Over the past 15 years, the funds market has increased rapidly, whereby Luxembourg is one of the main financial centres and the second-largest fund hub globally, after the United States.
Luxembourg is a popular location for the establishment of investment funds due to its well-regulated financial sector and legal framework that caters to different types of fund structures. Luxembourg private fund structures offer stability, investor familiarity, limited liability for investors and a more favourable business landscape.
General Partner (GP) typically refers to an individual or entity that has unlimited liability and managerial control in a limited partnership1or investment fund structure in the form of a limited partnership or a private equity fund. A GP is generally responsible for managing the operations of the partnership, representing the partnership externally, and assuming the liability for the partnership's obligations.
When we delve into the world of transfer pricing (TP), we find that GPs in investment funds are sometimes seen as having somewhat modest roles, even though some GPs engage in more substantial activities. Interestingly, not all GPs are compensated for their efforts. This raises an intriguing question: Do GPs even need a compensation? And what about Value-Added Tax (VAT)? Are GPs’ compensation subject to VAT, and if so, what would be the potential impacts to be considered?
Let's take a closer look at the GPs.
The GP as part of Luxembourg fund structures
GPs of Luxembourg limited partnerships may be individuals but are usually corporations or limited liability companies. The role and responsibilities of GPs are regulated under Luxembourg's law of 10 August 1915 on commercial companies, as amended (the 1915 Law) and, to the extent admitted by the law, under the limited partnership agreements (LPAs) concluded between Luxembourg funds and GPs.
In general, the economic interest of GPs in Luxembourg partnerships is limited. The structure of a Luxembourg fund often involves a GP and limited partners (LPs).
In principle, LPs are investors who contribute capital to the fund and generally have limited liability and involvement in the fund's operations. LPs invest capital based on their expectations of the GPs1 abilities to identify investment opportunities that will generate an attractive return for the whole partnership.
A GP, on the other hand, would assume greater responsibility, manages the fund's activities, and could have unlimited liability for the fund's obligations. In other words, the role of GPs in Luxembourg, especially within the context of an investment fund, is multifaceted and involves various responsibilities as part of its overall managerial control in Luxembourg partnerships or investment fund structures. In practice, an Alternative Investment Fund Manager (AIFM) is often appointed to manage the investment fund, but the GP generally remains responsible for supervising the performance of the AIFM.
GPs can offer significant business experience and managerial expertise of their principals or employees to portfolio companies and may have their own principals or employees serve as directors or officers of such managing companies. In addition, GPs may serve as financial intermediary for purposes such as:
- Structuring a capital fund's investment in portfolio companies;
- Identifying other funds to participate in financing rounds; or
- Assisting portfolio companies in obtaining commercial debt financing.
Each of these roles may create significant legal risks when for instance a portfolio company fails and the expected returns on invested capital are insufficient.
[1] “Partnership” in this article indistinctly refers to SCA, SCS and SCSp.
Role of GPs
The role of GP in Luxembourg is dynamic and entails a blend of strategic thinking, financial acumen, regulatory compliance, and strong interpersonal skills to effectively manage the fund and achieve optimal returns for investors. What are the roles of a GP in Luxembourg? They may consist of the following:
- Fund Management: managing the day-to-day operations of the funds, i.e., making investment decisions, executing strategies, and overseeing the funds' overall performance.
- Investment Strategy: formulating the investment strategy of the funds, i.e., determining the types of assets the fund will invest in, risk tolerance, target returns and other strategic considerations.
- Due Diligence: conducting due diligence on potential investment opportunities, i.e., assessing the financial health, market potential, and risks associated with various investment options before presenting them to the LPs.
- Investor Relations: being the primary point of contact for the LPs, i.e., providing regular updates on the fund's activities, performance and other relevant information.
- Risk Management: assessing and managing risks associated with the funds' investments such as market risks, regulatory risks, operational risks, etc.
- Compliance: ensuring that the funds' operations comply with Luxembourg's regulatory requirements and international standards.
- Capital Deployment: deciding how and when to deploy capital into various investments.
- Exit Strategy: planning and executing exit strategies for investments, i.e., selling assets, mergers and acquisitions, or other means of realizing returns for the fund.
