The primary corporate law in Luxembourg is the Luxembourg Law on Commercial Companies of 10 August 1915, as amended, which governs all of the (unregulated) corporate vehicles used in the Luxembourg market.
Luxembourg is attractive to the private equity market, for many reasons. While it has a reputation as a country which offers favourable tax treatment, many other features of the legal, regulatory and general commercial environment make it a suitable destination for private equity investors.
Surveys of some of the largest private equity firms have shown that the key factors identified for selecting Luxembourg were:
- its legal and regulatory environment;
- political and tax stability;
- its reputation; and
- the availability of skilled workers.
Regulated funds established in Luxembourg are subject to prior authorisation and supervision by the Commission de Surveillance du Secteur Financier (CSSF).
A detailed discussion on the regulated funds sector in Luxembourg falls outside the scope of this Q&A.
In the context of private equity transactions, there is limited regulatory involvement – generally this is relevant only to the extent that the target vehicle is itself a regulated entity. To avoid delays in the transaction process, if a regulated entity is involved, the CSSF should be involved as soon as possible and kept abreast of developments as the transaction advances.
A chain of Luxembourg entities is frequently involved in the structure. In recent years, sociétés en commandite spéciale (SCSs) (without legal personality) and sociétés en commandite simple (SCSps) have commonly been used as part of this structuring. These vehicles have become more popular as they allow parties significant flexibility with respect to the transfer of interests and distribution mechanisms. In addition, unlike the more traditional corporate vehicles, whose constitutional documents (articles of association) must be published in full, only a limited number of provisions of the relevant partnership agreement must be published.
This considerable degree of flexibility and confidentiality makes these vehicles attractive when multiple parties are investing; while the société à responsabilité limitée (Sarl) remains the most popular choice for finance entities and acquisition vehicles further down the chain. It is also possible for such minority investments to be for pure debt instruments or convertible instruments such as convertible bonds or warrants that can be converted into equity.
In terms of the actual transaction document and process, it is most common to see privately negotiated sale and purchase agreements, rather than auction sales.
The structures described in question 3.1 are relatively simple to establish and run. The SCS and the SCSp are particularly flexible vehicles and offer a high degree of confidentiality as regards governance and distribution mechanics, as there is no requirement to publish the partnership agreement.
However, as unregulated entities, it is not possible to create segregated portfolios of assets and liabilities (compartments), as it is possible to do with regulated fund vehicles (a detailed examination of which is beyond the scope of this Q&A).
The tax treatment of certain vehicles is also a key consideration in deciding on the specific transaction structure. One significant tax consideration is the fact that the SCS and SCSp, although advantageous for many reasons (as outlined above), are tax transparent and not subject to corporate income tax. Depending on the overall structuring, it may be more appropriate to opt for a taxable entity, such as the socieìteì en commandite par actions (SCA) (a taxable partnership, which, similar to the SCS and SCSp, can also have management through an unlimited liability general partner).
A wide range of funding structures is available under Luxembourg law. Typically, transactions are funded by investors through a variety of different funding instruments, split between equity (ordinary shares, preference shares, parts beneficiaires, warrants) and debt instruments (loans, bonds, preferred equity certificates), with most transactions involving a combination of two or more such instruments.
Bank financing remains a significant aspect of financing private equity transactions, with banks typically securing their loans through pledge agreements (most commonly share, receivable and account pledges).
The Luxembourg Collateral Act of 5 August 2005 (as amended) is widely regarded as being a creditor-friendly statute and is a favourable aspect of the Luxembourg legislative framework for private equity transactions.
It is not unusual for a lender to require that the borrowing entity in a transaction be established as a Luxembourg vehicle, in order to benefit from the creditor protection offered by the Collateral Act.
Debt funding can generally be put in place more quickly and with fewer formalities than equity instruments. It is also easier to facilitate repayment to lenders under debt instruments than it is to distribute monies under equity instruments. However, while ease of implementation and ease of cash repatriation may certainly be a relevant consideration, the decision as to the nature of the funding will also be impacted by tax considerations and the required control structure.
