Recent Luxembourg Case Law on the Commercial Activity of Partnerships: Between Clarifications and Interrogations

These last years, partnerships have become an essential tool in the range of vehicles available to investors and promoters operating in the private equity or investment fund sector. Flexibility, simplicity and tax transparency are often the words that come to mind when thinking of partnerships. Although widely used in Luxembourg, Luxembourg tax legislation (including circulars) is rather limited when it comes to determine the Luxembourg taxation applicable to these vehicles. In this respect, the Luxembourg Administrative Court (the "Court ") issued an interesting decision on 8 February 2018 clarifying the outline of the definition of the commercial activity but, at the same time, raising some questions on the circumstances in which a tax transparent entity is deemed to carry out a commercial activity. Although the Court had to examine other questions raised by the taxpayers, this contribution will only address the aspects of the case in relation to the commercial activity of a partnership from a Luxembourg tax perspective. A second part of this article by the Hogan Lovells (Luxembourg) tax team will notably cover the application of the double tax treaties between Luxembourg and Germany (the " Treaty") with regards to the income or gains received by a partnership.

Background

In 2006, a German resident individual subscribed shares into a German limited partnership (i.e. GmbH & Co.KG3 - the "Partnership") which acquired an asset linked note (the "ALN"). The general partner of the Partnership was a German corporate entity (i.e. GmbH4 - the "GP"). Due to poor performances of the underlying assets and significant interest payments due by the partnership under a loan financing the acquisition of the ALN, the ALN has been sold before its maturity and the proceeds (including portion of accrued interest and a capital gain - the ("Proceeds")) used to reimburse part of the shareholders investments. 

In the meantime, the individual became a Luxembourg tax resident and did not include the Proceeds received from the Partnership in their taxable basis. In the context of an automatic exchange of information between Germany and Luxembourg, the Luxembourg tax authorities were informed of the income received by the individual and decided to reassess the taxable basis of the individual to include the Proceeds and tax them accordingly. 

The Luxembourg taxpayer challenged this reassessment before the director of the Luxembourg tax administration (the "Director") on the grounds that such proceeds should be qualified as business profits and thus it was necessary to take into consideration the losses incurred by the partnership pro rata to their participation therein. The Director however confirmed that the Proceeds were to be qualified as capital gains and not as business profits as the Partnership did not carry out a commercial activity.  

Before the Luxembourg Administrative Tribunal, the decision of the Director has been partly overruled as it classified the Proceeds as business profits from a Luxembourg tax perspective. In this frame, the Luxembourg government lodged an appeal before the Administrative Court.

Decision of the Administrative Court

The Court as a preliminary step applied the comparability analysis method (Rechtstypenvergleich) to determine if the Partnership should qualify as a tax transparent or a tax opaque entity from Luxembourg tax perspective. In the present case, the Partnership has easily been compared to a Luxembourg limited partnership (société en commandite simple – "SCS") and has therefore been considered as transparent from a Luxembourg tax perspective. As a consequence, the Luxembourg resident limited partner was a priori taxable in Luxembourg pro rata to their share in the partnership on any net income or gain deriving from the Partnership, subject to the provisions of a double tax treaty. 

Nonetheless, the main issue was the type of activity carried out by the Partnership. Further to article 14 paragraph 1 of the Luxembourg Income Tax Law ("LITL"), there is a commercial activity when the activity is carried out independently, permanently, with the intention to realise profits and with a participation to the general economic environment. 

In addition to the criteria above, the case law generally considers that the activity of the entity should go beyond the mere management of private wealth (Vermögensverwaltung). The management of private wealth, even if not defined in Luxembourg tax laws, although not defined in Luxembourg tax laws, the management of private wealth is considered to be characterised as long as the substance of the assets is preserved (i.e. the main goal should be to maintain the enjoyment of private wealth) and the sale of such assets within a short period of time (usually one year) is an ancillary activity to their management. However, the Court highlighted that the management of financial assets was different from the management of other assets to the extent that regular acquisitions and sales of movable property were inherent to the management of such financial assets and thus entered within the scope of the management of private wealth. However, a commercial activity could be characterised in the case certain criteria are met such as the volume of the transactions, the maintenance of an organisation or the offer to a large public. In the case at hand, the Court decided that the mere collection of funds from a limited number of investors, the entry into a financing agreement and the investment in the ALN had to be considered as falling within the scope of the management of private wealth, even if the transaction had begun with the acquisition of the ALN and ended with its sale. 

