There are several reasons to allocate part of a portfolio to real estate: the reduction of the portfolio's overall risk due to the negative correlation of real estate with other asset classes, the hedge against unexpected inflation or deflation, the achievement of absolute returns above the risk-free rate, or the implementation of regular strong cashflows to the portfolio. Investments in real estate assets have become increasingly popular both with institutional and retail investors. The European Fund and Asset Management Association estimates the total assets under management for the European open- and closed-ended real estate market at the end of 2006 at €170 billion.

These facts speak in favour of gaining exposure to the real estate asset class, but investments in real estate can be a challenging undertaking from a legal, fiscal, accounting and operational perspective. Consequently, market participants are increasingly looking for vehicles that are flexible enough to respond to these various requirements.

Luxembourg, the primary investment fund centre in Europe, with almost €2 trillion fund assets under custody and administration, reacted to this industry demand by enacting an act dated February 13 2007 (the 2007 Act) on specialized investment funds (SIFs).

The comments on the bill of law underlined the importance to make the SIF a convenient fund vehicle for real estate investment, among others.

Corporate law aspects

As any Luxembourg undertaking for collective investment (UCI), the SIF can be structured under the contractual form (fonds commun de placement, or FCP) or under the corporate form (investment company).

When established under the contractual form, the SIF is managed by a management company subject to the act of December 20 2002 on UCIs (the 2002 Act). The management company must be established in Luxembourg either under Chapter 13 (compliance with substance requirements as defined by EU Directive 107/2001) or under Chapter 14 of the 2002 Act. The management company is entitled to delegate its administration and asset management to a third party if the administrator must be based in Luxembourg. Traditionally, the management company is set up in the form of a Luxembourg public limited liability company (société anonyme) subject to Chapter 14 of the 2002 Act. Unitholders of an FCP have no political rights and cannot participate in any decision regarding the management, the administration or the modification of the structure of the SIF, including its liquidation.

The FCP issues registered or bearer units. The conditions and the process of issue and redemption must be described in the management regulation.

When established in the form of an investment company, the SIF may choose from different corporate forms. A Luxembourg investment company is either constituted with variable capital (société d'investissement à capital variable, Sicav-FIS) or with fixed capital (société d'investissement à capital fixe, Sicaf-FIS) – FIS standing for fonds d'investissement specialise, that is, specialized investment fund.

Sicavs can adopt different company forms:

• public limited liability company (société anonyme, SA);
• corporate partnership limited by shares (société en commandite par actions, SCA);
• private limited liability company (société à responsabilité limitée, Sàrl); or
• a cooperative company organized under the form of an SA (société cooperative organisée sous forme d'une société anonyme, SCoSA).

A Sicaf can be set up under these forms, but other types of forms would also be available. There are no legal constraints on the rules applying to the issue and redemption of units or shares that are determined in the management regulations of the FCP or in the articles of incorporation of the Sicav/f. As opposed to a UCI subject to the 2002 Act, where 100% of a unit or a share has to be paid up when issued, only 5% of each share has to be paid up in a corporate SIF. This enables a Sicav/f to draw on committed capital according to investment opportunities and requirements from underlying assets.

Unlike Sicavs subject to the 2002 Act, a Sicav-FIS may issue non-share-capital securities such as debt securities and profit shares.

The corporate SIF is subject to a minimum capital requirement of €1.25 million, to be reached within 12 months of its authorization. An FCP must reach the same amount within 12 months in terms of net assets. For a Sicav/f, the subscribed capital, increased by the amount of share premium, is taken into account for the purposes of this requirement. Payment of interim or annual dividends is not subject to any legal restrictions except that at all times the minimum net assets (for FCPs) or the capital requirement increased by the amount of share premium (for corporate SIFs) must be maintained.

SIFs may be established as an umbrella structure with different sub-funds. The assets of each sub-fund are segregated from those of the other sub-funds. Each sub-fund can follow its own investment policy and hire its own investment manager or adviser.

Regulatory and operational aspects

The SIF is subject to the supervision of Luxembourg regulator Commission de Surveillance du Secteur Financier (CSSF). The SIF's assets must be entrusted to a depositary and its financial statements must be certified by an external auditor. The principle of supervision has been maintained but its practical implementation has been relaxed. Instead of detailed legal requirements, the contractual relationships with the involved parties will define duties, rights and processes.

Simplified registration process

The registration process is limited to the regulatory approval of the SIF's constitutional documents, choice of depositary and directors (or management company). The SIF is entitled to delegate the management of its assets to a third party and to appoint external investment advisers. The manager and the adviser do not need to be established in Luxembourg and are not required to be subject to the prudential control of a recognized supervisory body for investor protection.

By constitutional documents, the legislator means the issuing document, the articles of incorporation or the management regulations (of the FCP) as well as the agreements with the different service providers, including the depositary and the administrator.