- Performance Monitoring: continuously monitoring the performance of the funds' investments, i.e., analysing performance against benchmarks and adjust strategies as needed to optimise returns.
- Compensation Structure: negotiating their compensation structure with the LPs, i.e., including management fees, carried interest, and other incentives aligned with the funds' performance.
- Decision-Making Authority: decision-making authority regarding investments and fund management.
- Reporting: providing periodic reports to the LPs, detailing the fund's performance, investments, and other relevant information.
However, a GP may outsource most of the aforementioned value-added functions. How such functions are generally outsourced, is illustrated in the next section in which the transactional model of a GP is explained.
Transactional Model
In their capacity as managing general partners of the funds, GPs represent the funds and have the exclusive right to manage them. A GP may on behalf and for the benefit of the funds, appoint a related or third party as the Alternative Investment Fund Manager (AIFM) of the funds. In addition, GPs, may outsource other functions such as depositary activities and fund administration activities to external service providers.
A Luxembourg AIFM is, in general, responsible for the AIFM services including amongst others risk management, delegation and supervision of portfolio management, initial and ongoing due diligence on all delegates, etc. It may subsequently outsource part of its functions, such as portfolio management, investment advisory, valuation, and marketing of the funds, to related and unrelated entities.
In addition, GPs have the power to appoint other external services providers for functions such as depositary activities and fund administration activities.
The funds should generally pay a management fee to the GP to remunerate its overall functions performed, assets utilised and risks assumed as general partner of the funds. When a GP outsources part of its functions, it should remunerate the AIFM in charge of the AIFM services. For the performance of investment advisory services sub-delegated by the AIFM, the investment advisor receives an advisory fee from the funds usually through the AIFM or GPs. After remunerating the outsourced services, would the GP be left with any compensation?
How is TP related to a GP?
1. Analysis of the facts
When fund management services involve transactions between related parties, an analysis should be performed in accordance with the Luxembourg TP framework and OECD Transfer Pricing Guidelines for Multinationals and tax Administrations (OECD TP Guidelines) whereby it should be assessed whether the interacting related parties should receive an arm’s length remuneration.
From a TP perspective, the role and compensation of GPs can vary significantly. Some GPs may primarily oversee strategic decisions and have limited day-to-day involvement, while others roll up their sleeves and actively manage investments, assess risks, and shape the fund's direction.
For those GPs with more extensive functions, compensation may be a way to recognise their substantial contributions. These GPs may be engaged in investment decisions, risk management, due diligence, and more. In such cases, a compensation can serve as a reward for their expertise and efforts in steering the fund towards success.
However, not all GPs in the investment world are active decision-makers. Some GPs may play a more passive role, relying on external advisors or simply facilitating investments initiated by limited partners.
So, do these less active GPs need any compensation? This question depends on the particular circumstances of the fund, the GP's involvement, and market practices. In some instances, GPs may opt for a more modest or even symbolic compensation, aligning their interests with the long-term growth and success of the fund rather than seeking immediate financial rewards.
Ultimately, the answer to whether GPs need compensation depends on the nature of their functions, their contribution to the fund's performance, and the principles they uphold in shaping their compensation arrangements. The basis to understand the functions performed, risks borne, assets utilised and decisions made is a functional analysis. On the basis of a functional analysis, the most appropriate TP methodology can be selected. The selected TP method comes into play when determining whether the compensation provided to GPs is in line with the arm's length principle and accurately reflects the value they bring to the fund's operations.
In cases where the AIFM services are rendered by third party AIFMs (i.e. not a group affiliate to the funds or GPs) to the funds, the AIFM service fee does, in principle, not have to be tested from a TP perspective. Similarly, it could be considered that the total asset management fee (TAMF) would be at arm’s length since the investors in the fund are third parties that have accepted the volume of TAMF as determined in the funds' placement memoranda.
On the other hand, when GPs provide their general partner services to the funds, the arm’s length character of the remuneration to be earned by GPs for their services should be substantiated for tax and TP purposes.
Compensating GPs in Luxembourg within the context of TP involves ensuring that the remuneration arrangement between GPs and the funds is conducted at arm's length, meaning that the terms of the compensation are consistent with what would be agreed upon between unrelated parties in a similar transaction.