There are, of course, practical complications as a result of having multiple jurisdictions involved in one transaction. Closings must be carefully organised, with particular attention being paid to the timing of wire transfers. However, such practical points are easily addressed with some advance planning.
A more significant attention point from a Luxembourg law perspective is the fact that Luxembourg adopts the ‘real seat’ theory, meaning that – unlike other jurisdictions, such as the Netherlands, Ireland and the United Kingdom, which adopt the incorporation theory – a Luxembourg entity will be considered as a Luxembourg entity and subject to the laws of Luxembourg only to the extent that it has its ‘real seat’ in Luxembourg.
There are many different terms used in connection with this concept – ‘central administration’, ‘principal establishment’, ‘effective management’, ‘domicile’ – with the Luxembourg companies law referring to both ‘central administration’ and ‘domicile’. There is a rebuttable presumption as a matter of law that a company’s central administration is at the address of its registered office. Some of the key criteria in order to establish presence in Luxembourg (from a corporate law perspective) include:
- having corporate records maintained at the registered office of the company;
- holding shareholders’ meetings in Luxembourg; and
- perhaps most significantly, having physical board meetings in Luxembourg, at which significant decisions in the life of the company are taken.
From a tax perspective, the question can be more nuanced, as the level of substance required in Luxembourg depends to a certain extent on the other jurisdictions involved and the risk that they may challenge the substance of the company’s presence in Luxembourg.
This is an important point to be considered on a case-by-case basis.
If multiple investors are involved, it may be preferable to opt for an SCS or SCSp rather than one of the more traditional corporate vehicles.
While the Sarl, société anonyme and SCA are still very commonly used in practice, the new partnership vehicles offer significantly more flexibility in terms of unit transfers, issuances, distribution provisions and so on, which can be particularly helpful when dealing with multiple investors.
In the context of an investment in a target Luxembourg vehicle, the initial actions are establishing the acquisition structure and conducting due diligence on the target.
From a practical perspective, the opening of a bank account and the establishment of a relationship with a domiciliation agency as part of the set-up of the investment/acquisition structure can be the most time-consuming part of the process. The bank account is required if a société à responsabilité limitée (Sarl), société anonyme or socieìteì en commandite par actions is being used as part of the process, as these require that the share capital be wired to a bank account in the name of the company and blocked for the purposes of the notarial meeting at which the company is incorporated.
As the société en commandite simple and the société en commandite spéciale can be created by a private instrument between their members (the limited partnership agreement), the process is more straightforward; however, as a general partner is required for these vehicles and this frequently takes the form of a newly established Luxembourg Sarl, the bank account opening time constraints will apply in any event.
The typical Luxembourg target is a holding vehicle and, as such, diligence on these vehicles is generally limited to the following:
- a review of key constitutional documentation – articles of association and shareholders’ agreement (if any);
- diligence on the chain of title to shares and a review of any pledges in place (over shares or otherwise);
- a review of annual accounts and tax returns, including whether the company has been compliant with its filings; and
- a review of corporate decisions.
Generally, unless the target is a regulated entity, no regulatory clearances are required as part of the process.
From a competition law perspective, Luxembourg has no prior merger control regime.
Legal, tax and accounting advisers are usually involved in the due diligence process.
Legal and tax advisers are also heavily involved in the negotiation of the transaction documentation and the structuring of the investment structure.
Both locked box and closing accounts are common pricing mechanisms. Locked box pricing mechanisms are more typically seen when the parties are looking to minimise post-transaction adjustments to consideration, as would occur with the closing accounts pricing mechanism.
Break fees are permitted, but will be characterised as a penalty clause under Luxembourg law and will thus be subject to revision (upwards or downwards) if challenged in court.
As in other jurisdictions, the standard way to allocate risk between a buyer and seller in Luxembourg is through the use of warranties and indemnities in the acquisition agreement. Financial sponsors are reluctant to give anything other than the basic warranties upon sale (ie, warranties as to title, capacity and authority).