Neither the sponsor nor the investment manager or adviser is submitted to approval by CSSF. The driving persons behind the SIF project must be identified. The regulator's control focuses on the directors of the SIF (or its management company). The directors must be of sufficiently good reputation and have the appropriate experience. The directors bear contractual liability toward investors and liability in tort towards any party harmed by violation of the SIF's law, articles of incorporation or management regulation.

Regulatory approval is needed for the replacement of a director, the management company or the depositary, and any modification of the constitutional documents. The issuing document only needs to be adapted when additional units or shares are issued to new investors.

A specific feature of the 2007 Act is that application for entry on the official list of CSSF can be made within one month after the constitution of the SIF. This means that, in practice, the SIF can be run, even if the regulator approves the SIF a few months later.

Depositary's control relaxed

Although the SIF's assets must be entrusted to a depositary, the legislator introduces the possibility to relax the level of control for the depositary. The depositary must be a credit institution and it must either have its registered office in Luxembourg or be established in Luxembourg if the registered office is in another EU member state. Traditionally, the Luxembourg depositary assumes a double function: it is the safe-keeper (gardien), which implies the supervision of the UCI's assets, and it is in charge of monitoring the transactions the UCI is involved in. Under this second function the depositary ensures that, in transactions involving the assets, consideration is remitted within the usual time limits, that profits are distributed according to the constitutive documents, and that the issue and repurchase of units or shares are carried out in accordance with statutory and contractual obligations. If the UCI is constituted under the contractual form, supplementary duties are added.

Unlike the 2002 Act and the Sicar Act, Article 16 of the 2007 Act only describes the safekeeping function, which does not fundamentally differ from the one within a UCI or a Sicar.

The supervisory function of the depositary involves that it must know at any moment where and how the assets are invested. The supervisory obligation requires a look-through approach to obtain information on final investments behind the directly invested vehicles. However, the depositary is not responsible for the compliance of the SIF's portfolio with the investment policy.

As opposed to the safekeeping function, the monitoring of transactions is not covered by the 2007 Act. A transaction can be incorrect either in its decision process (the transaction should not have been taken) or in its execution (it has been inadequately executed). If the depositary executes an order duly instructed by, for example, the board of directors of the SIF, it cannot be liable if the board should not have taken that decision (for example, the decision was not compliant with the investment guidelines). If the depositary has wrongfully executed the decision, it will obviously be liable.

If the SIF is constituted under the contractual form, the depositary has the supplementary duty to accomplish all operations concerning the day-to-day administration of the SIF. The 2007 Act does not determine the tasks to be covered by the day-to-day administration. There is no doubt that the collection of interests or dividends from the underlying assets for the SIF's account or the execution of a payment in a reasonable timeframe are covered. The calculation of a correct gross asset value once a year, the proper valuation of the portfolio or the control of investment restrictions might or might not be considered day-to-day administration of the SIF. The legislator did not decide to add the control of these tasks, as is the case for the UCIs subject to Part II of the 2002 Act. Its intention was to reduce the level of legal requirements and to let the level of duties be a matter for the contractual relationship between the SIF and its depositary. As a result, the drafting of the depositary agreement is more important than ever.

Pragmatic approach to administration

Although the depositary is subject to CSSF approval, the 2007 Act does not explicitly require this approval for the administrator. The 2007 Act requires that the SIF's administration be carried out in Luxembourg. It can be concluded that, similar to the Sicar, no particular conditions apply regarding the appointment of the administrator except that it should have the required experience and the capacity to fulfil its duties.

The valuation of assets is based on the fair value concept unless another type of valuation is determined by the management regulation or the articles of incorporation. In the absence of a reliable market price, the value does not need to be established through marking to market but can be through marking to model.

If the portfolio is not composed of securities where reliable up-to-date prices are available to enable a mark-to-market valuation of the assets, the value can be based on principles developed by professional associations such as the Royal Institution of Chartered Surveyors or the European Association for Investors in Non-Listed Real Estate Vehicles.

The minimum frequency for the calculation of the net asset valuation is once a year. There is no obligation to publish the net asset value and the composition of the portfolio.

The SIF is subject to light financial reporting requirements: it is not required to issue semi-annual financial statements or a long-form report. The time period for drawing up annual financial statements has been extended, from four months after the closing of the business year to six. As opposed to UCI subject to the 2002 Act and similar to the Sicar, consolidation of subsidiaries is not mandatory.

Tax aspects

No capital duty or tax is payable in Luxembourg in connection with the issue of shares of an SIF, except for one lump sum capital duty of €1,250, which is payable when the SIF is set up.

A SIF is not liable to Luxembourg income tax. It is, however, liable to an annual subscription tax (taxe d'abonnement) of 0.01% of the value of the SIF's net assets. This levy is payable quarterly based on the fund's net assets as calculated at the end of each quarter.

