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The Importance of Substance and the Key Role of Alternative Administrators

In the Architecture of the Luxembourg Fund Industry

1.    Purpose of this position paper


Luxembourg is a major financial center and the location of choice for international investors and investment managers when deciding on the location for their European investment platform.


Today, the Grand-Duchy is the second largest fund center globally (No. 1 in Europe) with a stunning market share of 56% of global market share in cross-border investment funds. The assets under management in regulated Alternative Funds reached nearly EUR 1 trillion in 2023.[1] Luxembourg’s share in European alternative assets reached nearly 62% in 2022, totaling EUR 1.8 trillion (this includes regulated and unregulated investments).[2]


The attractivity of Luxembourg as a fund location is linked to its flexible and diverse legal and regulatory framework, a stable tax system, the availability of qualified and multilingual workforce, an investor-friendly business environment, the existing fund industry as well as political and financial stability. Moreover, Luxembourg is a trusted and well-known jurisdiction for both investors and investment managers.


The Luxembourg fund industry emerged over the last few decades and comprises specialized service providers that offer all-encompassing assistance around all aspects regarding the management of Alternative Funds (private equity, private debt, real estate, infrastructure, etc.) and their Luxembourg subsidiaries. Luxembourg Alternative Administrators play a key role in the architecture of this industry.


Luxembourg companies must have appropriate substance.[3] Here, Alternative Administrators frequently make a significant contribution (for example, through the rendering of specialized services, the renting of office premises and meeting rooms, and assistance with respect to the proper handling of corporate governance).


The purpose of this position paper is:

-        Outlining typical investment structures;

-        Defining the notion of substance and providing an overview of the importance of substance in international taxation;

-        Considering substance requirement in an EU context; and

-        Providing guidance regarding best practice.


This paper is the abridged version of the L3A position paper entitled “The Importance of Substance and the Key Role of Alternative Administrators in the Architecture of the Luxembourg Fund Industry”. For more information on sections 2, 3, 4 and 5, please refer to the unabridged version that can be found on the website of L3A.




2.    Typical Alternative Fund Structures


Alternative investments may involve different asset classes such as private equity, private debt, real estate, and infrastructure. Investments are typically made via a Luxembourg fund vehicle and subsidiaries that are resident in Luxembourg and in the investment jurisdiction. Alternatively, foreign funds may establish an investment platform in Luxembourg for investments into Europe.  


For more information on typical real estate and private equity funds with a Luxembourg investment platform, please refer to the unabridged version of this L3A position paper.


3.    The notion of substance


Substance is a key element in international taxation and is relevant for the application of domestic tax law, tax treaties and the arm’s length principle. However, the notion of substance is not a one-dimensional concept but involves several different elements that may be interrelated including corporate governance, the functional and risk profile of the company, infrastructure (employees, office premises, …), and commercial and legal reasons for establishing business activities in Luxembourg.[4]


The following chart depicts the different dimensions of substance[5]:



For more information on the notion of substance, please refer to the unabridged version of this L3A position paper.


4.    The importance of substance in international taxation


The importance of substance is known since many years and the awareness has only increased throughout the OECD base erosion and profit shifting (“BEPS”) Project. From a Luxembourg tax perspective, substance is necessary to ensure the Luxembourg tax residency of companies. Luxembourg companies performing financing activities within the meaning of the Luxembourg transfer pricing circular (the “Transfer Pricing Circular”)[6] must comply with specific substance requirements set out therein.


Furthermore, Luxembourg companies that are subject to supervision by the Luxembourg supervisory body of the financial sector (Commission de Surveillance du Secteur Financier, “CSSF”) such as Luxembourg AIFMs and management companies must comply with certain substance requirements from a regulatory perspective (that are determined by the CSSF).