The ultimate approach agreed to the level of warranty and indemnity protection very much depends on the relative bargaining power of the parties involved.
The approach to representations and warranties in Luxembourg is common to that seen in other European markets.
Representations and warranties are subject to certain limitations – usually, a time limitation of between one and two years and capped at an amount by reference to the purchase price.
In limited cases, where there is a known potential exposure, a portion of the purchase price may be retained to cover such exposure; but this is not common in private equity transactions.
Warranty and indemnity insurance is common in private equity transactions. When used, it can simplify the negotiation of the warranties between seller and buyer; but equally, putting such insurance in place can lengthen and complicate the due diligence process, as the insurer will also require access to the due diligence documentation.
Management incentive schemes can be implemented in various ways, depending on a number of different factors, including the type of corporate entity involved and the residence of participating management. Most commonly, they take the form of the issuance of a separate class of shares with specific economic rights attached. These can be held directly or through a pooling vehicle, depending on the desired control structure and the number of participants. It is worth noting – both in the context of management incentive schemes and more generally as regards management participation in Luxembourg entities – that Luxembourg public limited liability companies (SAs) have the ability to issue free shares to employees and management, both in the SA itself and in certain group companies. This offers significant flexibility in the implementation of management incentive schemes in such entities – before the free shares concept was introduced in 2016, the legal requirement to pay up a minimum of one-quarter of the nominal value of a share in an SA prior to issuance had complicated the process. It is also possible to issue to management share-like securities known as parts bénéficiaires, whose features are as set out in the articles of association. This flexibility with regard to voting rights economic entitlement makes them an attractive option for use in certain situations.
The Luxembourg income tax law distinguishes between two categories of carried interest income earned by the employees of alternative investment fund managers or management companies of alternative investment funds (AIFs):
- carried interest not structured under units, shares or representation issued by an AIF; and
- carried interest structured under units, shares or securities issued by an AIF.
The return on the former type of carried interest arrangement is taxed at the progressive income tax rate up to 45.78%. Capital gains on the second type of carried interest realised are subject to the same progressive income tax rate. However, if the gain is realised after a period of six months, it is not subject to taxation, unless the carried interest represents a substantial stake in a tax-opaque AIF. Such a substantial stake is generally present if the carried interest directly or indirectly represents more than 10% of the AIF’s capital. In this case, gains are taxed at half the progressive income tax rate (maximum tax rate of 22.89%). To ensure that the income paid under the second type of carried interest arrangement benefits from this exemption, the carried interest holder should dispose of its carried interest, which will generally entail a buy-back of carried units by the AIF.
Based on Circular LIR 104/21 of 29 November 2017 on stock options, transferable options are subject to taxation at the granting date, whereas individual/virtual options are taxed at the date of exercise. For transferable options granted on or after 1 January 2018 which are not listed and are not valued in line with a recognised financial method, the benefit is determined at 30% of the value of the underlying shares. In addition, all stock options granted as of 1 January 2018 must be notified to the Luxembourg tax authorities at each granting date of the stock options. For Luxembourg social security purposes, contributions are due on the granting of options. However, where the annual remuneration of the employee already exceeds the Luxembourg annual social security ceiling (€128,519.64 for the year 2020), no additional Luxembourg social security contributions will be due, except for dependence insurance at a rate of 1.4% due by the employee.
A new Circular LIR 104/2 has replaced those issued on 20 December 2012 and on 28 December 2015, as well as Service Notes LIR/NS 104/3 of 22 May 2013 and 104/4 of 12 January 2015.
Manager shareholders typically have a very small percentage stake in the company and accordingly, their vote is not decisive. Depending on the form of corporate entity involved, they may be given shares without voting rights or may be issued voting shares on condition that they elect to suspend such voting rights following subscription.
