CHEVALIER & SCIALES the new luxembourg fund l aw implementing ucits iv client memorandum 2011 investment management
This publication has been prepared by the law firm Chevalier & Sciales and is for general guidance only. The contents hereof are not intended to constitute legal advice and should not be treated as a substitute for the consultation with legal counsel necessary before concluding any transaction or undertaking.
contents 01 introduction 02 background to the new investment fund l aw 03 transitional arrangements 04 cross-investment by sub-funds 05 investor information and governance 06 delegation of functions 3 07 exemptions from the subscription ta x 08 other taxation issues 09 potential future changes to luxembourg s fund legisl ation
introduction On December 17, 2010, the legislation implementing the latest European Union directive on Undertakings for Collective Investment in Transferable Securities known to the world as Ucits IV was signed into Luxembourg law, upholding the proactive, pace-setting approach that over the past two decades has enabled the grand duchy to carve out a position of leadership in the European investment fund industry and one second worldwide only to the United States. The early passage of the law by Luxembourg, the first EU member state to adopt the Ucits IV rules, gave the country s fund industry the maximum time to prepare for the entry into effect of the directive on July 1, 2011. However, it also offered the opportunity to amend other aspects of Luxembourg s fund legislation including measures affecting vehicles not subject to the Ucits regime for the cross-border distribution of retail funds across Europe. 4 The legislation clarifies a number of areas relating to the regulation and tax treatment of Luxembourg funds and investment management entities. For example, it abolishes the subscription tax on fund assets in the case of exchange-traded funds, which are Ucits funds, as well as non-ucits funds whose strategy involves investment in microfinance, an area in which the grand duchy has carved out a leading role. Ucits IV was formally approved by the EU on July 13, 2009 under the designation of Directive 2009/65/EC. Rather than introducing sweeping changes to investment rules, as did its 2002 predecessor, the directive mostly involves changes designed to improve the efficiency of the European fund market, as well as strengthening the safeguards for investors that have been a key factor in the success of Ucits funds not only in Europe but elsewhere in the world. These include notably facilitating cross-border fund mergers, simplifying and shortening notification procedures required to sell funds in other EU member states, authorising master-feeder structures under the Ucits regime and creating a passport for management companies established in one member state to provide services to funds in another. In addition, the directive has created the Key Investor Information Document (KIID) to help retail investors understand the investment goals, risk and performance of Ucits funds. For more information about Ucits IV, please see our guide to the directive, Removing barriers to Europe s single fund market. This guide is designed to help fund industry participants and investors understand the changes made to the Luxembourg fund industry as a result of the law of December 17, 2010 as well as the new opportunities available to establish both Ucits and non-ucits funds in the grand duchy for marketing across Europe and beyond.
background to the new investment fund law The law of December 17, 2010, which was placed before Luxembourg s Parliament the previous August, repeals and replaces the country s previous law on undertakings for collective investment of December 20, 2002. Like its predecessor laws, the legislation has two principal parts, Part I covering open-ended Ucits funds and Part II principally covering non-ucits undertakings for collective investment, sometimes referred to as UCIs but here described as Part II funds for the sake of clarity. Part II also covers closed-ended Ucits funds, Ucits whose shares or units are not marketed to the public within the EU or may only be marketed to the public in non-eu countries, as well as other categories of Ucits for which the Luxembourg regulator, the Financial Sector Supervisory Authority (CSSF), determines that the investment rules in Chapter 5 of the law may not be appropriate because of their investment or borrowing policy. In addition, some provisions of the legislation apply to Specialised Investment Funds (SIFs), which are largely governed by separate legislation of February 13, 2007. Part I of the legislation incorporates most of the changes brought to the EU cross-border retail regime by Ucits IV, including the simplified notification procedure in Chapters 6 and 7, Ucits merger rules in Chapter 8, and master-feeder fund structures in Chapter 9. Rules on management companies, including the passporting of management services into and out of Luxembourg, constitute Part IV, while Part V of the legislation, covering general provisions applicable to both Ucits and non-ucits funds, includes the replacement of the simplified prospectus by the KIID. 5 The legislation also includes various changes for both Ucits and non-ucits funds unrelated to the introduction of the Ucits IV Directive but that are designed to make Luxembourg more attractive as a jurisdiction for the management and domicile of funds aimed at both retail and sophisticated investors.