Luxembourg companies that are part of an international investment structure or a member of a multinational group may have to comply with an increased level of substance in order to be out of reach of anti-abuse legislation provided under foreign tax laws (anti-Directive/Treaty shopping rules, general anti-abuse rules, etc.) and tax treaties concluded by Luxembourg (the principal purposes test, the beneficial ownership concept, etc.). However, in an EU context, these substance requirements must be consistent with EU law as interpreted by the Court of Justice of the European Union (“CJEU”).[7]


Substance may also be required from a transfer pricing perspective given that the application of the arm’s length principle relies on several concepts that are closely linked to substance. The economic reality further needs to be consistent with the fact pattern described in the transfer pricing analysis.


Finally, a lack of appropriate substance can be a source of reputational risk which is a sensitive topic for investment managers that provide investment opportunities to investor that often have a conservative profile (for example, pension funds and other institutional investors).


For more information on the importance of substance in international taxation, please refer to the unabridged version of this L3A position paper.


5.    Substance requirements in an EU context


A large part of the investments of Luxembourg funds and companies is made in other EU Member States. In an EU context, anti-abuse provisions and related substance requirements provided under domestic tax law and bilateral tax treaties must be compliant with EU Law.


Here, decisions of the CJEU are helpful for the interpretation of the “wholly artificial arrangement” doctrine and the concept of beneficial ownership.


For more information on the limits of substance requirements in an EU context, please refer to the unabridged version of this L3A position paper.



6.    Best practice


6.1. Overview


The substance of Luxembourg companies must be appropriate for the activities performed. In an EU context, anti-abuse legislation under domestic tax law and bilateral tax treaties must be consistent with EU Law as interpreted by the CJEU. Hence, Luxembourg companies should consider the restrictive case law of the CJEU when determining an appropriate level of substance.


Luxembourg companies may organize their substance through the adoption of an insourcing or an outsourcing model albeit each and every Luxembourg company relies to a certain extent on external service providers as not each task can reasonably be organized internally (accounting, legal, tax advisory services, compliance, reporting, etc.).


The increasingly complex legal, regulatory, tax and compliance environment is contributing to this need for qualified service providers. Indeed, over the last decade more and more reporting and compliance obligations have been added, mostly driven by initiatives and developments at EU level.


Alternative Administrators with their highly specialized service offer play a key role in the architecture of the Luxembourg fund industry and allow international investors and investment managers to manage their Luxembourg investment platform in a seamless fashion.


While this position paper focuses on Luxembourg companies that are (indirect) subsidiaries of alternative funds, the guidance provided in this section equally applies to Luxembourg companies involved in unregulated investment structures.


6.2. Corporate governance


6.2.1.    Composition of the board of directors


The composition of the board of directors is central for proper corporate governance.


As a tendency, the board members should have different backgrounds and experience, to be able to consider all aspects regarding the conduct of the Luxembourg company and its investments.


The board of directors should generally be composed of directors that have an investment background and directors that have a good knowledge of Luxembourg accounting, legal, tax, regulatory and compliance aspects which are crucial for the management of the Luxembourg investment platform.


The qualification and experience of the directors should be commensurate to the activities performed by the Luxembourg company and the magnitude of the decisions to be taken during board meetings. In other words, directors must be qualified and have sufficient experience to take informed decisions on behalf of the company.


According to the Luxembourg Transfer Pricing Circular, Luxembourg finance companies should have at least 50% Luxembourg (professional) resident directors. This might be a good approach for all Luxembourg companies albeit there is no formal requirement for such board composition.

Directors must have sufficient time to dedicate to the director’s role (including the preparation of and the participation to board meetings) and, potentially, the management of day-to-day business activities if this is part of the role.


This implies that the number of director mandates (and potentially an employment) should be appropriate for the director's disposable time. However, there is no one-size-fits-all approach, and it must be considered how time-consuming different director mandates are. For example, when a director is appointed to the board of directors of several companies in the same fund structure, it can be expected that significant synergies may be generated (similar investment strategy, investment structure, financing instruments, etc.), resulting in a higher number of mandates that can be reasonably managed by that director.


