Luxembourg: Taste success

Luxembourg is, behind the US, the world's second ranking financial centre for the domicile and servicing of investment funds. Since 1959, when the first fund was established, the investment fund industry has expanded to 3,395 funds in April 2009. This success originated with the authorities' encouraging attitude to foreign capital and investment, and has been considerably strengthened by Luxembourg's prime location in the heart of Europe. It is close to the main markets targeted by investment funds, it has a highly qualified, multilingual workforce, and is politically, economically and socially stable. This unique business-friendly environment is crucial to mitigate the effects of the financial turmoil the investment funds world is experiencing and, indeed, Luxembourg seems to be doing better than most major financial centres.

As of March 31 2009, total assets of undertakings for collective investment and specialised investment funds reached €1,526.56 billion compared to €1,530.29 billion on February 28 2009 (a 0.24% decline). The Luxembourg government has implemented innovative fiscal measures and further reforms are due at the European level (such as the implementation of the Ucits IV Directive). Moreover, the events of the past months have encouraged the Luxembourg government to take the security of investors into consideration.

Legal framework

The December 20 2002 law relating to undertakings for collective investments (2002 Law) shaped the Luxembourg investment fund market by differentiating between Undertakings for Collective Investment in Transferable Securities (Ucits, Part I of the law) and Undertakings for Collective Investment (UCIs, Part II of the law). Further to the February 13 2007 law relating to Specialised Investment Funds (Sif) (Sif Law), the Luxembourg investment funds are now divided into three categories: UCIs, or which there were 698 in March 2009; Ucits of which there were 1,840 in March 2009; and Sif of which 858 existed in March 2009.

Ucits

Ucits are designed for retail investors and benefit from a European Passport, enabling them to be freely marketed throughout the EU with a minimum of formalities. These funds are open-ended and must comply with stringent requirements set by the EU legislator in terms of eligibility of assets, risk-spreading requirements and, more generally, in terms of substance and supervision.

Major changes in this area of the law are due following the approval on January 13 2009 of the European Commission's proposal to improve the EU framework governing Ucits funds. In practice this will mean the implementation of the Ucits IV Directive which aims to liberalise the regime for cross-border retail funds.

UCIs

In contrast, UCIs (Part II) can only market their units in other EU countries after complying with the specific conditions stipulated by the authorities in the country concerned. The criterion defining whether a UCI is subject to Part I or Part II of the 2002 Law is the intended investment objective, as Part I applies only to UCI whose sole objective is to invest in transferable securities and/or other liquid financial assets (such as money market instruments or cash deposits), whereas a UCI may also invest in activities such as alternative investments (such as hedge funds), venture capital, and real estate.

Sif

The Sif Law provides a separate statutory regime specifically designed for investment funds dedicated to sophisticated investors. The Sif is a lightly regulated and tax efficient fund which gives an onshore alternative to consider (as compared to traditional offshore jurisdictions such as the Cayman Islands or the British Virgin Islands) when deciding on the jurisdiction for setting up a fund and the type of fund vehicle to use. Sif are subject to each country's distribution rules.

The regulatory body is the Commission for the Supervision of the Financial Sector, (CSSF). If it is subject to a continuous control by the CSSF, a fund set up under the Sif Law does not need prior approval to incorporate, but it is still a condition for funds set up under the 2002 Law. Directors of a Sif are still subject to CSSF approval.

To help compliance with setting-up requirements, investors benefit from the financial facilities offered by the high-profile Luxembourg economic environment, including 152 banks (as registered on the official list on February 28 2009), a broad range of international and local law firms exceedingly qualified in this field, as well as audit firms and tax advisers.

Constitution of a fund

Investment funds may take the form of an open-ended legal entity (such as an investment company with variable capital, known as a Sicav, of which there were1,452 in March 2009), of a closed-ended legal entity (such as an investment company with fixed capital, known as a Sicaf, of which there were 18 in March 2009), or of a common contractual fund which has a management company (such as an FCP of which there were 1,926 in March 2009). All these different entities can create sub-funds, each with a different investment policy. In this context, each compartment will be deemed to be a separate entity; the assets of a compartment are exclusively available to satisfy the rights of investors in relation to that compartment.

Sicav/Sicaf

A Sicav is a limited-liability company whose capital is at any time equal to its net assets. Its capital increases and decreases automatically as a result of subscriptions or redemptions, without any formalities required. Sicavs may take different legal forms, depending on the law to which they are subject. In contrast, a Sicaf is a limited-liability company with fixed capital, open-ended only if the investors can buy and sell shares at their request and at a price equal to the net asset value per share. However, due to its limited flexibility, the Sicaf is rarely the choice of investors.

