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TAX PLANNINGINTERNATIONALREVIEWInternational Information for International Business

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JANUARY 2018

Luxembourg: Impactof the PPT onAlternativeInvestments

Oliver R. Hoor and Keith O’DonnellATOZ Tax Advisers (Taxand Luxembourg)

Luxembourg is a prime location for the structuring of alternativeinvestments in and through Europe: its extensive tax treatynetwork is a contributing factor to the country’s attractiveness tointernational investors. What effect will the PPT have onalternative investments structured via Luxembourg and whatlimitations have been imposed by recent cases of the CJEU?

On December 18, 2017, the 2017 Update to the OECDModel Tax Convention (the ‘‘OECD Model’’) and therelated Commentary were released. The 2017 Updatealso includes guidance on the interpretation of thePrincipal Purposes Test (‘‘PPT’’) in a non-CIV fundcontext. This guidance is particularly relevant for so-called alternative investments such as private equity,real estate and infrastructure investments. This articleanalyzes the impact of the PPT on alternative invest-ments structured via Luxembourg and considers thelimitations imposed on the PPT by European Union(‘‘EU’’) law, including recent cases of the Court of Jus-

tice of the European Union (‘‘CJEU’’) that struck downFrench and German anti-avoidance rules.

Introduction

Bilateral tax treaties are an important and well-established feature of the international tax system.Their main purpose is the promotion of cross-bordertrade and investment through the allocation of taxingrights between two Contracting States and the deter-mination of mechanisms for the elimination of doubletaxation. As of today, there are more than 3,000 taxtreaties in force around the globe. Though every tax

Oliver R. Hoor, TaxPartner, and KeithO’Donnell, Manag-ing Partner, ATOZTax Advisers(Taxand Luxem-bourg)

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treaty is subject to negotiations between the two Con-tracting States, the majority of tax treaties are fairlysimilar. This is because the treaty negotiations be-tween the Contracting States are generally based onthe OECD Model and are then tailored to the particu-lar economic interest of each Contracting State.

The abuse of tax treaties and, in particular, treatyshopping, has been identified as one of the most im-portant sources of base erosion and profit shifting(‘‘BEPS’’) concerns within the OECD BEPS Project.Action 6 of the BEPS Action Plan aims at the preven-tion of perceived tax treaty abuse. The Final Report onAction 6 was released in October 2015 and providesfor recommendations regarding the design of taxtreaty provisions and domestic tax rules that shouldprevent the abuse of tax treaties. More precisely, thereport proposes a limitation-on-benefits (‘‘LOB’’) pro-vision, a PPT and a series of specific anti-abuse rules(‘‘SAAR’’) which would come in addition to existinganti-abuse measures such as the beneficial ownershipconcept.

Action 15 of the BEPS Project was concerned withthe development of a multilateral instrument (‘‘MLI’’)in order to allow countries to swiftly implement taxtreaty-related BEPS measures such as the PPT. Whilethe MLI provided a lot of flexibility, allowing parties(i) to choose the tax treaties that should come withinthe scope of the MLI, (ii) opting out for (part of) pro-visions and (iii) choosing to apply optional and alter-native provisions, the PPT had to be adopted as a so-called minimum standard measure. Luxembourg is asignatory to the MLI and as such will apply the PPT inits covered treaties. Depending on the speed of ratifi-cation by the treaty partners concerned, the PPT willtherefore likely become effective starting from 2019 inall covered tax treaties concluded by Luxembourg. Inthis regard, the 2017 version of the Commentary tothe OECD Model will be of significant importance forthe interpretation of the PPT.

Luxembourg is a leading global center for invest-ment management, both for investments in tradi-tional assets such as listed shares and bonds, but alsoin ‘‘alternative‘‘ investments, a term used to describeinvestment in assets as varied as private equity, pri-vate debt, real estate, infrastructure, etc. Alternativeinvestment strategies often involve more sophisti-cated structures, reflecting the more complex natureof the underlying assets and thus, the impact of thePPT is of keen interest in this sector.

The Principal Purposes Test

The PPT is included in Paragraph 9 of Article 29 of the2017 version of the OECD Model and reads as follows:

Notwithstanding the other provisions of this Conven-tion, a benefit under this Convention shall not begranted in respect of an item of income or capital if itis reasonable to conclude, having regard to all relevantfacts and circumstances, that obtaining that benefitwas one of the principal purposes of any arrangementor transaction that resulted directly or indirectly inthat benefit, unless it is established that granting thatbenefit in these circumstances would be in accordancewith the object and purpose of the relevant provisionsof this Convention.