Luxembourg (professional) resident directors are often employees of the investment manager (or another Luxembourg group company), employees of an Alternative Administrator, or independent directors. The question arises whether directors that are also in an employment position can exercise the director role in an independent fashion. However, the severe director responsibilities applicable under Luxembourg law that may result in material personal liability in case of wrongdoings or negligence (irrespective of contractual aspects) ensure that Luxembourg directors exercise their role independently. Thus, one must distinguish the directorship mandate from any employment position and directors are to be considered as the very own resource of the company they manage.


6.2.2.    Meetings of the board of directors


The board meetings of a Luxembourg company should be held regularly in Luxembourg with the physical presence of all appointed Luxembourg and non-resident directors. The airplane tickets and hotel bills of non-resident directors traveling to Luxembourg (these costs will likely be borne by the company) as well as other relevant documentation evidencing the physical presence of the directors in Luxembourg should be kept in the premises of the company (in practice, digital copies should suffice).


The frequency of the annual board meetings (once or twice per year, quarterly or monthly) should be consistent with the level of activities performed by the Luxembourg company and may vary from one year to another. For example, in an Alternative Fund context, it might be expected that a LuxMasterCo making several investments during the investment phase should have sufficient board meetings to take all important decisions regarding the conduct of the company's business activities. On the contrary, companies with a more stable activity (for example, property or deal companies during the investment period) may require a lower number of board meetings.


Nevertheless, as a tendency, each time key decisions regarding the conduct of the company’s business activities are taken, a meeting of the board of directors should be held (this might happen on an ad-hoc basis).


In addition, regular meetings should also be held to discuss, amongst others, the following topics: (i) overview of the performance of existing investments; (ii) review of (interim) financial statements of the Luxembourg company; (iii) budget review and approval; (iv) employment policy (v) recent corporate, regulatory and tax developments impacting the Luxembourg investment platform and local property or holding companies and (vi) reporting to the shareholders and convey of the Annual General Meeting of the shareholders.

When directors are not able to attend a board meeting, they may provide a proxy to a director that will attend the meeting. Board meetings should generally not be organized via conference call or video conference. However, in exceptional cases, when not all the directors may travel to Luxembourg, it might be considered to organize the board meeting in Luxembourg and to initiate a digital communication channel (for example, a video conference) from Luxembourg. Here, it would be advisable for the director that is not physically present in Luxembourg to take an observing role.


6.2.3.    Decision-making and involvement of the directors


All important strategic and commercial decisions regarding the conduct of the Luxembourg company's business must be taken during board meetings in Luxembourg. Here, the board of directors is the competent body to take all the important decisions regarding a company’s business activities.


This implies that all directors need to be actively involved in the decision-making process. Accordingly, all directors should receive relevant (supporting) documentation before the board meeting to allow directors to prepare themselves and to take informed decisions.


In some cases, it may be useful to invite key investment professionals, members of the deal team or other professionals/service providers to the meetings of the board of directors to share their views and insights. This can improve the information base of directors before important decisions are made.

Given the time constraints that are often present when investment managers propose investments or disinvestments, it cannot be excluded that in some cases the relevant documentation is not available a long time before the board meeting. However, in these circumstances, directors need to arrange their time in a way that allows them to be ready to take decisions during the board meeting.


While board meetings may be prepared abroad, they must be independently vetted by the directors during their board meetings in Luxembourg. Likewise, non-residents may make strategic recommendations to the board of directors, but the directors must independently appraise each proposal and not merely “rubber stamp” these recommendations.


6.2.4.    Minutes of the board meetings


The content and decisions taken during board meetings must be documented in meeting minutes. Here, it would be wise to adopt a descriptive approach that also depicts the facts and circumstances that have been considered by the directors. 


As best practice, the minutes should be prepared shortly after the Board meeting to capture all relevant aspects discussed during the meeting and to record the Board's decisions in writing. However, in practice, and predominantly for timing purposes, proposed resolutions may be prepared in advance as part of the preparation for the Board meeting and finalized thereafter.


