ATAD 2 (the second Anti-Tax Avoidance Directive) is an EU directive introduced in 2017 that extended the original anti-Tax Avoidance Directive to apply anti-hybrid rules to arrangements involving non-EU as well as EU counterparts. The impetus for the rules came from the OECD’s Base Erosion and Profit Shifting (BEPS) Action 2 which sought to combat hybrid mismatches. The objective was to prevent groups relying on the same arrangement being treated for tax purposes differently in two different jurisdictions, in order to create tax arbitrage situations. This could be from hybrid entities, for example where an entity is tax transparent in one jurisdiction and opaque in another, with that hybridity resulting in tax mismatches for instance if the income arising to the vehicle does not give rise to tax liability in either jurisdiction. Or it could arise from hybrid instruments, for instance an instrument that is treated as debt for the issuer, but equity in the hands of the holder, with payments under the instrument treated as deductible interest for the payer, but tax exempt distributions for the payer. Within the EU, ATAD 2 required member states to implement these rules mostly with effect from January 2020, although some elements took effect from 2022. The UK, despite leaving the EU, has its own version of ATAD 2, having enthusiastically adopted the BEPS Action 2 recommendations in the form of its hybrid mismatch rules introduced by Finance Act 2016 and amended a number of times since.
Typically, the focus of fund structuring from a tax perspective is on achieving tax neutrality. That is, ensuring that investors in the fund are subject to an overall tax treatment that is no worse than it would have been had they invested directly in the underlying assets. The application of the ATAD 2 rules to fund structures potentially gives rise to tax leakage in a number of different ways. This is perhaps unsurprising given that investment funds often involve cross-border flows of money, with a need to cater for investors potentially in multiple different jurisdictions with a range of tax profiles. The hybrid rules can impact deductibility of interest payments and, even more fundamentally, if the reverse hybrid rule applies at the level of the fund, this could impact the tax treatment of the fund itself, such that a transparent fund vehicle may become subject to tax, jeopardising the tax neutrality of the arrangements.
An important initial question is whether investors in an investment fund will be considered associated enterprises so as to fall within scope of the ATAD 2 rules. In relation to hybrid instruments, an associated enterprise is, broadly, one where an entity has a 25 per cent direct or indirect interest in terms of voting rights, capital ownership or entitlement to profits. For other aspects of the hybrid rules, there is a 50 per cent threshold. Whilst on first blush one might think that it would be rare for any investor in a widely held fund structure to meet those thresholds, it is important to consider whether any investors could be “acting together” for the purposes of these rules. The directive itself does not define this concept but there is some detailed OECD guidance on this point which indicates that where there is a common investment mandate given to the general partner or the fund to invest in assets on behalf of the investors, it does appear that such investors may well be seen as acting together with regard to any master company owned by the fund. In contrast, when it comes to the fund entity itself where you would be looking at the application of the reverse hybrid rules, investors generally subscribe to the fund independently and therefore it is more difficult to run the argument that the investors are acting together with respect to that entity.
Not all European jurisdictions have implemented ATAD 2 in the same way, which can create additional complexity and uncertainty for fund structures. For example, Luxembourg has introduced rules that provide that investors holding less than 10 per cent interests in a fund should not be considered to be acting together unless they are in fact acting together. Germany has applied the 25 per cent threshold across the board (including for hybrid instruments) and has a broader concept of structured arrangements, which means that if the structure is designed to leverage hybridity and take arbitrage benefits, then the ATAD 2 rules would kick in in Germany, irrespective of any shareholding percentage. The UK, on the other hand, takes a strict approach to acting together, but a more liberal approach to imported mismatches. Essentially, this means that if the arrangement passes through a jurisdiction that has implemented ATAD 2 and is compliant with ATAD 2, then this is sufficient for UK purposes. So where the UK is the investment jurisdiction, it will respect (for instance) Luxembourg’s interpretation of ATAD 2 in respect of a Luxembourg fund, whereas the UK will apply its own stricter rules to a UK-established fund. There is also the concept of significant influence which is an alternative criterion to the above thresholds, which can be relevant where either the GP holds a participation in the fund or certain investors with significant holdings have a say in investment committees or similar bodies.
There will often need to be a balancing act between different considerations. For instance, U.S. investors may have a preference to invest through tax transparent vehicles. This is because of the anti-deferral regimes in the U.S. (i.e. the CFC and PFIC regimes) which do not just bring with them current income inclusion problems, but also raise issues around penalties, interest and significant complexity as a result of some calculations being done at entity level and others at shareholder level and the challenges of the associated filings. This can mean that, from a U.S. tax perspective, it may often be preferable to make a check-the-box election. However, that election means you instantly have hybridity for ATAD 2 purposes. Therefore these U.S. investor preferences have to be weighed carefully against the ATAD 2 implications. For instance, checking the box could lead to a double deduction situation, whereby a counteraction under ATAD 2 (such as a denial of deductions) can only be avoided if there is double inclusion income (i.e. the income is effectively taxed twice) to compensate.
In terms of the impact of ATAD 2 on fund structures, we have seen a definite increase in the use of opaque fund vehicles particularly with EU sponsors and this can help in particular with access to tax treaties and withholding tax reliefs. Unsurprisingly, U.S. and non-EU sponsors tend to be more reluctant to use opaque vehicles, although this can be a point about familiarity of how certain vehicles work. For those wanting to stick with their transparent vehicles, there are some options for mitigating the ATAD 2 risk, such as ensuring that investors who might be impacted by ATAD 2 invest through an opaque feeder vehicle, monitoring the investor base or relying on the carve out for collective investment vehicles. The options need to be considered on a case by case basis, taking into account the risk appetite of the sponsor and investors and the main focus of the fund to choose the most robust structure from an ATAD 2 perspective, whilst factoring in other tax (and non-tax) considerations.
ATAD 2 has also had an impact on fund documentation. It is advisable to include provisions in the fund documentation allocating ATAD 2 risk, although this is more common in European based funds as opposed to U.S. based funds with limited exposure to European assets. We would typically see disclosure of ATAD 2 related risks in the risk factors and it is common to require investors to give representations as to their ATAD 2 status. In addition, there may also be an ATAD 2 questionnaire where the fund manager obtains information on the tax status of the investor. This can vary in terms of the length and depth of questions depending on how deeply the fund manager wants to investigate the position. It is important to not just collect but evaluate the responses from the investors and monitor any changes in information to ensure all the data required is available both to ensure compliance but also to be able to respond to potential audits by tax authorities in the future.
As a rule, fund sponsors should engage with ATAD 2 issues at an early stage of the fund formation and investment process to ensure the risks are factored in and to develop strategies that work commercially and fit with wider legal and commercial requirements. Whilst ATAD 2 is unlikely to be fatal to a fund, it does require careful planning and analysis to get the structure and documentation right.