Accordingly, the PPT would deny a treaty benefitwhere it is reasonable to conclude that obtaining this

treaty benefit was ‘‘one of the principal purposes’’(emphasis added) of any arrangement or transactionunless the taxpayer is able to establish that grantingthe benefit would be ‘‘in accordance with the objectand purpose’’ of the relevant treaty provisions. How-ever, is a prudent business manager not expected toconsider tax as a cost in each and every genuine busi-ness transaction? Likewise, are fund managers invest-ing cash on behalf of their investors not obliged toconsider and manage the level of taxation as part oftheir fiduciary duties?

Contradictory Message

The contradictory message of the PPT is that treatybenefits are available to qualifying taxpayers unlesstaxpayers intend to gain from those benefits. Obvi-ously, this injects a subjective element into everyaspect of determining whether treaty benefits areavailable. The PPT imposes a significant burden onthe taxpayer (‘‘establish that the granting of tax benefitwould be in accordance with the object and purposeof provision in the convention’’), whereas the onus onthe tax administration is set at a relatively low level(‘‘reasonable to conclude’’, ‘‘one of the main purposes’’,‘‘directly or indirectly’’).

Moreover, according to the Commentary on Article29 of the OECD Model, the phrase ‘‘that resulted di-rectly or indirectly in that benefit’’ and the terms ‘‘ar-rangement or transaction’’ should be interpretedbroadly. In any case, the threshold to deny treaty ben-efits in accordance with the PPT is significantly re-duced as compared to the previous guidance in theCommentary.

The Commentary emphasizes, however, that it isimportant to undertake an objective analysis of theaims and objects of all persons involved in puttingthat arrangement or transaction in place or being aparty to it. It is interesting to note the paradox con-tained in this undertaking: an objective analysis ismade seeking a conclusion on the subjective aims andobjects of various persons. It is further stated that itshould not be lightly assumed that obtaining a benefitunder a tax treaty was one of the principal purposes ofan arrangement or a transaction. Furthermore,merely reviewing the effects of an arrangement willnot usually enable tax authorities to draw a conclu-sion about its purposes.

Conversely, a person should not be able to avoid theapplication of the PPT by merely asserting that the ar-rangement or transaction was not undertaken or ar-ranged to obtain the benefits of the Convention. In thesame vein, the Commentary asserts that obtaining thebenefit under a tax convention does not need to be thesole or dominant purpose of a particular arrangementor transaction in order for the PPT to be applicable.

Uncertainty for Taxpayers

Overall, the PPT creates significant uncertainty fortaxpayers (and their advisors) because of the unpre-dictable outcomes, and causes serious concerns forbona fide businesses. Holding, financing, IP manage-ment and other investment activities are all legitimateand genuine business activities that may fall withinthe scope of the PPT. In the view of the authors, a PPT-like rule should be designed to tackle only clear-cut

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cases of treaty abuse in arrangements that are set upfor the predominant purpose of obtaining treaty ben-efits.

PPT Scope Limited

Crucially, the Commentary limits the scope of the PPTthrough the statement that a purpose will not be aprincipal purpose when it is reasonable to concludethat obtaining the benefit was not a principal consid-eration and would not have justified entering into anarrangement or a transaction that has resulted in thebenefit. This limitation in its first part suffers frombeing somewhat circular: a purpose is not a principalpurpose if its consideration was not a principal con-sideration. However, the second part of the limitation,(i.e., that if the treaty benefit would not justify enter-ing into the arrangement, then the purpose of obtain-ing a treaty benefit is not a principal purpose), isclearer and may be helpful.

It seems reasonable to conclude that ‘‘alternative’’investments, where such investments are made for le-gitimate commercial purposes (generating regularincome, maximization of value, etc.) should generallynot be in the focus of the PPT, despite the fact that taximplications cannot be completely neglected when in-vestments are structured. The examples given in thecommentary to the OECD Model shed a bit more lighton such investments and the application of the PPT.

Non-CIV Fund Examples in the Commentary to theOECD Model

Opening Comments

The 2017 Update to the OECD Model and the relatedCommentary provide for guidance on the interpreta-tion and application of the PPT. In particular, three ex-amples included in the Commentary are of particularrelevance when it comes to analyzing alternative in-vestments (i.e., examples K, L and M relating to Para-graph 9 of Article 29).