transitional arrangements Part V also includes transitional arrangements for funds and management companies in Chapter 25 of the legislation. The legislation gave existing Ucits funds and management companies up to July 1, 2011, the deadline for transposition of the Ucits IV directive into national legislation, to comply with its provisions (apart from those concerning the KIID), although they were free to become compliant before the deadline. The areas of the legislation applicable to non-ucits funds and management companies, as well as its tax provisions, came into force on January 1, 2011. Existing Ucits and those created between January 1 and July 1, 2011 had a choice between remaining under the 2002 legislative regime up to July 1 or switching to the Ucits IV rules any time after January 1; the same rules applied to new and existing Ucits management companies. All Ucits funds established from July 1, 2011 onward must have the KIID ready at time of launch, but so-called grandfathering rules give funds established before July 1 a transition period of up to 12 months to publish a KIID. 6 Existing Part II funds and non-ucits management companies became subject to the legislation as of January 1, 2011. Grandfathering rules provide a transition period for the provisions on the delegation of functions, notably the requirement that any entity to which investment management functions are delegated must be subject to prudential regulation, up to July 1, 2012. cross-investment by sub-funds Sub-funds of Ucits or Part II funds with an umbrella structure may henceforth invest in other subfunds of the same structure. Until the change in the law the CSSF had ruled that sub-funds set up as companies could not invest in shares issued by another sub-fund of the umbrella structure, since technically this would involved a corporation investing in its own shares, since all sub-funds are part of the same corporate structure. This situation resulted from Luxembourg s legislation on commercial companies, which restricts the circumstances in which a company can acquire and hold its own shares. To ensure a level playing field among the various legal structures, the CSSF made it a matter of administrative practice that sub-funds of common contractual funds (FCPs) could not invest in other sub-funds of the same structure either. The new legislation opens the door to cross-sub-fund investments within both corporate and contractual fund structures, but only subject to various limits and conditions, which for Ucits reflect the standard investment diversification rules and restrictions. According to Article 46 (1) of
the law, a Ucits sub-fund may not invest more than 20 per cent of its assets in another sub-fund of the same structure (or indeed of any other structure). Under Article 48 (2), it may acquire no more than 25 per cent of the shares of the umbrella fund as a whole, but within this constraint it may acquire all the shares in the other sub-fund. As long as it abides by these restrictions, it may invest all of its assets in other sub-funds belonging to the same umbrella structure. However, according to Article 181 (8), one sub-fund of an umbrella structure may only invest in another sub-fund of the same structure as long as the latter is not authorised to invest more than 10 per cent of its assets in other sub-funds of the same structure, a measure designed to prevent so-called cascade investments, and as long as it does not cross-invest in the first sub-fund, a socalled circle investment. The same article states that there must be no duplication of management, subscription or redemption fees between the sub-fund making the investment and the sub-fund being invested in. This also applies to investments in sub-funds of separate Ucits managed directly or indirectly by the same or an affiliated management company. This provision differs from the treatment of investments in sub-funds of Ucits or non-ucits funds managed by a separate management company, where double charging of management fees is permissible as long as the investing fund s prospectus and its annual report disclose the maximum proportion of management fees charged to both the investing Ucits and to the fund(s) in which it is investing. 7 Article 181 also stipulates that any voting rights relating to the shares or units acquired in another sub-fund of the same structure are suspended for the duration of the investment. In addition, the value of the shares or units in a Ucits or Part II sub-fund will not count toward the calculation of the net assets of the investing sub-fund for the purposes of the minimum asset level, which stands at 1.25m. The legislation states that a Ucits or Part II sub-fund may only invest in other sub-funds of the same structure subject to the conditions laid down in its management regulations or instruments of incorporation and prospectus. Under the new rules authorising Ucits master-feeder structures, one sub-fund may not become a feeder to another sub-fund in the same structure. The changes to the rules governing cross-investment by sub-funds within the same Ucits or Part II fund umbrella structure have been sought by the investment management industry to improve the efficiency of asset pooling arrangements, such as cash management, and notably by permitting