The compensation arrangements for GPs are often designed to align their interests with the success of the fund and its investors. The terms are negotiated and outlined in the LPA (or in the placement memoranda), which is a legally binding document that governs the relationship between GPs and LPs.
2. Selection of TP method
In applying the OECD TP Guidelines to the facts and circumstances related to the general partner services rendered by GPs, it is necessary first to consider the pricing method that should be most appropriate to set the prices for the transactions concerned.
The selection of the TP method depends in large part on the functional analysis that precedes it. This section illustrates the TP methods available under the OECD TP Guidelines and an assessment of
what method could be the most appropriate to test the arm's length nature of the intra-group transactions in scope.
Depending on the outcome of a functional analysis, hereby a few potential TP methodologies that could be considered when compensating a GP in Luxembourg:
- Comparable Uncontrolled Price (CUP) Method: This method involves comparing the GP's compensation to prices charged for similar services in transactions between unrelated parties. In the context of a GP, you would look for comparable compensation arrangements between GPs and their limited partners in similar fund structures. The challenge here is finding truly comparable arrangements, as compensation for Luxembourg GP structures can vary significantly compared to market transactions. However, when comparable arrangements exists, this method may be the most appropriate methodology to be applied.
- Transactional Net Margin Method (TNMM): The TNMM involves comparing the net profit margin earned by the GP with that of comparable entities engaged in similar activities. The GP's costs, functions, and risks would be analysed and subsequently compare the GP’s profit margin to similarly situated entities in the industry. This method requires a reliable benchmarking analysis whereby appropriate comparable transactions should be identified. A profit level indicator that may be considered is a mark-up on total costs.
- (Transactional) Profit Split Method: The profit split method allocates profits between related parties based on their respective contributions to the value creation. In the case of a GP, the value added by the GP's functions, risks, and assets in the fund's operations should be overall assessed. When using a Transactional Profit Split Method, the focus is on the allocation of profits from a specific transaction or group of transactions. This method may be less obvious, but may be considered for transactions with more complex activities (e.g. when the GPs perform valuable activities and not only broad oversight and control). In that respect, considering that most of the Luxembourg GPs merely perform broad oversight and control, the Transactional Profit Split Method is not commonly used to estimate the remuneration of the GPs.
3. Compensation of a GP
Compensating a Luxembourg GP within the context of TP involves ensuring that the compensation arrangement between the GP and the LPs is conducted at arm's length, meaning that the terms of the compensation are consistent with what would be agreed upon between unrelated parties in a similar transaction. On the basis of the selected TP method, it should be determined whether and what compensation should be applied.
For GPs that perform a number of important value-added functions, a typical compensation would be a percentage of the total Assets Under Management of the fund or a percentage of the TAMF. Such compensation should generally cover its costs for performing the functions and leave a certain level of profits.
In some cases, there could be direct third party comparables available (e.g. CUP) that may be utilised to determine the level of compensation. If there are no direct third party comparables available, external comparables may be applied using public available databases.
For GPs that do a minimum activity and bear limited to no risks, a compensation may potentially be based on a cost plus type of compensation. Under such methodology, the costs of the activities should be covered leaving a mark-up on costs.
So, in short, for the question whether a GP requires a compensation the answer is yes! Now the level of compensation really depends on its functional and risk profile.
Now it is clear that a GP needs a compensation, the next topic is to understand what this means from a VAT perspective.
How is VAT related to a GP?
As the GP should generally receive a remuneration for providing or procuring services to the partnership, the GP should be regarded as a VAT taxable person in Luxembourg. Also, it was confirmed a few years ago that the GP and the partnership should be regarded as two distinct persons for VAT purposes and their VAT position was to be assessed separately. The situation could, however, be different when a GP only receives profit distributions from the partnership. Based on EU case law, only payments which are the consideration for a transaction, or an economic activity come within the scope of VAT and the receipt of “dividends” is not the consideration for any economic activity as those arise simply from ownership of the asset (here, the interest in the partnership) and are subject to the existence of distributable profits.