The Commentary stresses though that when read-ing the examples, it is important to remember that theapplication of the PPT must be determined on thebasis of the facts and circumstances of each indi-vidual case. Furthermore, the examples are meant tobe of merely illustrative nature, and should explicitlynot be interpreted as providing conditions or require-ments that similar transactions must meet in order toavoid the application of the PPT.

A Regional Investment Platform

Example K deals with a situation where a companyresident in State R (‘‘RCo’’) is a wholly-owned subsid-iary of a fund that is established, resident and subjectto regulation in State T. The fund in this example mayrefer to different situations such as a private equityfund or a sovereign wealth fund structuring invest-ments via a subsidiary that functions as an investmentplatform.

It is further stated that RCo operates exclusively togenerate an investment return as the regional invest-ment platform through the acquisition and manage-ment of a diversified portfolio of private market

investments in countries that are located in a regionalgrouping that includes State R.

The reasons for establishing RCo as a regional in-vestment platform were mainly driven by:s the availability of directors with knowledge of re-

gional business practices and regulations;s the existence of a skilled multilingual workforce;s State R’s membership to a regional grouping; ands the extensive tax treaty network of State R, includ-

ing a tax treaty with State S which provides for lowwithholding tax rates.

Regarding the substance of RCo, it is stated that thecompany employs an experienced local managementteam to review investment recommendations fromthe fund and to perform the following functions:s approving and monitoring investments;s carrying on treasury functions;s maintaining RCo’s books and records; and

s ensuring compliance with regulatory requirementsin the investment jurisdictions.

The board of directors of RCo is appointed by thefund and is composed of a majority of State R residentdirectors with expertise in investment management,as well as members of the fund’s global managementteam. Moreover, RCo pays tax and files tax returns inState R.

In the example, RCo, which has a portfolio of in-vestments in different jurisdictions in the same re-gional grouping, contemplates an investment in acompany resident in State S. Under the tax treaty be-tween State R and State S, the withholding tax rate ondividends is reduced from 30 percent to 5 percent. Incontrast, the tax treaty concluded between State S andState T provides for a withholding tax rate of 10 per-cent. The following chart depicts the investmentstructure:

It is explicitly stated that the very fact that RCo con-siders the existence of a benefit under the StateR–State S tax treaty with regard to dividends wouldnot be sufficient to trigger the application of the PPT.The guidance further emphasizes that the intent of taxtreaties is to provide benefits for the very purpose ofencouraging cross-border investment. Therefore, itwould be necessary to consider the context in which


the investment was made, including the reasons forestablishing RCo in State R. As regards this example,it is concluded that it would not be reasonable to denythe benefit of the State R–State S tax treaty unlessother facts and circumstances suggest otherwise.

A Securitization Vehicle

Example L deals with a securitization company (‘‘SV’’)that has been established by a bank in State R. Thebank transferred a portfolio of loans and other receiv-ables owed by debtors located in a number of jurisdic-tions.

The SV has issued a single share which is held ontrust and has no economic value. Otherwise, the SV isfully funded by notes which are widely-held by third-party investors. These notes are listed on a recognized

stock exchange which allows for their trading on thesecondary market and the notes are held through aclearing system.

The example further states that the bank kept asmall percentage of the notes for regulatory reasons.As regards the assets owned by the SV, it is stated thatthe SV holds 60 percent of its portfolio in receivablesof small and medium-sized enterprises resident inState S that generate regular interest payments.

The bank is resident in State T, which has a taxtreaty with State S that provides benefits equivalent tothose provided under the State R–State S tax treaty,namely a 10 percent limitation of withholding tax oninterest (the domestic withholding tax rate applicableon interest in State S would be 30 percent).

The following chart depicts the investment struc-ture:

According to the example, the reasons for establish-ing the SV were driven by a large number of issues, in-cluding:

s the robust securitization framework of State R;

s State R’s securitization and other relevant legisla-tion;

s the availability of skilled and experienced personneland support services in State R;

s the existence of tax benefits provided under the ex-tensive tax treaty network of State R.

It is assumed that investors’ decisions to invest inthe SV are not driven by any particular investmentsmade by the SV. Moreover, the investment strategy ofthe SV is not driven by the tax position of the inves-tors. While the SV is subject to tax in State R on its in-terest income, the interest payments under the notesissued by the SV are fully deductible for tax purposes.