the creation of a sub-fund within an umbrella structure as a fund of funds that invests in other subfunds within the structure. However, the restriction on a sub-fund investing in another sub-fund that is permitted to invest more than 10 per cent of its assets in other sub-funds of the same structure, which applies both to Part II funds as well as to Ucits, where this rule is stipulated by the directive, prevents managers creating a fund of funds that invests in other funds of funds within the same structure. In a related change, the CSSF may withdraw authorisation of a sub-fund within a Ucits or Part II umbrella structure without withdrawing authorisation for the other sub-funds in the structure. investor information and governance 8 The legislation introduces various changes affecting Ucits and Part II funds with a corporate structure that previously were caught up by provisions of the general commercial law that were not necessarily relevant to funds. For example, the annual report for corporate funds no longer has to be sent to shareholders with the convening notice to the annual general meeting, as required under legislation dating back to 1915. This is designed to save on mailing costs that can represent a significant expense for umbrella funds with large numbers of sub-funds and investors, although accounts must still be sent to shareholders who ask for them. In addition, the board of a corporate fund may establish a date of record five days before the AGM in order to determine attendance rights, what constitutes a quorum and majority vote requirements. This is also of particular relevance to funds with large numbers of investors where it may be very difficult, expensive and time-consuming to do so on the day of the AGM itself. Finally, articles of incorporation drawn up in English are no longer required to be translated into French or German for registration purposes. delegation of functions The legislation brings the rules on delegation of functions for Part II funds and non-ucits management companies into line with those governing Ucits funds and management companies. Notably they may delegate investment management functions only to entities that are authorised for investment management and are subject to prudential supervision. This may require amendments to the prospectus and articles of existing funds. The previous fund legislation did not set any conditions under which Part II funds and non-ucits management companies could delegate investment management, administration and distribution
functions, although as a rule the regulator has in practice restricted the delegation of investment management to third-party entities that are subject to prudential supervision. Exceptions to this de facto requirement in the past included notably investment management carried out by Swiss managers that were not subject to regulation at home. However, the shift in emphasis toward greater regulation of the investment management industry, including products aimed as sophisticated investors, has resulted in the new legislation explicitly requiring that any entity to which investment management is delegated be subject to supervision. The legislation also reflects not only the Ucits IV directive but also the future Alternative Investment Fund Managers (AIFM) Directive, which will take effect on July 22, 2013, in requiring the establishment of regulatory co-operation arrangements, not defined in the law, between the CSSF and the regulator of any delegated investment manager domiciled outside the EU. The law also stipulates that the fund s depositary may not also act as its delegated investment manager, and that the regulator must be informed when any delegation takes place. exemptions from the subscription ta x A number of provisions in Article 175 of the legislation mitigate the impact of the subscription tax (taxe d abonnement) on assets for certain categories of fund as of the beginning of 2011. Whether Ucits or non-ucits structures, exchange-traded funds are now exempt from the tax, even though they are not explicitly referred to by that term in the legislation. 9 Instead it states that Ucits and Part II funds or their sub-funds whose securities are listed or traded on at least one recognised stock exchange or other regulated market open to the public, and whose exclusive object is to replicate the performance of one or more indices, are exempt from the tax. The legislation stipulates that an index must represent an adequate benchmark for the market to which it refers and must be published in an appropriate manner. Further criteria may be laid down in a separate regulation issued by decree. The definition of an index is less stringent than those contained in Part I of the legislation governing Ucits funds. Article 44, which states that a Ucits may invest up to 20 (rather than 10) per cent of its assets in transferable securities or money-market instruments from the same issuer if its investment policy is to replicate a stock or bond market index, says that to be eligible for recognition by the CSSF, in addition to representing an adequate benchmark for the market to which it refers and being published in an appropriate manner, the composition of the index must be sufficiently diversified. This implies that Part II funds may track indices that are less diversified than those eligible for Ucits investment without losing the benefit of being exempted from the subscription tax.