FCP

An FCP is a co-proprietorship whose joint owners are only liable up to the amount they have contributed. An FCP is deprived of a legal personality and must therefore be managed by a Luxembourg management company on behalf of its joint owners. Ucits are managed by management companies under the conditions laid down in Chapter 13 of the 2002 Law, whereas Chapter 14 of the 2002 Law lays down the conditions under which management companies rule UCIs and Sif.

Choosing a legal structure

The choice of whether to create a fund as an FCP or as an investment company is mainly based on tax considerations, as an FCP is tax transparent. Marketing and operational considerations are also relevant when choosing the legal structure.

The formation expenses will consist for all funds of a fixed registration duty of €75, notary fees, legal fees, and a CSSF filing duty (fixed, for 2002 Law UCIs, at €2,650 for a single market UCI and at €5,000 for a multiple compartment UCI). In contrast, the CSSF filing duty has been fixed, for Sif Law UCIs, at €1,500 for a single compartment UCI and € 2,650 for a multiple compartment UCI. The formation expenses may also include (if a listing on the stock exchange is contemplated), its admission fee, fixed at €1,250.

The minimum capitalisation (€1,250,000) required under both laws must, in case of a Sif, be reached within 12 months of approval from the CSSF, and six months in the case of other investment funds.

Investment funds set up under the 2002 Law can be distributed to the public. Hence, no restriction applies upon eligible investors, whereas the Sif Law introduces a qualified investor scheme. In this context, Sifs are reserved for well-informed investors who are able to understand and assess the risks associated with investment in such a fund (well-informed investor meaning either an institutional investor, a professional investor, or any other investor who has declared in writing that he is an informed investor and either invests a minimum of €125,000 or has an appraisal from a bank, an investment firm or a management company certifying that he has the appropriate expertise, experience and knowledge to adequately understand the investment in the fund).

Investment restrictions

Under the broad principle of risk spreading, all funds are subject to different rules restricting the scope of their investment policy. Those rules are quite restrictive towards Ucits, somewhat lighter concerning UCIs, and much lighter when it comes to Sif.

Ucits

The 2002 Law provides for numerous restrictions upon investments by Ucits, which have been clarified in recent regulatory developments:

- Circular CSSF 07/308 lays down rules for the implementation of a risk management framework. These rules mean that a Ucits fund must self-assess itself as either sophisticated or non-sophisticated. A sophisticated Ucits fund is obliged to create a developed risk management unit and is able to make significant use of derivative financial instruments. Non-sophisticated Ucits funds, with much less-developed risk management units, can only use derivative financial instruments for hedging purposes. This Circular also specifies some valuation rules stating that overall risk exposure related to financial derivative instruments should not exceed the total net asset value.

- The February 8 2008 Grand-Ducal regulation clarifies the notion of Ucits as provided in the 2002 Law, in light of the Commission Directive 2007/16/EC.

- The Circular CSSF 08/339 displays the guidelines given by Cesr (The Committee of European Securities Regulators) in relation to eligible assets for investment by Ucits, and in this context provides additional clarification relating to eligible assets for investment by Ucits covered by Directive 85/611/EEC, as amended.

- CSSF Circular 08/356 describes in detail the techniques and instruments Ucits may use, including securities lending transactions. The main innovation to be noted refers to permitted collateral and permitted assets in which cash collateral can be reinvested. In this respect, this Circular specifies how collateral and assets acquired upon reinvestment of cash collateral must be kept safe in order to avoid counterparty risk for the Ucits fund exceeding its legal limits.

Non-Ucits – Part II Funds

The investment and borrowing rules are subject to CSSF approval, and specific rules are laid down in Circular IML 91/75 (as amended by Circular CSSF 05/177), while others are specifically applicable to UCIs pursuing alternative investment strategies. Those rules are laid down in Circular CSSF 02/80 state that:

- Aggregate commitment in terms of short selling may not exceed 50% of assets, and no more than 10% of the same type issued by the same issuer may be sold short;

- Borrowings must not exceed 200% of the net assets; and

- Counterparty risk, defined as the difference between the value of assets given as a guarantee and the amount borrowed, cannot represent more than 20% of the UCI's assets per lender.

Sif

Sif are not required to comply with any detailed investment restrictions or leverage rules; the Sif Law merely stating that a Sif should apply the principle of risk diversification. This principle provides that the collective investment of funds must be made in assets "in order to spread the investment risks". The CSSF clarified in its Circular 07/309 that:

- A Sif may not invest more than 30% of its assets or commitments to subscribe securities of the same type issued by the same issuer;

- Short sales may not result in the Sif holding a short position in securities of the same type issued by the same issuer representing more than 30% of its assets; and

- When using financial derivative instruments, the Sif must ensure, via appropriate diversification of the underlying assets, a similar level of risk-spreading.

However, the CSSF may, upon appropriate justification, grant exemptions to these rules on a case-by-case basis.