As in the previous example, it is explicitly statedthat the very fact that RCo considers the existence of abenefit under the State R–State S tax treaty withregard to interest payments would not be sufficient totrigger the application of the PPT. The guidance re-emphasizes that the intent of tax treaties is to providebenefits to encourage cross-border investment. There-fore, it is necessary to consider the context in whichthe investment was made. As regards the SV example,it is concluded that it would not be reasonable to deny

the benefit of the State R–State S tax treaty unlessother facts and circumstances suggest otherwise.

A Real Estate Fund

Example M deals with a real estate fund (the ‘‘Fund’’)that is established in State C for investing into a port-folio of real properties situated in a specific geo-graphic area. According to the fact pattern, the Fundis fiscally transparent under the domestic tax law ofState C and managed by a regulated fund manager.The Fund is marketed to institutional investors suchas pension funds and sovereign wealth funds. Com-mitments to the Fund have been made by a range ofinvestors resident in different jurisdictions.

The investment strategy of the Fund which is set outin the marketing materials for the Fund is not drivenby the tax positions of the investors but is based on in-vesting in certain real estate assets, maximizing theirvalue and realizing appreciation through the disposalof the investments.

The investments of the Fund are structured via aholding company that is resident in State R(‘‘HoldCo’’). HoldCo manages all investments of theFund in immovable property assets and holds theseassets indirectly through wholly-owned local compa-nies. HoldCo further provides debt and equity to theselocal companies which directly own the real proper-ties.


HoldCo is established for a number of commercialand legal reasons, such as:s protection of the Fund from the liabilities of and

potential claims against the Fund’s immovableproperty assets;

s facilitation of debt funding (including debt ob-tained from third parties);

s management of investments (including the acquisi-tion and disposal thereof);

s administration of claims for relief of withholdingtax under any applicable tax treaty (according tothe guidance in the example, this is an importantfunction of HoldCo as it is administratively simplerfor one company to get treaty relief rather than tohave each institutional investor process its ownclaim for withholding tax relief. This holds all themore true when each investor would be entitled totreaty benefits on a small amount).

Following a review of possible locations, the deci-sion to establish HoldCo in State R was mainly drivenby:s the political stability in the holding jurisdiction;

s the regulatory and legal systems of the holding ju-risdiction;

s lender and investor familiarity with the holding ju-risdiction;

s access to appropriately qualified personnel; and

s the extensive tax treaty network of State R, includ-ing tax treaties with the different target jurisdic-tions.

It is further stated that HoldCo does not obtaintreaty benefits that are better than the benefits towhich its investors would have been entitled if theyhad made the same investments directly (under thetax treaties concluded between the investor and in-vestment jurisdiction to the extent applicable).

In the example, it is explicitly mentioned that theimmovable property investments of the Fund aremade for commercial purposes despite the decision toestablish HoldCo in State R having been taken againstthe backdrop of the tax treaty network of State R andrelated tax treaty benefits. In addition, given that itwas assumed that the investors would be entitled tothe same treaty benefits in case of direct investments,no additional benefit has been generated through thestructuring of investments via HoldCo. As regards thisexample, it is concluded that it would not be reason-able to deny tax treaty benefits unless other facts andcircumstances suggest otherwise.

Reasons for Establishing a Company inLuxembourg

Opening comments

When analyzing the potential application of the PPTin case of Luxembourg companies it is necessary toconsider (i) the reasons for choosing Luxembourg asa business location, (ii) the substance and corporategovernance of the company, as well as (iii) its func-tional and risk profile, and (iv) the commercial andlegal reasons for establishing the company.

Features of the Location

The three examples mention a number of differentreasons that might be considered when deciding onthe optimal jurisdiction for establishing a company.These reasons include:

s the political stability of the jurisdictions;

s the regulatory and legal environment;

s lender and Investor familiarity with the jurisdic-tion;


s the availability of directors with knowledge of re-gional business practices and regulations;

s the existence of a qualified, multilingual workforce;and

s the membership of the holding jurisdiction to a re-gional grouping (for example, the EU).

Depending on the investment activity, more specificconsiderations, such as the existence of a robust secu-ritization framework and other relevant legislation,might be a key reason when deciding on the residencestate of a company. Furthermore, it has been explicitlystated that an extensive tax treaty network includingtax treaties with the investor and the investment juris-dictions is a positive feature of a jurisdiction.

