What Does Substance Really Mean For Alternative Investments?

Some may be under the impression that substance is a widely known tax concept and that there is not much to say.

From a tax point of view, however, substance remains a changing concept, evolving with tax laws, jurisprudence and doctrine. Since the Organisation for Economic Co-operation and Development (OECD) presented their action plan on base erosion and profit shifting (BEPS), the concept of substance has reached another level with the principal purpose test (PPT) introduced in Action 6.

The PPT is an anti-treaty abuse clause that "allow[s] contracting states to deny the application of treaty provisions when transactions or arrangements (such as the setting up of a SPV in Luxembourg) are entered into in order to obtain the benefits of these provisions in inappropriate circumstances." Private equity, real estate, and hedge/debt funds (so called "AIFs") are quite worried about the potential consequences of a broad interpretation of the PPT concept, which may disqualify them (and their SPVs) for double tax treaty benefits.

AIFs in light of BEPS Action 6

AIFs are nothing else than arrangements between multiple investors aiming at diversifying their risks and benefiting from an increased scale of investment in addition to the expertise of an asset manager. However, this risk-spreading and economy of scale will remain inefficient if we cannot put, tax-wise, the investor in a situation equal to one of direct investing. This is why AIFs are usually set up under tax transparent funds with a tiered SPV structure, i.e. to benefit from double tax treaties and hence minimise tax leakages on distribution from the portfolio to the final investor.

Is the objective of tax neutrality sufficient to qualify for treaty benefits within the meaning of Action 6? We have little guidance on how to determine when a particular tax consideration may be considered "principal purpose," particularly when there are multiple purposes. The three draft examples (aiming at clarifying the PPT for AIFs) published, for guidance, early in 2017 by the OECD acknowledge that a specific provision under a tax treaty (e.g. the reduced withholding tax rate) cannot be denied even if it was taken into account in structuring the relevant investment.

Further features required

To secure treaty benefits, the set-up of a regional holding platform for PE, RE and other AIFs will, however, require additional features such as the competence of a local management team to review/approve/monitor...