Investment Issues. A Publication of the International Investment Management Group of Linklaters French REITs proposal published for consultation Contents French REITs proposal published for consultation 1 The AMF recently published, for consultation, draft amendments to its General Regulation setting out its proposal for a French REIT, referred to as an OPCI. These include provisions in relation to conditions for subscription of units and shares, valuation rules and management rules for those OPCI which do not take the form of a company, information for holders and for the OPCI's prospectus and the conditions upon which management companies will be allowed to manage OPCIs. The proposed rules are available (in French) at http://www.amf-france.org/documents/general/7299_1.pdf. Comments are requested by 10 November 2006. Luxembourg State Aid: The European Commission demands the repeal of the Luxembourg 1929 Holding Company regime grandfathering provisions are made for existing 1929 Holding Companies On 19 July 2006, the European Commission decided that the tax regime applicable to holding companies governed by the Luxembourg law of 31 July 1929 (referred to as 1929 Holding Companies ) constitutes State Aid within the meaning of article 87 of the EC Treaty. This decision was taken on the ground that the 1929 Holding Companies regime grants unjustified tax advantages to providers of financial services who set up holding structures in Luxembourg and distorts competition and trade by altering the playing field between financial undertakings. Luxembourg State Aid: The European Commission demands the repeal of the Luxembourg 1929 Holding Company regime grandfathering provisions are made for existing 1929 Holding Companies 1 Luxembourg: Part I UCITS investing in open-ended hedge funds, under art. 41(2)a) of the Law 3 The SFC of Hong Kong provides guidance on the Risk Management and Control Process of UCITS III Funds domiciled in Luxembourg, Ireland and the United Kingdom when applying for SFC authorisation 5 Issue 90 29 September 2006 1
Impact of the decision The decision by the European Commission brings to an end to a period of uncertainty for the Luxembourg financial centre, which had anticipated its impact. Indeed, the number of companies incorporated under the 1929 Holding Companies regime has steadily decreased over the past few years to the benefit of other regimes applying to holding companies, such as the so-called Soparfis ( Sociétés de Participations Financières ). Unlike 1929 Holding Companies, Soparfis are fully subject to corporate income tax but can benefit, upon complying with certain conditions, from specific exemptions on income earned and capital gains realised on participations pursuant to the Luxembourg participation exemption regime. The Luxembourg participation exemption regime is the implementation in the Luxembourg domestic law of the EU Parent-Subsidiary Directive. Soparfis therefore operate in compliance with the European legislation and are, in any case, not harmed by the European Commission s recent decision. Because of its grand-fathering provisions, the decision by the European Commission will probably not have too negative impact on the market: Existing 1929 Holding Companies will have to consider exits and alternative structures, to be implemented before 1 January 2011. Newly created vehicles should be able to achieve results which are similar to the ones obtained by use of the 1929 Law. The Luxembourg Government has negotiated a provision which means that existing 1929 Holding Companies are granted a grand-fathering period (until 31 December 2010) to change their tax status. 1929 Holding Companies created before 20 July 2006 can therefore continue to benefit from their tax exempt status until 31 December 2010. The partial or total disposal of the shares of existing 1929 Holding Company benefiting from the grandfathering clause will, however, not be permitted during this transitional period. Further details of this development are set out below. The advantages of the 1929 Holding Company regime The law of 31 July 1929 on holding companies (the 1929 Law ) was originally introduced to attract financing and licensing activities to Luxembourg and to create a Luxembourg vehicle allowing the coordination of multinational groups. Under the 1929 Law, 1929 Holding Companies are fully exempt from Luxembourg corporate income tax and the distributions they make are free from withholding taxes, without any conditions. History of the State Aid Investigation In 2003, the European Council of Ministers (the Council ) found that the Luxembourg tax regime for 1929 Holding Companies contained harmful tax measures within the meaning of the EC Code of Conduct on business 2 Issue 90 29 September 2006