The following are exempt from subscription tax:

• the value of the assets represented by units/shares held in other UCIs, provided those units/shares have already been subject to the subscription tax under the 2007 Act or the 2002 Act;
• SIFs and individual parts of umbrella SIFs: (i) whose exclusive object is collective investment in money market instruments and placing deposits with credit institutions; (ii) whose weighted residual portfolio maturity does not exceed 90 days; and (iii) that have obtained the highest possible rating from a recognized rating agency. Where several classes of securities exist within the SIF or the compartment, the exemption only applies to classes whose securities are reserved for institutional investors.
• SIFs whose securities are reserved for: (i) institutions for occupational retirement provision, or similar investment vehicles, created on the initiative of one or several employers for the benefit of their employees; and (ii) companies of one or several employers investing funds they hold, to provide retirement benefits to their employees.

SIFs existing under a corporate form and management companies of a contractual SIF are considered taxable persons for VAT purposes. Management services provided to SIFs are exempt from VAT in Luxembourg.

Taxation of investors

Unit/shareholders are, in principle, exempt from any Luxembourg taxes on capital gains, income, withholding, estate and inheritance except for: (i) unit/shareholders domiciled, resident or that have a permanent establishment in Luxembourg; (ii) non-residents of Luxembourg who hold 10% or more of the issued share capital of the SIF and who dispose of all or part of their holdings within six months from the date of acquisition; or (iii) certain former residents of Luxembourg owning more than 10% of share capital of the SIF.

Withholding tax might be due if the laws of June 21 2005 implementing EU Directive 2003/48/EC of June 3 2003 on taxation of savings income in the form of interest payments and ratifying the treaties entered into by Luxembourg and certain dependent and associated territories (the 2005 Laws) apply. The 2005 Laws have entered into force on July 1 2005. Under the 2005 Laws, certain interest payments made by a Luxembourg paying agent to beneficial owners who are individuals or a residual entity within the meaning of Article 4.2 of the 2005 Laws resident or deemed resident for tax purposes in another EU member state may be subject to the application of a withholding tax (at a rate of 15% until July 1 2008, 20% for the subsequent three years and 35% thereafter).

Depending on the investment policy of the SIF and, in particular, on the percentage of the assets of the SIF invested (directly or indirectly) in debt-claims, income deriving from interest payments distributed by the SIF and income realized upon the sale, refund or redemption of shares/units of the SIF might be subject to withholding tax when received by individuals (or so-called residual entities) resident for tax purposes in another EU member state. SIFs existing under contractual form could fall within the scope of the 2005 Laws.

Distribution of the SIF

The SIF is a special type of UCI in that its units or shares can only be distributed to well-informed investors.

The 2007 Act defines well-informed investor as an institutional investor, a professional investor or any person that declares in writing their adherence to this status and that invests at least €125,000. If the invested amount is less than €125,000, the private investor must provide a certificate from a credit institution, an investment company or a management company regarding their relevant expertise, experience and knowledge. The lightened supervision and reporting requirements justify the exclusion of retail investors from the access to the SIF.

The SIF cannot be registered for public distribution. Attention should be kept on not violating local private placing rules. The EU Commission intends to analyse national private placement rules to develop harmonization in the field of non-Ucits distribution. These efforts enable a more secured placement of the SIF throughout Europe. The SIF cannot become an open-ended retail fund. But the SIF may be structured in such a way that its units or shares qualify as transferable securities in the meaning of European Directive 2007/16 regarding the clarification of certain definitions under Ucits III. As a result, and under certain conditions, units or shares of a real estate SIF may become an eligible asset for a Ucits.

Author biographies

Patrick Goebel Allen & Overy Patrick Goebel holds a degree in finance from the Université Paris IX – Dauphine (France), and a degree in private business law and a master in banking and finance law from the Université Paris I – Panthéon Sorbonne (France). He has been a CFA charterholder since 2006. Before joining the investment funds department at Allen & Overy Luxembourg in October 2006, Goebel was with Fortis Banque Luxembourg. His last role with Fortis was as head of engineering within prime fund solutions. Goebel is a member of the Luxembourg CFA Association and of the Association of the Luxembourg Fund Industry (ALFI). He was admitted to the Luxembourg Bar in April 2007. Jean-Luc Fisch Allen & Overy Jean-Luc Fisch is counsel in the tax department of Allen & Overy, having joined the Luxembourg office in 1999. He advises on tax and corporate issues of pan-European real estate investments, M&A, private equity funds, international reorganizations, structured finance and joint ventures. Fisch holds a master's degree in international and European private law from the University of Montpellier (France) (1995) and an LLM in tax law from the University of Munich (Germany) (1996). He was admitted to the Luxembourg Bar in 1997. In 1999, he was admitted to practise law before the High Court of Justice in Luxembourg (Avocat à la Cour). Fisch has been a speaker at several tax conferences in Luxembourg and Europe. Between 2003 and 2006, he taught corporate tax law at the University of Luxembourg as a University assistant for the financial law master's programme (maîtrise de droit financier). He is a member of the International Bar Association (IBA), the American Bar Association (ABA) and the International Fiscal Association (IFA).