Luxembourg is a prominent financial center with amajor fund industry and a tried and tested holding lo-cation that meets all the above criteria. In addition,Luxembourg has a flexible and diverse regulatoryframework which provides for a number of different(fund) vehicles and regimes that can be tailored to theneeds of each individual set-up. Easy access to the au-thorities (including the regulatory bodies) furthercontributes to the investor-friendly business environ-ment in Luxembourg.

When investors consider a potential future IPO orthe issuance of bonds (or other financial instruments)to the public, Luxembourg has a recognized stock ex-change that provides access to the capital markets.Last but not least, the healthy budgetary and financialsituation of Luxembourg cannot be overrated as an el-ement that maintains the trust of investors against thebackdrop of events witnessed in other countries.

Substance and Corporate Governance

Substance is a key element in international tax plan-ning and is relevant for the application of both domes-tic tax law and tax treaties. The notion of substanceinvolves a number of elements such as:s equipment, facilities and employees;s directorship and the place where decisions are

taken;s legal documentation and contractual aspects;s transfer pricing documentation;s the actual conduct of business activities; ands business purpose.

Substance is crucial for managing tax residency andto avoid a situation in which a corporate structure is(partially) disregarded under foreign anti-abuse pro-visions. The notion of substance also concerns thebeneficial ownership concept that is employed undertax treaties and in some cases under domestic tax lawwith the objective to avoid tax treaty or EU directiveshopping. When Luxembourg companies operate inforeign jurisdictions, it is crucial to avoid the constitu-tion of unintentional permanent establishments thatcould otherwise give rise to significant tax costs in therespective host states. Appropriate substance is fur-ther relevant in order to avoid the application of thePPT in tax treaties.

In light of the above, it is critical that all importantstrategic and commercial decisions which are neces-sary for the conduct of the company’s business are ac-tually taken in Luxembourg. Accordingly, the boardmeetings of a Luxembourg company should be held

regularly in Luxembourg with the physical presenceof substantially all appointed directors.

The board of directors should be composed at leastin part, if not in majority, of qualified Luxembourgresident directors who are in a position to exercise amanagement function and should be seen to do so inthe documentation of business transactions. ExampleK, described above, cites a board composed of major-ity of local resident directors—such a board composi-tion is a common recommendation in substancerelated discussions. Examples L and M, however, aresilent on the subject of the board composition. Thus,nonresidents may be part of the board, or, as externaladvisers, may make strategic recommendations to theboard: however, the directors must independently ap-praise each proposal and not merely ‘‘rubber stamp’’the recommendations. The meetings of the board ofdirectors should be properly documented in the min-utes of these meetings that should at least include adescription of the topics discussed and the decisionstaken.

A Luxembourg company should further have a Lux-embourg bank account and its books and recordsshould be kept in Luxembourg. The equipping of aLuxembourg company with facilities (i.e., a dedicatedand equipped office space) and (part-time) employeesshould be appropriate for the business activities per-formed and needs to be determined on a case-by-casebasis.

In practice, there are different ways to organize thesubstance of a Luxembourg company, ranging fromset-ups with significant internal resources thatmanage most of the tasks internally, to set-ups thatrely, for cost-efficiency purposes, on an outsourcingmodel where certain functions are outsourced toqualified service providers (or other group compa-nies) and monitored by the employees or the directorsof the company (for example, accounting and compli-ance services).

In other cases, asset managers may have significantsubstance in a management or service company thatrenders services to other Luxembourg companies.While the charging of services to the Luxembourgbeneficiaries may be a good indication of the activitiesperformed by these entities, the tax authorities ofsome investment jurisdictions have a strong prefer-ence to find salary costs in the financial statements ofentities that rely on benefits under their domestic taxlaw or tax treaties. Here, global employment contractsthat split the salary costs of employees between thedifferent group companies benefiting from their workmay provide a better comfort level. In addition, othercosts such as rental costs may be split among differentLuxembourg companies in accordance with appropri-ate allocation keys.

Functional and Risk Profile

Another aspect to be considered is the functional andrisk profile of the company, which may vary from onecase to another. The examples in the Commentary al-ready provide for a number of functions that might beperformed by a holding company, including:

s approving and monitoring investments;

s carrying on treasury functions;


s maintaining the books and records of the company;and

s ensuring compliance with regulatory requirementsin the investment jurisdictions.