In addition to the nature of the allocations made to the GP, the VAT treatment of the remuneration would depend on whether the GP renders management services to a qualifying fund or to a non-qualifying fund2. In practice we see GPs managing Alternative Investment Funds (AIFs) and/or non-AIFs under the form of SCSp even though other forms of partnerships can be used. In general, the services rendered by the GP to qualifying funds should be VAT exempt thanks to the fund management exemption whereas the services provided to non-qualifying funds would be subject to VAT.
A more complex situation could arise where one GP renders services to both types of entities and therefore would have an activity partially allowing VAT recovery. In addition, when the same GP is managing both qualifying and non-qualifying partnerships, the question as to whether the services are specific and essential for the management of the qualifying funds could be raised for the purposes of applying the fund management VAT exemption.
Depending on the activities performed, the GP could be liable to comply with certain VAT obligations (i.e. VAT registration and filing of VAT returns depending on the VAT registration regime). It is crucial that the remuneration of the GP is supported by legal documentation reflecting the economic reality of the situation.
[2] The qualifying funds are listed under article 44,1, d) of Luxembourg VAT Law. There are amongst others collective investment funds including SICAVs, SICARs, alternative investment funds, securitisation vehicles.
TP documentation: is it so important for the GPs’ intra-group activities?
The arm’s length character of intra-group transactions should be substantiated by robust TP documentation. Even though the domestic TP regime legislation does not specifically require the preparation of TP documentation to be filed along with the annual corporate tax return, in line with the Luxembourg's general TP legislation (i.e. Articles 56 and 56bis of the Luxembourg Income Tax Law and paragraph 171 of the General Tax Code) the prices applied on intra-group arrangement should be at arm's length. The arm's length nature of the general partner activities of Luxembourg
GPs should be documented and supported in a TP documentation to be prepared in accordance with the OECD TP Guidelines.
In other words, Luxembourg taxpayers should support the facts and provide information with regards to statements and declarations made in the tax returns of the GPs. In case the Luxembourg taxpayers cannot reasonably evidence that the intra-group transactions involving the GPs could not be considered as arm’s length, the Luxembourg tax authorities (LTA) might perform their own TP assessment that could impact the GPs’ taxable basis, e.g., the LTA would argue that the GPs should be entitled to a percentage of the TAMF.
Therefore, it is key for the Luxembourg taxpayers to develop, apply and whenever appropriate update their GP’s TP policies for risk mitigation purposes.
GPs under local tax audits
Since the creation of a separate tax audit division within the Luxembourg tax authorities (LTA), tax audits have now become more frequent. As tax assessments in Luxembourg may cover up to five years and even be extended to 10 years in case of filing of an incomplete or incorrect tax return, potential tax risks may be relatively high.
New draft bill 8186 (the Draft Law) proposes a formalising of the collaboration between the Luxembourg regulator Commission de Surveillance du Secteur Financier (CSSF) and the LTA. In detail, the Draft L aw proposes an exchange of information between the LTA and CSSF to mitigate potential inconsistent reporting. Besides the increased focus on TP by both the CSSF and LTA, it will become much more important to have consistent and up to date reporting to mitigate regulatory and TP exposures going forward. Therefore, the potential tax risk could also be incurred in case the LTA and/or CSSF would request information about the TP treatment of the GPs' remuneration and extend their review on a broader scale for other intra-group arrangements within the same fund structure. Consequently, the TP support of the GP functions and monitoring of proper implementation of transfer prices requires an appropriate and active tax risk management function at the level of the fund managers.
From a VAT perspective, some challenges could be expected especially in the framework of inter-administrative cooperation between the Luxembourg direct, indirect tax and regulatory authorities (Law dated 19 December 2008 as amended).
Does a GP need a compensation?
From a TP perspective, this is a question that requires a proper functional analysis on the actual facts and circumstances. A GP is responsible for a number of value-added functions. As GPs can outsource one or more of these functions, it should be carefully analysed what the GP is actually performing after it outsourced (part of) its activities. The compensation should be based on the final situation that may be specific for each GP.
From a VAT perspective, the VAT status of the GP should be carefully assessed aligning with the TP position as the provision of services for remuneration should in principle be subject to VAT (unless specific rules apply).
A common assessment at the set-up of the fund structure should allow mitigating challenges from the tax perspective.
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