Such approach allows Luxembourg companies to evidence that the decision-making took place in Luxembourg, even years after the board meeting took place.

6.2.5.    Legal documentation


Luxembourg companies may enter into various legal agreements with related and third parties (for example, financial instruments, derivative instruments, and service agreements). All these agreements must be properly documented.


Likewise, transactions such as the purchase or the sale of a participation, the increase or the decrease of a loan or the redemption of shares or debt instruments must be formalized in legal documentation.


Decisions of the board of directors must be detailed in board resolutions that are designed to formally record the decision the board has made and give individuals or organizations authority to follow the specific course of action decided on.

Luxembourg companies should keep their legal documentation, books and records in Luxembourg.


6.2.6.    Compliance obligations


Luxembourg companies must comply with various compliance obligations, such as filing annual financial statements, preparing corporate income tax and VAT returns and analysing potential reporting obligations under the mandatory disclosure regime (“MDR”).


Here, it is important that the directors ensure that the relevant deadlines are respected as non-compliance may result in penalties (monetary and other) for the company and, potentially, the directors themselves.  


Therefore, timely compliance with those obligations must be high on the agenda of the directors of Luxembourg companies.


6.2.7.    Transfer pricing documentation


When Luxembourg companies enter into agreements with related parties, the terms and conditions agreed upon (interest rates, finance margins, fees, etc.) must adhere to the arm's length standard.[8]


Luxembourg tax law does not (yet) explicitly set out transfer pricing documentation requirements. However, this does not mean that Luxembourg companies are under no obligation to substantiate the arm’s length character of their controlled transactions in transfer pricing documentation.


Instead, pressure to produce sound transfer pricing documentation for Luxembourg tax purposes may derive from different directions such as the magnitude of the intra-group transactions and the related tax risks (that should be considered in the cost-benefit analysis), the rules around burden of proof, and the possibilities of the Luxembourg tax authorities to challenge transfer pricing.


Whenever the Luxembourg tax authorities can reasonably evidence that the transfer pricing of an intra-group transaction is not consistent with the arm’s length principle (the threshold in terms of evidence for the Luxembourg tax authorities to challenge the transfer pricing of Luxembourg companies is rather low), it is for the taxpayer to disprove this rebuttable presumption. However, in the absence of appropriate transfer pricing documentation, it is difficult to prove the arm’s length character of intra-group pricing.


Therefore, taxpayers should take a pro-active attitude towards transfer pricing and prepare documentation, where appropriate, at the time they enter into an intra-group transaction. In practice, Luxembourg companies should screen all intra-group transactions to identify issues that could raise questions on the part of the Luxembourg tax authorities and assess the magnitude of related tax risks. Based on this analysis, directors should be able to determine which transfer pricing documentation should be prepared.


However, taxpayers should not consider the preparation of transfer pricing documentation as a mere compliance exercise. Instead, in the current international tax environment, companies should integrate the documentation of transfer prices in their wider tax strategy and use it to reflect the business rationale behind the corporate structure and intra-group transactions.


It is also important that transfer pricing policies are not disregarded after their implementation. As best practice, taxpayers should review their transfer pricing documentation at least once a year to ensure that the fact pattern is still consistent with reality and to determine whether an update might be necessary.


6.3. Activities performed by the company


Luxembourg companies involved in Alternative Investments generally perform various activities throughout the investment process as outlined below.


6.3.1.    Assessment of investment opportunities


Before an investment is made, the board of directors must positively assess potential investment opportunities. These are typically proposed by the investment manager that provides the directors with comprehensive information (due diligence report, structure paper, business plan and expected cash flow, etc.) based on which the directors can independently assess the quality of the investment opportunity.


As a best practice, directors should be informed early in the pre-investment phase (e.g., by sharing draft transaction overview, draft term sheets, draft tax reports, draft due diligence reports, etc.) to have sufficient time to assess this investment opportunity and prepare for the board meeting.