Also exempted are funds and sub-funds whose shares or units are reserved for investment by occupational pension schemes. This was already the case under Luxembourg s previous 2002 fund legislation, but only for pension funds of the same group where Ucits or Part II funds were being used as dedicated group pooling vehicles by the pension fund. However, the SIF legislation of February 2007 offered the exemption even when the investment funds were not part of the same group as the pension scheme. Ucits and Part II funds now benefit from the same exemption. One uncertainty in the legislation is that, unlike in other sections dealing with exemptions from the subscription tax, Article 175 (c) referring to funds reserved for occupational retirement schemes fails to add the rider that if several classes of securities exist with a fund or sub-fund, the exemption only applies to classes of funds or units that meet the criteria. This technically excludes from the exemption funds or sub-funds that also have separate classes of shares or units offered to nonpension fund investors. This apparent oversight may be remedied in future amendments of the legislation, for instance when the planned Ucits V directive is agreed (see page 12 below). 10 In addition, the legislation formally enshrines an existing exemption from the subscription tax for both Part II funds and SIFs whose main objective is investment in microfinance institutions. The exemption was introduced by legislation of December 18, 2009, with the criteria for the exemption defined by a regulation introduced by decree on July 14, 2010. According to the regulation, Part II funds and SIFs that hold the LuxFLAG Microfinance Label, which certifies to investors that the fund in question is predominantly invested in the microfinance sector and meets internationally recognised standards, are automatically exempted from the tax. Funds that do not hold the LuxFLAG label may also benefit from the exemption if their investment policy requires that at least 50 per cent of their assets are invested in one or more microfinance institutions, as defined in the regulation. other ta x ation issues An important stipulation in Article 179 of the legislation, designed to consolidate the grand duchy s position as Europe s largest investment fund hub, states that Ucits and Part II funds domiciled in other jurisdictions but managed by a Luxembourg management company, and whose centre of management or head office may therefore be deemed to be in the grand duchy, are not subject to Luxembourg corporate income tax, municipal business tax and wealth tax. This clarification was introduced in the legislation to avert any uncertainty that Ucits domiciled in other EU member states but managed by a Luxembourg management company under the new
management company passport provisions introduced in the Ucits IV directive might become subject to tax in Luxembourg. The issue of a fund s potential tax liability in the jurisdiction in which its management company is located has been raised as a potential problem that might impede use of the management company passport. Any EU member states without such a clear exemption are likely to find it difficult to attract management companies looking to manage Ucits on a cross-border basis. Another change to the general taxation regime affecting funds in Luxembourg is designed to maintain the grand duchy s attractiveness as a domicile for master funds within master-feeder structures, which are eligible under the Ucits regime for the first time with the introduction of Ucits IV. According to Article 178, profits arising from the sale by non-residents of shareholdings exceeding 10 per cent of the total in a corporate Ucits fund or another type of corporate fund structure, including a Part II fund, SIF or risk capital investment company (Sicar), are no longer subject to taxation in Luxembourg, even if the investment has been held for less than six months. This provision was introduced to prevent non-luxembourg feeder funds from being caught by general corporate tax provisions governing short-term investments when divesting from Luxembourg Ucits master funds. 11 Although this section does not state explicitly that it applies to SIFs, it refers to revenues gained and capital gains realised through sale of shares in a SIF as in other types of fund. Previously non-residents selling shares of a SIF within six months of acquiring them would be taxable in the grand duchy, unless there was a double tax treaty in place between Luxembourg and the investor s country of residence. The change brings the rules fully into line with the principle that capital gains arising from the sale of SIF shareholdings are taxable in the jurisdiction where the shareholders have their domicile. These changes reflect the sensitivity of the Luxembourg authorities to taxation issues that analysts have already highlight as potential obstacles that could prevent the European fund industry gaining the full benefit of the efficiency gains that Ucits IV seeks to offer, and which to date have proved a greater hindrance than regulatory barriers to the complete establishment of a European Union single market for investment funds. A report last year co-sponsored by the European Fund and Asset Management Association noted that in certain member states the activities of the fund management company could cause Ucits funds they manage in other member states to become taxable in the country where the management company is domiciled. There could also be an effect on the fund s ability to benefit