In practice, Luxembourg companies may perform anumber of additional functions, such as:

monitoring of the performance of subsidiaries;s analyzing investment opportunities;s rendering of administrative and other services to

subsidiaries;s monitoring of dividend, interest and other pay-

ments;s performing financial controlling within the group

(optimization of the group’s interest costs, etc.)s monitoring and management of risks in relation to

the investment activities;s management of intangible property rights;s drafting or review of legal documentation;s preparation of financial reporting;s dealing with accounting and bookkeeping require-

ments;s direct and indirect tax compliance.

Luxembourg companies that perform holding andfinancing activities generally have an even more di-verse functional and risk profile. Under the Luxem-bourg transfer pricing rules, companies performingfinancing activities are required to have a real pres-ence in Luxembourg, to determine the equity at risk inrelation to the loan portfolio and to report an arm’slength remuneration on their financing activities inconformity with the OECD Transfer Pricing Guide-lines.

When certain functions are outsourced to qualifiedLuxembourg service providers or other group compa-nies, it is for the directors or staff of the Luxembourgcompany to carefully monitor the proper perfor-mance of these functions.

Commercial and Legal Reasons

Investors generally have a number of legitimate com-mercial and legal reasons for the implementation of acompany in Luxembourg. Reasons mentioned in theexamples include:s protection of the Fund from the liabilities of and

potential claims against the Fund’s immovableproperty assets;

s facilitation of debt funding (including debt ob-tained from third parties);

s management of investments (including the acquisi-tion and disposal thereof); and

s administration of claims for relief of withholdingtax under any applicable tax treaty.

However, there may be many other commercial andlegal reasons such as:s existing operations and ‘‘substance’’ in Luxembourg

for the management of other investments, generat-ing synergies and cost-efficiencies over all the in-vestment structures;

s flexibility of the Luxembourg regulatory environ-ment (freedom in terms of structuring, time tomarket, etc.);

s existing business relationships with Luxembourgbusiness partners and service providers;

s benefits derived from the EU passporting systemunder the European AIFMD (the prudential direc-tive dealing with alternative fund management);

s familiarity of investors with the legal and regula-tory environment allowing fund distribution to aninternational investor base;

s experience of the Luxembourg marketplace regard-ing the structuring and management of alternativeinvestments.

Considerations Regarding Alternative InvestmentsStructured via Luxembourg

Application of the PPT in General

According to OECD guidance, the PPT requires an in-depth analysis of all facts and circumstances of eachcase in order to determine whether obtaining the ben-efit was a principal consideration and would have jus-tified entering into an arrangement or a transactionthat has resulted in the benefit. Thus, tax authoritiesshould not easily conclude that (one of) the principalpurpose(s) was to obtain benefits under a tax treaty.

When it comes to the interpretation of the examplesin the Commentary, it is explicitly stated that the ex-amples are ‘‘purely illustrative’’ and should not be in-terpreted as providing conditions or requirementsthat similar transactions must meet in order to avoidthe application of the PPT. Therefore, it cannot beconstrued that the PPT should apply if a particularaspect described in the examples is missing. Instead,it has to be determined on a case-by-case basiswhether one of the principal purposes of an arrange-ment or a transaction was obtaining treaty benefits.

In practice, the reasons and factual circumstancesthat are relevant for the decision to structure invest-ments via Luxembourg companies may vary signifi-cantly from one case to another (existing operations,functions, commercial and regulatory reasons, etc.).Given these differences, taxpayers should establishthe reasoning of their decision to structure invest-ments via Luxembourg so as to be prepared for poten-tial questions from foreign tax authorities.

The examples in the Commentary further seem tohint at certain factors, that when present, reduce therisk of the PPT being applied, such as:s investors are resident in different jurisdictions;s investments are made in different target jurisdic-

tions;s an investment structure is subject to regulation.

However, even if investors are resident and invest-ments are made predominantly in one jurisdiction,the examples do not seem to suggest that the PPTshould be applicable in any case. Rather, an analysisof all facts and circumstances of the specific caseshould provide answers to the question as to whetherone of the principal purposes was to obtain a tax ben-efit. For example, it might be planned to start with cer-tain investors and to widen the scope of the investorbase or the investment jurisdictions at a later stage.Notably, in the examples K and M, investments havebeen structured by funds via a wholly-owned subsid-iary resident in another jurisdiction. In both cases, theCommentary concludes that the PPT should not beapplicable.