The assessment of investment opportunities is generally made in preparation of and, collectively, during the relevant Board meeting. When the investment proves to be consistent with the fund’s investment strategy, the board of directors should pass a resolution with a positive decision.


6.3.2.    Implementation of investments


When the directors decide in favor of an investment opportunity, the investment must be duly implemented.


This involves, amongst others, the organization of the fund flows, the documentation of financing instruments, the preparation of legal documentation, the preparation of transfer pricing documentation and, potentially, the incorporation of additional entities.


The way investments are organized is generally determined in structure papers that consider the legal and tax rules in Luxembourg and in the investment jurisdiction.


6.3.3.    Monitoring the performance of the investments


The performance of investments must be monitored on an ongoing basis. The monitoring frequency will generally depend on the investment horizon, the magnitude of the investment, the volatility of the investment and the overall economic environment in the investment jurisdiction.


As a tendency, long-term investments that are subject to a low volatility (for example, real estate and infrastructure investments) may require fewer performance reviews than investments with a shorter lifetime and a higher volatility (for example, venture capital investments and investments into distressed debt).


Investments should at least be reviewed on an annual basis. This may be done as part of the preparation of the financial statements when potential value adjustments must be considered (i.e. when the fair market value of the assets falls below its book value). In other cases, it might be more appropriate to consider the performance of the investments on a bi-annual or even quarterly basis.


6.3.4.    Risk management


Luxembourg companies may bear different types of risks such as credit risks in relation to financing activities, liquidity risks and tax risks. When these risks are material, they must be actively managed. Risk management refers to the identification, assessment, and control of risks.


Depending on the importance of the risk, a more formal approach might be considered (for example, preparation of a formal risk management policy).


The roles and responsibilities around risk management may be allocated to employees of the company, employees of another Luxembourg group company or an external service provider but, ultimately, need to be monitored by the directors of the Luxembourg company.


6.3.5.    Management of investments


The management of investments refers to important business decisions during the investment period and decisions regarding a (partial) exit from the investment.


During the lifetime of the investment, it may, for example, be necessary to provide additional funding to an operational company in need of cash or a property company that performs upgrades to its real property.


Moreover, the economic environment (an economic shock, a recession, a downturn in a certain industry, …) may require changes in the investment strategy or present exceptional circumstances that need to be navigated.


At the end of the investment period, investments are commonly sold. Here, the intention is to benefit from value appreciation. In some cases, a partial exit (that is a partial sale of the investment, potentially to establish a joint venture) may be considered, offering other investors a certain share in the investment.


Decisions regarding the management of the investment must be taken by the board of directors and should be properly documented in board resolutions and minutes of the board meetings.


6.3.6.    Cash repatriation and re-investment


Cash derived from investments throughout the lifetime of the investment (for example, dividend and interest income) or upon an exit may either be repatriated to the investors or re-invested if an appropriate investment opportunity presents itself.


The decision as to whether cash is repatriated or re-invested needs to be taken by the directors of the company. When investments are (partly) financed by debt instruments, the legal documentation should not include a provision that would require an automatic obligation to pay interest accrued under such instruments. Instead, it might make sense to clarify that the payment of (accrued) interest is generally at the discretion of the directors of the borrowing company, although absent any provision to the contrary this would de facto be the case.


When loans are obtained from banks, the terms and conditions of such loans should generally specify in detail the payment obligations of the borrowing company. However, the payment of interest to a bank should not be controversial regarding beneficial ownership.


Decisions regarding the use of cash should also be discussed during Board meetings and detailed in the minutes thereof.


6.4. Infrastructure


6.4.1. Employees


Investment managers may adopt different business models when it comes to employees and the management of investments. More concretely, it is possible to choose between an insourcing model (where most functions are performed internally), an outsourcing model (where most functions are outsourced) and varying levels in between.


