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Complex new world for SPVs
A large and growing area of financial and corporate structuring activity in Luxembourg in recent years has involved special-purpose vehicles. Today they face a dramatic change in the regulatory landscape, thanks to the European Union’s EMIR legislation on derivatives and Alternative Investment Fund Managers Directive, as well as the still-to-be-seen impact of future EU rules on shadow banking and alternative credit providers – but also the opportunities created by the Grand Duchy’s new limited partnership regime.
At the latest Linklaters Luxembourg Breakfast Seminar on 22 May 2014, entitled SPVs: Challenges Ahead, capital markets and banking partner Patrick Geortay, tax partner Olivier Van Ermengem, corporate/M&A partner Nicolas Gauzès and capital markets and banking counsel Mélinda Perera analysed the current role played by SPVs in the Grand Duchy and how this may be affected by the evolving international tax and regulatory environment. Along with other elements of international corporate structuring, SPVs are coming under increased scrutiny from governments concerned that tax avoidance mechanisms may be costing them much-needed revenue.
Many shapes and forms – Corporate form flexibility
Geortay notes that SPVs come in many different shapes and forms, and that they are not necessarily easy to define, but they have broadly accepted features: a corporate vehicle, established and used for a specific transaction or investment, investment pool or financing transaction, unregulated or very lightly regulated, and designed to function in a tax-efficient manner. They can form part of an integrated group or function on a stand-alone basis, separate from the originator, promoter or investors.
Bringing you up to speed.
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In Luxembourg, SPVs may use any corporate form provided for by the country’s companies law, a choice driven by both domestic and international tax considerations, the flexibility required from the corporate regime applicable to the SPV vehicle, and the characteristics of the transaction. For example, for an SPV that will issue bonds to be listed on a financial market, the choice will fall on a public limited company (S.A.) or equivalent rather than a private limited liability company (S.à.r.l.).
The transactions that can be carried out through SPVs include financing transactions, holdings, sub-holdings, intermediate holdings, and structured finance, including securitisations. On the liabilities side, they can use debt instruments, bonds, notes and ordinary financings and conclude derivative transactions. They can hold any type of investment or asset: one or more individual assets, or a pool; assets that are actively managed or that remain static for the duration of the transaction.
Impact of EMIR
SPVs will be impacted by the European Market Infrastructure Regulation, which came in force (partially) in August 2012 and aims to make the derivatives market safer and more transparent, when they enter into derivative contracts for hedging purposes or as financing tools such as total return swaps, Ms Perera says.
In addition to financial institutions, the regulation for the first time imposes direct obligations on all end-users such as corporates, pension funds or hedge funds that enter into derivative contracts, depending on which of four categories – financial counterparties, systemically important non-financial counterparties (NFC-, large derivative users), non-systemically important non-financial counterparties (NFC-), and third-country (non-EU) entities – they fit into.
SPVs: Challenges Ahead – Breakfast Series Bulletin
22 May 2014
If you comply with what is required or advised, at the end of the day you have an SPV with more substance, that is more robust and viable and will be less likely to be subject to challenge within and outside Luxembourg.Patrick Geortay, partner, capital markets and banking group
By contrast, securitisation vehicles clearly are out of scope of the directive and under the banking rules. Joint ventures, which by definition have more than one investor, could be considered to fall under the directive if they have a defined investment policy and are considered to be raising capital, as opposed to receiving capital at the initiative of the partners.
If the SPV is set up as a co-investment vehicle, with only one target company, it is unlikely to be considered an AIF established to invest in various assets according to predefined criteria. Right now the judgement needs to be made by the SPV’s creator(s), since the CSSF is tied up with authorisations ahead of the July deadline and negative clearance of non-AIFs is not a current priority.
Limited partnership ‘sweetener’
In addition to the compliance burden introduced by the AIFMD, Luxembourg at the same time introduced ‘a kind of sweetener’, Gauzès says, with a form of SPV characterised by contractual freedom and a great deal of flexibility. The revised limited partnership regime includes the upgrading and modernisation of the Société en Commandite Simple (Common Limited Partnership or CLP) to provide greater flexibility and track developments in other jurisdictions.
As an unregulated vehicle, the CLP offers a high level of flexibility in the way its capital is structured and paid, whether in cash or in kind, whether or not there are shares or accounts, the level of capital (there is no minimum) and how the entry and exit of limited partners should take place. There is also additional flexibility in terms of management and governance, since a CLP can have non-voting interests (unlike an S.à.r.l., which cannot have non-voting shares).