Another alternative is to issue parts beneficiaries, which are a flexible instrument that can be issued with or without voting rights and do not form part of the share capital of the company. If expressly provided for in the articles of association of the company (relevant for the société à responsabilité limitée (Sarl), SA and socieìteì en commandite par actions), it is possible to authorise the board to suspend the voting rights of any shareholder who breaches his or her obligations under the articles of association or the subscription agreement.
It is relatively common for breach of a manager shareholder’s obligation to be sanctioned by the compulsory transfer of his or her shares. Such compulsory transfer mechanism is generally regarded as valid, provided that:
- it is set out in the articles at the time the relevant shareholder acquires the shares;
- the triggers are framed by reference to objective criteria set out in the articles;
- the prescribed procedure for operating the compulsory transfer provisions is followed; and
- the leaver is entitled to receive a ‘fair price’ for his or her shares, with the mechanism to calculate the price also being set out in the articles at the time the relevant shareholder acquires the shares.
Luxembourg takes a similar approach to other jurisdictions as regards good and bad leavers. Good leavers generally include those leaving for reasons outside of their control – illness, incapacity or death. Bad leavers are typically defined as those who voluntarily resign or are dismissed for cause.
It is common to have a right to nominate a number of board members for appointment to the board commensurate with the percentage interest held in the Luxembourg portfolio company. Although there is no percentage ownership which legally carries a board nomination right, in practice, a board nomination right is often given for shareholder interests of 15% and above. The nomination right is usually coupled with a voting commitment from the other shareholders to vote in favour of the appointment of such persons put forward.
Minority shareholders or investors seeking a more passive role in the structure may be granted an observer right with the ability to be convened to all board meetings and attend such meetings, but without any right to speak at or vote at such meetings.
Consideration of substance in Luxembourg (as discussed at question 3.5) also impacts on governance, as in addition to balancing nomination rights between shareholders in the event of multiple investors, it is also necessary to strike a balance between Luxembourg residents and non-residents on the board.
As a general principle of Luxembourg law, Luxembourg does not generally accommodate the broad concept of group interest, as is the case in other jurisdictions. The members of the board of a Luxembourg company will therefore be legally required to consider and take decisions in the interests of the company itself on a standalone basis, and not in the interests of the nominating shareholder. However, there is case law which recognises that what is in the interests of the company will vary from case to case; and for Luxembourg entities whose sole purpose is to act as financing or holding companies, the interest of the company’s shareholders (as a group) will be of primary importance.
The private equity firm should also give consideration to the composition of the board overall and whether the persons it is appointing are persons who are willing to travel to Luxembourg to attend physical meetings in person. These considerations are even more significant given the current global travel restrictions. It may be worth considering appointing local independent persons to the board of managers, rather than appointing internal persons from the organisation who will be unable to physically travel to Luxembourg on a regular basis.
The veto power depends on the percentage ownership and the negotiated terms of the investment. It is common to have certain decisions at board level subject to prior shareholder approval – for example, a material change in the business plan, or the sale of a significant asset. From a Luxembourg law perspective, it is important only to ensure that the veto rights do not deprive the board of its function entirely. The board must remain the organ which manages the company and cannot be stripped of this function by virtue of all decisions being escalated to shareholder level or being taken subject to approval by one board member alone.
Regardless of the percentage investment in the portfolio company, a private equity investor will always be provided with standard information rights, such as the right to receive quarterly management accounts.
With respect to the ability to influence the performance of the portfolio company, this is typically achieved only through the methods already outlined above – that is, board representation and the reservation of certain decisions to the shareholders.
If all investors are exiting together upon the sale of the underlying investment held by the Luxembourg entity, the most common exit mechanism is the sale of the investment followed by liquidation of the holding company, which permits a tax-efficient repatriation of proceeds.
In circumstances where the exit is being facilitated by the sale of the Luxembourg vehicle itself, a private equity firm holding a majority interest will have addressed this during the implementation stage by negotiating drag-along provisions to enable the sale of the entirety of the Luxembourg vehicle. Similarly, as a minority investor, tag-along provisions will commonly be negotiated in order to ensure an exit route in the event of the sale of the majority stake.