An investment manager may, for example, centralize the employees at the level of an AIFM, a management (or service) company or a Luxembourg master company (i.e., the direct Luxembourg subsidiary of a fund) that renders services to other Luxembourg group companies. Alternatively, staff may be employed by several Luxembourg companies.  The employment situation often evolves over time with the investment manager's activities. However, even when an insourcing model is adopted, certain functions need to be outsourced to specialised service providers as it is difficult, if not impossible, to deal with all functions internally in an environment in which increasingly more regulatory, compliance and reporting obligations are introduced.


Another business model would be to rely to a large extend on the outsourcing of functions to specialised service providers such as Alternative Administrators (having the necessary experience, knowledge, infrastructure and tools). Whenever functions are outsourced, the activities and results must be monitored, either by employees of the group (in Luxembourg) or the directors of the Luxembourg company. Ultimately, the responsibility regarding all outsourced functions lies with the company’s directors.


6.4.2. Office premises


Luxembourg companies need to have access to appropriate office premises and meeting rooms. The requirement to rent business premises is closely linked to the business model adopted by the investment manager (insourcing vs. outsourcing).   


When a company or a group of companies has employees (be it at the level of an AIFM, a management company or a Luxembourg master company), it needs to have office premises for its employees. Office premises are generally rented. Here, Alternative Administrators that often rent out office premises may provide international investors and investment managers with reasonable solutions.


Obviously, Luxembourg companies must organize meeting rooms for the board of directors’ meetings. These rooms must be available whenever needed (whatever the frequency of board meetings is).


In addition, office premises and board meetings have to be equipped with appropriate IT equipment to facilitate the work of employees, the directors and the board of directors of Luxembourg companies.


6.4.3. Bank account


A Luxembourg company should generally have an operational bank account with a Luxembourg bank to make payments when investments are made, to pay for goods and services, to collect cash from investments, and to repatriate or re-invest cash.


However, if it proves difficult to open a bank account with a Luxembourg bank and/or an investment manager has good business relations with a banking institution in another EU member state, it is also possible to open a bank account with such foreign bank.


6.4.4. Machine learning


Machine learning (also referred to as “artificial intelligence” or “AI”) is a new phenomenon that recently gained massive traction with applications such as ChatGPT. It can be expected that machine learning will soon be capable of taking over increasingly more functions which could be disruptive when it comes to our understanding of substance.

Functions that could be automated or performed by machines include, amongst others, accounting, tax compliance, reporting, and even the drafting of legal documentation. One may further think about a robot reception or an AI personal assistant that replaces the human executive assistant.


When Luxembourg companies will take advantage of such new technologies, the functions performed by logarithms will still need to be monitored and reviewed by people, be it employees or directors that manage day-to-day operations. Therefore, it would be reasonable to attribute such functions substance-wise to the people in a monitoring position as it is the case with today’s computer usage.


6.4.5. Other ancillary elements


Other ancillary elements of substance may include the development of a website of the Luxembourg group (or rather part of a website of the investment manager), time records, security access, local business cards for employees and directors, local marketing material or local letterheads of the Luxembourg companies.

[3] In the context of this position paper, the notion substance should be understood as all the elements, facts and circumstances that evidence that a Luxembourg company is treated as tax resident and that its place of effective management is located in Luxembourg.

[4] Oliver R. Hoor, “Transformation of the Luxembourg tax environment towards the post-BEPS era”, Legitech 2021, p. 235.

[5] See Oliver R. Hoor, “Alternative Investments in Luxembourg: A comprehensive tax guide”, Legitech 2021, p. 234.

[6] Tax Circular L.I.R. N° 56/1- 56bis/1 of 27 December 2016.

[7] See Oliver R. Hoor, “The Concept of Substance in a post-BEPS World”, Tax Notes International, 2019, p. 597.

[8] See Oliver R. Hoor, “Transfer Pricing in Luxembourg”, 2nd edition, Legitech 2021, p. 141 f.



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