Reporting and audit requirements

Prospectus

Funds are obliged to issue a prospectus containing information concerning the fund and its management company. The July 10 2005 law on prospectuses for securities specified that the obligation to publish a full prospectus does not apply to units issued by UCI, other than the closed-end funds. Such funds shall publish a simplified prospectus. Public security offers representing units issued by UCI other than the closed-end type shall be subject to the sole provisions of the laws on UCI. According to the 2002 Law, both the simplified and full prospectus must include the information necessary for investors to make an informed judgment of the investment proposed to them, and especially of the risks attached to it. Investors should note that when the Ucits IV Directive comes into force, the simplified prospectus is expected to be replaced by a key investor information document.

Issuing document

Funds subject to the Sif law are only required to produce an issuing document, displaying, with no minimum content, the information necessary for investors to be able to make an informed judgment about the investment proposed to them. The issuing documents and any modifications to them must be communicated to the CSSF.

Financial statement

One difference between the 2002 Law and the Sif Law is that the obligation to publish a financial statement is only annual in the case of a SIF, whereas an investment fund subject to the 2002 Law must publish an audited financial statement annually and semi-annually.

Such financial statements must be audited by an authorised independent auditor, namely a member of the Luxembourg Institute of Auditors. This auditor is obliged, if any information provided to investors does not truly describe the financial situation of the fund, to report this promptly to the CSSF. The same obligation applies if the auditor becomes aware during the audit that any fact or decision is liable to constitute a material breach of the law or regulations, or to affect the continuous functioning of the UCI.

Taxation of funds

Luxembourg funds are essentially tax-exempt vehicles, and indeed Luxembourg Ucits, UCIs and Sif do not pay Luxembourg income or capital gains tax, nor is a stamp duty on share issues or transfers to be paid.

The Luxembourg authorities are currently working on a wide range of fiscal reforms. The first main change, from January 1 2009, is the abolition of fixed capital duty and of the withholding tax on dividends paid to recipients resident in countries that have concluded a tax treaty with Luxembourg.

Under the Sif Law, an annual subscription tax has been fixed at 0.01% of net assets, compared to 0.05 % for funds under the 2002 Law. It is however only 0.01% for UCIs whose exclusive policy is the investment in money market instruments or deposits with credit institutions. Other funds, such as certain institutional cash funds and pension pooling funds, are exempt from this subscription tax, no matter which Law they are set up under. It should be noted that investors may invest in a Sif by means of equity or debt, hence benefiting from effective tax optimisation, and that there is no debt to equity ratio to be respected in the case of a Sif.

In order to avoid double taxation, Luxembourg has signed double taxation treaties with 52 countries, and 21 others are under negotiation or awaiting the approval of the Luxembourg Parliament or the foreign country. However, it has to be emphasised that only 27 of these treaties are applicable to Sicavs and Sicafs.

Stock exchange listing

A fund may be listed on the Luxembourg Stock Exchange (LSE). A few conditions have been imposed for a foreign fund to list on the LSE, mainly that the fund promoter must be of good repute, have adequate professional experience, and that the functions of investment manager, management company, custodian and transfer agent be carried out by a separate entity.

The Stock Exchange maintenance fee has been fixed at €1,875 for the first line of quotation, €1,250 for a second one, €875 for a third one, and €500 for the fourth and the following lines of quotation.

The Luxembourg investment fund industry, largely benefiting from its location in a strong financial centre, is now an internationally recognised onshore label for investment funds. The greatest asset of Luxembourg is undoubtedly political voluntarism, demonstrated by a constant anticipation of the need of investors – either in the transposing of European legislation or in the shaping of national legislation – in order to create a stable, protective and favourable environment according to the expected development of the market.

This pragmatism on the part of the Luxembourg authorities, exemplified by the recent fiscal exemptions and by the way the CSSF dealt with the global financial turmoil, is invaluable when shepherding investors in days of global uncertainty. Lastly, the increasingly important issue of transparency is covered by national and European regulations and provides new investors with an especially protective framework as compared to traditional offshore jurisdictions such as the Cayman Islands or the British Virgin Islands. For instance, the European Commission has proposed a Directive on Alternative Investment Fund Managers (AIFMs) with the objective to create a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level.

Author biographies

Rémi Chevalier Chevalier & Sciales Rémi Chevalier is a partner with the law firm Chevalier & Sciales. He specialises in the area of investment funds and banking and finance. He regularly advises private equity and investment firms. Olivier Sciales Chevalier & Sciales Olivier Sciales is a partner at Chevalier & Sciales. He specialises in investment funds focusing mainly on their structuring and implementation (Ucits, UCIs and Sifs).. Olivier Sciales has been recommended and recognised by various publications in the field of investment funds such as the Guide to the Worlds' Leading Investment Fund Lawyers and Practical Law Company.