taxation. This was mainly due to the fact that 1929 Holding Companies benefited from an exemption on dividends received from non-eu resident subsidiaries whose benefits had been taxed at a low rate or not taxed at all. The Council therefore invited the Luxembourg Government to amend and/or repeal the measures considered harmful and contained in the 1929 Holding Company regime. On 21 June 2005, Luxembourg introduced a new law amending the 1929 Law (the New Law ) and dealing with the criticisms from the Council. This New Law abolished the tax exempt status for 1929 Holding Companies receiving more than 5% of all their dividends from non-eu resident subsidiaries which are not liable to a rate of income tax in their country of residence comparable to the rate of Luxembourg corporate income tax (the non-comparable tax is defined as a tax of 11% on the business profits computed similarly to the Luxembourg s rules). Despite the New Law, on 21 October 2005 the European Commission made, additional suggestions to the Luxembourg Government inviting it to further amend the 1929 legislation. Faced with the refusal of the Luxembourg Government to do so, the European Commission decided, on 8 February 2006, to launch a formal investigation into the 1929 legislation. After an in-depth investigation of six months, the European Commission eventually came to the conclusion that the changes to the 1929 Holding Company tax regime introduced by the New Law were not sufficient to eliminate the harmful tax features of the regime, which had been considered to constitute a State Aid incompatible with the Common Market. The repeal of the 1929 Holding Company regime The decision of 19 July 2006 provides that: The legislation applying to 1929 Holding Companies has to be repealed by the end of 2006; No new 1929 Holding Companies can be created after 20 July 2006; Existing Holding companies will not have to pay taxes advantages received. Luxembourg: Part I UCITS investing in open-ended hedge funds, under art. 41(2)a) of the Law There have recently been helpful developments regarding the investments permitted by Part I UCITS in open-ended hedge funds. If the requirements explained below (regarding equivalent supervision and transferable securities) are complied with, Part I UCITS may invest in open-ended hedge funds or fund of hedge funds up to 10% of their net assets, together with any other transferable securities that fall within 41(2)a) of the Law. Investment Issues. 3
Art. 41(2)a) of the Law of 20 December 2002 relating to undertakings for collective investment (the Law ) provides that a UCITS may invest no more than 10% of its assets in transferable securities and money market instruments other than those referred to in paragraph (1). Some time ago, the CSSF took the position that units of open-ended real estate funds would be eligible instruments within the exception provided for by art. 41(2)a) of the Law. In its 2005 Annual Report, the CSSF advised it considered that a Part I UCITS may also invest up to 10% of its net assets in regulated open-ended hedge funds, provided that the hedge fund is submitted to equivalent supervision and that it further complies with the conditions laid out by CESR in its document 06-005 relating to transferable securities. The CSSF has recently accepted investments in open-ended fund of hedge funds based on the same principles. The target hedge fund must be submitted to equivalent supervision. Although there is no list established by the CSSF of supervisory authorities that are considered as equivalent, it is understood that the following jurisdictions are eligible: all EU Member States, EFTA member States (i.e. Iceland, Liechtenstein, Norway and Switzerland), Jersey, Guernsey, the United States, Canada, Hong Kong and Japan. Supervision in other jurisdictions must be qualified on a case-by-case basis by the CSSF. The hedge fund s units must qualify as a transferable security. The second part of CESR s advice to the European Commission on clarification of definitions concerning eligible assets for investments of UCITS, published in January 2006, clarifies, among other things, the meaning of transferable security by laying out the conditions to be complied with in order to determine whether financial instruments, whose underlying involves products of varying degrees of liquidity, constitute a transferable security. CESR concluded that structured financial instruments, if they are traded on a regulated market, benefit from a presumption (but not a guarantee) of liquidity and of negotiability. UCITS are thus able to rely on the presumption of liquidity of listed hedge fund units. However, if the UCITS becomes aware that any particular security is not liquid, the presumption of liquidity no longer applies; CESR lists a number of criteria to consider when determining the liquidity of a security: The security must be capable of being sold at a limited cost in an adequately short time frame. The UCITS needs to assess the liquidity of the security to establish whether its addition to the portfolio would compromise the portfolio liquidity and to ensure that the UCITS as a whole is able to handle reasonably foreseeable requests for redemption. Therefore, in 4 Issue 90 29 September 2006