from double taxation agreements, and the provision of management services would be subject to VAT at the rate and under the conditions imposed in the home state of the management company. In addition, the report identified potential problems with master-feeder fund structures, such as adverse tax consequences for the feeder fund or investors where a Ucits fund takes on feeder fund status. Investing via a master fund could also give rise to additional tax charges if a country levies withholding tax on distributions by a master fund to a feeder, or capital gains tax where the feeder fund disposes of shares in the master fund. The Luxembourg legislation transposing Ucits IV into national law has addressed these particular issues, but others remain, especially in the area of the tax treatment of investors resident in different member states in the event of fund mergers, which differ from country to country. potential future changes to luxembourg s fund legisl ation 12 Although EU member states have only just amended their fund legislation to incorporate the changes required to adopt the Ucits IV directive (or in some cases are still in the process of doing so), further revisions are planned in order to bring definitions of the role and responsibilities of depositary institutions in relation to the funds for which they provide custody of assets, their managers and investors, as well as rules governing the remuneration of managers, into line with those in the AIFM Directive, which is due to come into effect on July 22, 2013. Under the Ucits regime the depositary must be located in the fund s domicile, but its responsibility in the event of loss of assets, as highlighted by the Madoff scandal when Bernard L. Madoff Investment Securities acted as sub-custodian to feeder funds through which investors allocated capital to his purported strategy, is currently a matter of contention between member states and the subject of court cases in leading fund jurisdictions such as Luxembourg and Ireland. Under the AIFM Directive, the depositary is liable for the loss of financial instruments in its custody unless it can prove that the loss was an external event and unavoidable despite all reasonable care. It is liable in the event of other losses in case of intentional acts causing loss or negligence. In the event of losses under a sub-custody arrangement, the depositary may escape liability if there is a contractual transfer of liability to the sub-custodian in agreement with the fund and with the manager. The definition of the depositary s role and responsibility is set to reflect these provisions in the next iteration of the Ucits regime, known as Ucits V. The proposed rules drawn up by the
European Commission would require Ucits funds to appoint a single depositary to be entrusted with safekeeping of all the fund s assets, in a position to have oversight and responsibility for all assets and cash transactions for the fund. In addition, Ucits V will stipulate remuneration structures that include criteria for performance-related remuneration and rules for guaranteed variable remuneration, for fixed and variable components of total remuneration, for pension benefits and employment termination compensation, covering fund management staff whose roles have a material impact on the risk profile of the fund, including senior management, other members of the board of directors, supervisors, risk managers and other employees earning compensation at a level comparable with that of senior managers. Remuneration policies would have to be designed to promote effective risk management and prevent conflicts of interest, although the application of the rules would be flexible in order not to be disproportionate to the size and organisation of the fund management company and the nature, scale and complexity of its investment activities. The European Commission is expected to publish a draft Ucits V directive before the end of 2011. 13
for further information please contact: olivier sciales, partner oliviersciales@cs-avocats.lu rémi chevalier, partner remichevalier@cs-avocats.lu www.cs-avocats.lu You may find more information on our UCITS IV blog at www.cs-avocats.lu/ucits-iv
CHEVALIER & SCIALES LUXEMBOURG 51, route de Thionville L-2611 Luxembourg Luxembourg DUBAI Level 41 Emirates Towers P.O. Box 31303 Dubai United Arab Emirates Tel : +352 26 25 90 30 Fax : +352 26 25 83 88 Tel: +971 4 319 7903 Fax: +971 4 319 7904 www.cs-avocats.lu