In a partial exit scenario, the choice of exit strategies is as varied as the choice of investment instruments. If the investment in the Luxembourg vehicle is through shares, then the exit can be by way of share redemption; if the investment is by way of debt funding, exit will be by debt repayment and so on.
There are no specific regulatory considerations in connection with the exit strategies outlined above. If part of the anticipated exit strategy is the liquidation of the selling Luxembourg holding vehicle, consideration should be given as to whether there is any potential exposure for the company under representations and warranties provided as part of the sales process which would need to be addressed as part of the liquidation process.
Luxembourg is typically the host jurisdiction of the private equity fund and the acquisition structure. Key tax points of focus include:
- the substance of the Luxembourg acquisition structure;
- securing interest deductions at target and holding company level; and
- safeguarding the tax neutrality of the fund vehicle.
The key risk is the loss of tax-deductible interest accruals because of the Luxembourg implementation of the Anti-tax Avoidance Directives. Those risks may potentially materialise if a Luxembourg fund organised as a limited partnership onboards so-called ‘bad investors’. Bad investors view the Luxembourg fund as tax opaque. This situation potentially gives rise to a hybrid arrangement and therefore a loss of interest deduction capacity.
Good investors typically require protection against such tax leakage caused by bad investors. Protection can be provided through specific structuring or through clauses in the limited partnership agreement.
Tax strategies are typically focused on accommodating sufficient substance and beneficial ownership at the level of the Luxembourg investment structure.
A sufficient level of substance and beneficial ownership should generally protect against tax claims arising in the target jurisdictions. Although predominantly driven by business considerations, the design of acquisition structures typically anticipates securing tax deductions and flexible and tax-free repatriations of cash back up to the fund.
Luxembourg is a very significant jurisdiction for private equity capital raising and transaction activity. Brexit has led to further growth in the market in Luxembourg, as many private equity firms have taken the opportunity to strengthen their presence here.
However, despite this recent growth and the possibilities offered as a result of Brexit, the challenges faced in 2020 as a result of the COVID-19 pandemic are unprecedented and private equity firms have not been immune from the uncertainty which the pandemic has created across all aspects of the global economy.
While, unsurprisingly, transaction activity slowed in the early months as a result of parties choosing to postpone until there was more stability, there are still many private equity firms with cash available which are looking for investment opportunities and – again as a result of the pandemic – there are many investment opportunities out there.
Directive (EU) 2018/822 relating to the mandatory exchange of information in the field of taxation in relation to reportable cross-border arrangements (DAC 6), which applies to cross-border arrangements whose first step was implemented after 25 June 2018, was set to enter into force on 1 July 2020. As a result of the COVID-19 pandemic, however, Luxembourg has been given a further six months before the reporting obligation takes effect – it will now take effect on 1 January 2021. While private equity investments are not the focus of DAC 6, assessing the potential application of this law will become a necessary part of every transaction.
Transactions will be reportable if they meet certain characteristics as set out in the law, referred to as ‘hallmarks’. Some of these hallmarks are also subject to the main benefit test – that is, the transaction is reportable if the main benefit (or one of the main benefits) is obtaining a tax advantage. Many, if not all, private equity transactions will not satisfy the main benefit test on the basis that, although there may be tax structuring considerations, the main drivers behind the transactions are legitimate commercial reasons and not the creation of tax benefits.
In May 2020, a bill of law was submitted to the Luxembourg Parliament aimed at introducing a procedure for the screening of foreign investments. The bill is at a very early stage, but its focus is on introducing a requirement to make a prior notification to the minister of the Economy in Luxembourg of foreign investments of more than 10% in a company or group of companies established in Luxembourg, with the minister then authorising or refusing such proposed investment based on a specific procedure.
As outlined in this Q&A, the Luxembourg market is one in which private equity can thrive. Other than the challenges outlined above, there are no particular attention points of which to be aware.