In addition, the general partner does not have to be the manager, allowing the use of a manager subject to the same liability regime as the directors of an S.A. The limited partners still benefit from limited liability as long as they do not interfere in the management, which is clearly defined.
The legislation also introduced the Société en Commandite Spéciale (Special Limited Partnership or SLP), identical to a CLP but without legal personality. The advantages of this include a further argument to demonstrate that the company is tax-transparent in whatever jurisdiction may be relevant, and in terms of accounting obligations, because the vehicle does not fall within the scope of directives covering other companies. This gives flexibility in reporting to investors. Assets held by the SLP are registered in the name of the partnership and are not accessible to creditors of the limited partners, nor vice versa.
Already Luxembourg limited partnerships have been taken up by early adopters as pure SPVs, but also as funds such as SICARs, and they are under consideration in complex structures as carried interest or management investment vehicles. Says Gauzès: “There is not yet common practice in the market – it is still a work in progress. The templates are still being developed. But as the issues that were first encountered are being addressed and the vehicles become better known, we expect to see their use growing rapidly in the coming months.”
Under most circumstances an SPV will not be classified as a financial counterparty, unless it is considered an alternative investment fund. It will be considered an NFC+ if the rolling average of the gross notional value of its OTC derivative positions in an asset class over 30 working days exceeds any of the thresholds of €1bn for credit- and equity-linked instruments, or €3bn for interest rate, foreign exchange, commodity and other derivatives; if below all the thresholds, they are categorised as NFC-. Programme issuers are more likely to exceed the thresholds than one-off issuers, Ms. Perera notes.
Because the MiFID II legislation has not been implemented in the same way in all EU member states, the definition of derivative differs slightly between countries, prevents EMIR from having a ‘convergence application’, she says. Certain types of instrument that are considered derivatives in certain countries but not in others will not be taken into account until there is more clarification. Derivative positions used for hedging can be deducted from the notional position.
SPVs that exceed the NFC+ thresholds (also if, having done so, fall below them again) are required to notify Luxembourg regulator CSSF and the European Securities and Markets Authority of this. They are subject to three main obligations: reporting, clearing and implementation of risk-mitigation techniques.
Since February this year, the conclusion, modification or termination of a derivative transaction, including intra-group arrangements, must be reported by all end-users, irrespective of their classification, to a trade repository, regulated entities that manage the data on a secure and confidential basis, no later than the following working day. Reporting can be delegated to a derivative counterparty or a third party, but the obligation will remain with the SPV.
The obligation to clear a transaction through a central counterparty does not apply to transactions involving NFC- counterparties, nor to intra-group positions, and is limited to eligible derivatives: standardised and liquid instruments such as interest rate and credit default swaps. For non-cleared, bilateral transactions, risk mitigation techniques apply.
All types of counterparty must conduct ‘good trade hygiene’ including documentation of protection, dispute resolution and portfolio reconciliation, but Ms. Perera notes that this is becoming standard documentation today. Financial and NFC+ counterparties are obliged to monitor the mark-to-market value of the derivative; they are also subject to collateral requirements, capital requirements are limited to prudentially regulated financial counterparties.
SPVs and the AIFMD
Users of SPVs will also have to consider the impact of the AIFMD, which took effect in July 2013 and will apply to all alternative fund managers from 22 July this year. As Gauzès observes, the directive triggers a host of requirements, including the need for the manager to be authorised, rules on remuneration, leverage, delegation, governance and reporting, the placing of fund assets in the custody of a depositary – and the existence of criminal penalties for managing an alternative fund without proper authorisation.
At first sight an SPV might seem to be clearly neither an alternative fund manager (AIFM) nor an alternative fund (AIF). However, definitions are crucial. Holding companies are excluded from the AIFMD scope but their definition in the directive, the company at the top of a group structure, is quite different from the traditional use of SPVs as companies that buy target companies with a view to reselling them. As a result, it could be dangerous to rely on the holding company exemption to assume an SPV is not covered by the AIFMD.
Filling shadow banking gaps – Alternative credit providers
Ms. Perera notes that SPVs also stand to be affected by future regulation targeting the so-called shadow banking sector – credit intermediation involving entities and activities outside the regular banking system, both a contributor to and a result of the financial crisis. The European Commission has identified as shadow banking activities that are currently insufficiently regulated and that involve raising funding with deposit-like characteristics, performing maturity and/or liquidity transformation, allowing credit risk transfer, using direct or indirect leverage and investing in loans. Examples are securitisation and securities lending and repurchase agreements.