Since the activities performed by the Partnership were not considered as a commercial activity based on paragraph 1 of article 14 LITL, the Court verified whether the Partnership could be deemed to carry out a commercial activity within the meaning of article 14 paragraph 4 LITL. In accordance with this article applicable at the time of the case, a Luxembourg tax transparent entity was deemed to carry out a commercial activity when at least one of its general partners was a company limited by share. In the present case, the Court noted that the GP was a company limited by shares and thus confirmed the application of article 14 paragraph 4 LITL.

Conclusion

Although this decision is interesting, the conclusions to draw therefrom are rather mixed. 

On one hand, this decision confirms that the recognition of a commercial activity has to be assessed on a case-by-case basis, taking into account the nature of the assets managed. As regards the management of financial assets, the Court clearly states that acquisitions and sales within a relatively short period of time are not sufficient to consider that a commercial activity exists, as such transactions are inherent to the management of financial assets. Other criteria such as the volume of the transactions, the maintenance of an organisation or the offer to a large public will need to be considered to determine whether an entity carries out an economic activity or not. These precisions are particularly welcome, especially for non-regulated structures using Luxembourg limited partnerships (SCS or special limited partnerships (société en commandite simple spéciale – "SCSp"). Contrary to SCS or SCSp qualifying as alternative investment funds5, reserved alternative investment funds6, special investment funds7 or investment company in risk capital8, which are deemed not to exercise a commercial activity according to the circular L.I.R. n° 14/4 of 9 January 2015 (the "Circular"), there are fewer guidelines on "non-regulated" SCS/SCSp which may be, depending on their activity, considered as exercising a commercial activity and thus be subject themselves to municipal business tax and attract corporate income taxation at the level of the partners. This case brings more comfort to investors or sponsors who would want structuring an investment through a "non-regulated" SCS/SCSp.  

On the other hand, this decision raises certain questions regarding the application of the deemed commercial activity provided for by article 14 paragraph 4 LITL. According to these provisions, an SCS/SCSp may be considered as exercising a commercial activity if (i) its general partner is a company limited by share capital and (ii) holds at least 5% of interest in the partnership (at the time of the case, the second condition was not provided in the article). Although the article does not make any distinction with regards to the residence of the general partner, there was a large consensus among the doctrine and practitioners on the fact that a foreign general partner was not able to taint a Luxembourg partnership, in the absence of Luxembourg permanent establishment. This position relied on the preparatory works of the Luxembourg law of 21 December 20019 as well as the German-inspired "isolate consideration" theory (isolierende Betrachtungsweise). In the case at hand, and although this was not debated among the parties, the Court considered that a non-Luxembourg GP, i.e. a German GmbH, had tainted the partnership in accordance with paragraph 4 of the article 14 LITL (as applicable at this time) and thus the Luxembourg partners had realised a commercial income due to the application of article 14 paragraph 4 LITL. No particular reference to a permanent establishment in Luxembourg was made by the Court. Given the circumstances of the case, it is not easy to assess the impact of such a decision. In the case at hand, the partnership was a German entity that was compared to Luxembourg entity to determine the nature of the income from a Luxembourg tax perspective (as the limited partners were resident in Luxembourg). The question is thus whether another position would have been adopted if the partnership had been a Luxembourg partnership. In addition, this question had not been debated among the parties. Therefore, there are few elements to determine whether the position of the Court is limited to this specific case or if it can be extended to Luxembourg partnerships. Until the Court or the Luxembourg tax authorities further clarify this point, caution should be excercised when the general partner is a company limited by share capital, even if the latter is a non-Luxembourg resident entity. The risks that a Luxembourg SCS/SCSp is tainted are rather limited since the law of 12 July 2013 on alternative investment fund managers has modified article 14 LITL to include a safe harbour provision for corporate general partners holding less than 5% of interest in an SCS/SCSp. In other cases, special care should be taken and potential structuring could be advisable to avoid any adverse Luxembourg tax impacts for the members of the SCS/SCSp that could be considered as having a permanent establishment in Luxembourg and be taxed accordingly.

If you have any questions, please contact your Hogan Lovells (Luxembourg) tax team.

Cour Administrative, 8 February 2018, role number 39274C.  

Double tax treaty signed between Luxembourg and Germany dated 23 August 1958 (terminated on 1 January 2014).  

Gesellschaft mit beschränkter Haftung & Compagnie Kommanditgesellschaft.  

Gesellschaft mit beschränkter Haftung.  

Law of 12 July 2013 on alternative investment fund managers. 

Law of 23 July 2016 on reserved alternative investment funds.  

Law of 13 February 2007 relating to specialised investment funds.  

Law of 15 June 2004 relating to the investment company in risk capital.  

N° 4855.

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