determining the appropriate degree of liquidity, the frequency with which the UCITS offers dealing facilities must be taken into account. As with the presumption of liquidity, the presumption of negotiability is not a guarantee, even if the hedge fund units are listed. The investment must not affect the UCITS ability to redeem units at the request of the unitholders. Finally, besides the liquidity and negotiability requirements, the investments, in order to fall within the definition of transferable security : must not expose the UCITS to losses beyond the amount paid for. must be subject to accurate reliable and regular pricing. regular accurate and comprehensive information thereon must be available. CESR also emphasises the fact that the acquisition of any transferable security must be consistent with the stated investment objectives of the UCITS. There should, however, be no obligation to look through the target fund to determine whether it invests itself in eligible assets. The SFC of Hong Kong provides guidance on the Risk Management and Control Process of UCITS III Funds domiciled in Luxembourg, Ireland and the United Kingdom when applying for SFC authorisation The Hong Kong Securities and Futures Commission ( SFC ) has prepared a guide ( Guide ) on the information relating to the risk management and control process that must be provided to the SFC in support of an application for the authorisation of UCITS III funds which use or will use the expanded investment powers available under UCITS III, especially those using financial derivative instruments ( FDIs ) for investment purposes. While the Guide is prepared based on the European Commission Recommendation 2004/383/EC (the Recommendation ) on the use of FDIs for UCITS and the SFC will have regard to the requirements of the home regulators of the relevant UCITS III funds, the contents in the Guide are for guidance so should not be regarded as exhaustive. The Guide sets out the items and areas relating to the risk management and control process that the SFC normally expects to be provided in order to give the SFC a general and basic understanding of the risk management processes of the relevant UCITS III funds using expanded investment powers. The information to be provided to the SFC is set out in more detail below: Investment Issues. 5
General Information to be provided to the SFC Description of the entities or business units responsible for FDI valuations, risk measurement and management. Descriptions of the overall level of expertise of the key personnel (e.g. employment history), and/or departments involved and independence of such personnel/entities (e.g. reporting lines within the organisation). An organisational chart would be helpful for such purpose. Information of the specific types of FDI that will be utilised by the fund, including an explanation of the types of risks that may impact the fund by utilising FDI. A description of the valuation rules for the specified types of FDI, including the policy with regard to the valuation of illiquid FDI and OTC FDI, and in particular, the frequency of valuation and policy on independent verification. A brief overview of the systems being used by the risk manager to monitor, measure and manage the risk process. A summary of policies in relation to the monitoring and management of legal risk, particularly in the context of OTC derivatives and any other relevant risks. Information with regards to risk exposure and leverage to be provided to the SFC A description of the methodology used by the fund to calculate its global exposure and leverage with the appropriate rationale based on whether the fund is classified as a sophisticated or a non-sophisticated fund as per the Recommendation (e.g. if a sophisticated fund uses VaR it must indicate the calculation parameters, both quantitative and qualitative.). Policies and procedures for stress testing and scenario analysis, where applicable. A description of the policy adopted/to be adopted regarding issuer concentration risk (position risk) and cover requirements. Procedures and policies of the fund to monitor and control the levels of global exposure and leverage to ensure that they are in compliance with requirements, including details of the management controls and systems for: monitoring trade execution monitoring position netting monitoring compliance with internal policies/procedures and quantitative limits preventing limit breaches. A description of any additional risk management policies and procedures used e.g. benchmarks, back testing, tracking-error, stop-losses. 6 Issue 90 29 September 2006
A description of the methodology used by the fund to calculate its counterparty exposure. Procedures and policies of the fund to monitor and control its counterparty exposure and risk, including: counterparty approval criteria policy on collateral policy on netting details of the management controls and systems for monitoring of compliance and quantitative limits e.g. concentration limits preventing limit breaches. Information on reporting procedures to be provided to the SFC Description of internal reporting procedures including the escalation procedures and remedial policy in the event of limit breaches. Investment Issues. 7
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