ‘bad investors’ own at least 50% of the fund. To assess this, fund managers need investors to disclose whether their home jurisdictions regard the fund as non-transparent. As such, they need to monitor the investment pool closely.
Conclusion
Summary of key points
- An SCSp is a tax-transparent entity for corporate income tax and net-wealth tax in Luxembourg. The SCSp will therefore not pay these taxes there, although the investors will pay tax in their countries of residence
- Municipal business tax (MBT) may be levied on the SCSp if it carries on a business activity, or its general partner holds an interest in the SCSp of 5% or more
- An SCSp enables investors to benefit from tax treaties between their country of residence and the countries in which the investments are located
- The reverse hybrid rule may lead to an SCSp becoming taxable
- Fund managers need to closely monitor investors’ profiles to ensure that the reverse hybrid rules don’t come into play
Final thoughts on the benefits and importance of tax transparency for SCSps
The main benefit of tax transparency for an SCSp is certainty for fund managers and investors alike. This certainty along with clarity as to whether and how much tax may be levied on profits and gains arising from the SCSp portfolio are key factors in attracting investors.
Recommendations for investors and fund managers
Because the reverse hybrid rules may make an SCSp taxable, fund managers must take care to monitor their investor profiles closely, and investors must be completely transparent with those fund managers. Since a taxable fund is not a good look for fund managers, as well as monitoring their investor base, they should make sure that their partnership agreement contains clauses that enable them to force investors to arrange for their holdings to be restructured so that the fund remains compliant.
References
[1] https://www.pwc.lu/en/real-estate/docs/pwc-re-lux-special-partnership.pdf
[8] https://www.imf.org/external/pubs/nft/1998/tlaw/eng/ch21.pdf
[9] https://assets.kpmg.com/content/dam/kpmg/lu/pdf/cheat-sheet-for-limited-partnership.pdf
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