It also seeks to address the principal players in such activities, which in Luxembourg include private equity funds, hedge funds, corporates and pension funds, which for the most part use SPVs for their shadow banking investments. The Commission’s aim is to identify the entities that could be covered, map the existing regulatory and supervisory regimes, identify the gaps and suggest possible remedies.
This issue could affect SPVs depending on how they finance themselves and what they do with the money they receive.
On the liabilities side of the balance sheet, they could be considered to be conducting banking activity, by collecting deposits from the public, if they issue bonds to the public on a regular basis, although one or two stand-alone issues would be unlikely to be considered as such. For securitisation vehicles, they would also be regulated if they issue securities to the public on a continuous basis. More than three issues of securities to the public per year may be considered ‘a continuous basis’, requiring licensing of the SPV under Luxembourg’s securitisation law.
On the assets side of the balance sheet, the CSSF has published guidelines on what is and is not considered lending activity that would be subject to the law on the financial sector. Loans will not require regulation if made to a limited circle of previously known persons, if it does not have some kind of ‘professional character’, nor if is used to finance the group to which the SPV belongs. For securitisation vehicles, while an SPV can provide loans, its role should be passive and limited to administration of financial flow and prudent management. It could also acquire a portfolio of loans that are not completely drawn or comprise automatically revolving credit as long as this is within a predefined framework and the SPV has no discretionary power.
International tax pressure
Finally, SPVs are having to adapt to an evolving international tax environment. Van Ermengem notes that exchange of information agreements increasingly cover not only private individuals but structures and their tax situation. The sharing of information by tax administrations, initially within the EU, later across the OECD, and probably eventually worldwide, will impact the way SPVs structure their transactions, he says.
The OECD Base Erosion and Profit Shifting initiative to curb corporate tax avoidance proposes a more stringent assessment of beneficial ownership than has been prevalent up to now. Its recommendation on treaty-shopping proposes that double tax treaties and domestic law incorporate limitation of benefits clauses that will require identification of the parties behind the SPV.
Another BEPS action point, hybrid mismatch, has already been taken up by the European Union, which has proposed amendment of the EU parent-subsidiary directive to prevent member states granting the exemption on dividends that have been deducted or not taxed in the source country, to avoid double non-taxation. Hybrid instruments with this effect are often used in SPV structures, Van Ermengem says.
National legislators are increasingly introducing general anti-abuse rules that typically include a main purpose test, enabling tax administrations to challenge structures or transactions whose motivation or main purpose appears to be tax avoidance or that lack adequate business grounds. This means the business substance of transactions will take on much more importance in the structuring of transactions to make them ‘bullet-proof’ for tax purposes.
Building up substance
Tax residency, a very important consideration in tax planning, was previously linked to either the country where the company was incorporated or where it had its statutory headquarters. Now it is increasingly linked to a company’s substantive activities, where its management and decision-making takes place. Tax administrations are looking at physical elements: the location of the offices, directors, employees and bank accounts. As a result, structures in Luxembourg will probably need to build up their substance.
Already Luxembourg rules on substance cover areas such as a majority of the board and bank accounts being in the Grand Duchy. An area likely to grow in importance is that the transactions and remuneration of the finance SPV are supported by a transfer pricing report compliant with OECD principles. Says Van Ermengem: “It also helps to get the Luxembourg tax administration on your side, because they are more comfortable about granting rulings. It is security for them and for you, as well as adding substance to your activity.”
The final point, he says, is the business rationale for choosing Luxembourg: why a structure passes through Luxembourg – for example, for regulatory purposes. One client came especially to Luxembourg because it offers a securitisation vehicle regime allowing compartments, which was not available elsewhere.
Conclusion: Challenges, but also opportunities
Geortay notes that substance is critical not only for tax purposes but to enable compliance with new and future regulatory requirements, and that this represents both challenges and opportunities. He says: “If you comply with what is required or advised, at the end of the day you have an SPV with more substance, that is more robust and viable and will be less likely to be subject to challenge within and outside Luxembourg.”
Speakers’ details
Patrick GeortayPartner, LuxembourgTel: +352 2608 [email protected]
Nicolas GauzèsPartner, LuxembourgTel: +352 2608 [email protected]
Olivier Van ErmengemPartner, LuxembourgTel: +352 2608 [email protected]
Mélinda PereraCounsel, LuxembourgTel: +352 2608 [email protected]
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