The structuring of investments via a Luxembourgfund and Luxembourg companies should make cor-porate structures even more robust, reinforcing thecommercial rationale behind the investment struc-ture. These considerations will likely strengthen theexisting trend towards more onshore alternativefunds for which Luxembourg’s fund industry is wellknown and equipped.

Whether or not a tax benefit is derived through thestructuring of investments via a holding company canclearly be a secondary, rather than a principal pur-pose, as example K describes a situation in which thetax treaty concluded between the fund location andthe investment location was less beneficial than thetax treaty concluded between the holding location andthe investment location.

The PPT in an EU Context

In an EU context, the application of the PPT should besubject to a stricter standard, which is determined bythe jurisprudence of the CJEU. As a rule, the funda-mental EU freedoms of establishment and free move-ment of capital, as interpreted by EU case law, providethat a given structure may only be disregarded if it isproven to be a ‘‘wholly artificial arrangement’’ whichdoes not reflect economic reality and the purpose ofwhich is to unduly obtain a tax advantage. Such apurely artificial structure may be present in case of‘‘letterbox companies’’. In the Cadbury Schweppescase, the CJEU acknowledged that a taxpayer is free torely on its EU freedoms for tax planning purposes aslong as the underlying contractual arrangements arenot ‘‘purely artificial’’.

The right of a EU Member State to protect its taxbase against abusive arrangements is limited by thefundamental freedoms. It follows that ‘‘tax jurisdic-tion shopping’’ is a legitimate activity in an internalmarket, even if the choice of jurisdiction is principallybased on tax considerations. Why should an investorbe obliged to choose a high-tax jurisdiction or arrangehis affairs in such a way as to be liable to more taxthan necessary? Nevertheless, EU Member States arefree to protect their tax bases by way of anti-abuserules which are exclusively directed at ‘‘wholly artifi-cial arrangements’’.

An abusive situation does not depend only on the in-tention of the taxpayer to obtain tax advantages (i.e., amotive test) but requires the existence (or absence) ofcertain objective factors. Among these objective ele-ments, the CJEU emphasized the importance of theexistence of an ‘‘actual establishment’’ in the host state(for example, premises, staff, facilities and equip-ment) and a ‘‘genuine economic activity’’ performedby the foreign company. Here, a company may evenrely on staff and premises of affiliated companies resi-dent in the same jurisdiction. Thus, in a fund context,it should suffice if an asset manager has a manage-ment company with substance that renders services toall the investment vehicles rather than requiring eachand every company in a fund structure to employstaff. This has been a key point of debate to date, withcertain source jurisdictions, notably Germany, havinglegislation (described below and now largely discred-ited) that pushed fund managers to arrange their op-erations in such a way as to have ‘‘substance’’ in many

individual companies, an outcome that (very ironi-cally), many fund managers felt was fairly artificial.

The notion of ‘‘genuine economic activity’’ shouldbe understood in a very broad manner and may in-clude the mere exploitation of assets such as share-holdings, receivables and intangibles for the purposeof deriving what is often described as ‘‘passive’’income. The nature of the activity should not be com-promised if such passive income is principallysourced outside the host state of the entity.

In addition, no specific ties or connections betweenthe economic activity assigned to the foreign entityand the territory of the host state of that entity can berequired by domestic anti-abuse provisions. There-fore, insofar as the EU internal market is concerned,the mere fact that an intermediary company is‘‘active’’ in conducting the functions and assets allo-cated to it (rather than being a mere letterbox com-pany) should suffice to be out of the scope of domesticanti-abuse rules or the PPT in tax treaties concludedbetween EU Member States.

It is interesting to note that until now, nationalcourts have not deviated from the ‘‘wholly artificial ar-rangement’’ doctrine laid down by the CJEU. Whilethe CJEU does not seem to require an extensive levelof substance, from a risk management perspective itmay nevertheless be wise to exceed the minimumstandard of substance in order to limit foreign taxrisks.

As such, the PPT poses significant compatibilityissues with EU law. In fact, the PPT may deny treatybenefits on the sole grounds that one of the main pur-poses was to obtain treaty benefits. Accordingly, evencompanies having economic substance in their stateof residence and performing bona fide business activi-ties may not be entitled to treaty benefits. However,within the EU, restrictions can only be justified by theneed to prevent tax avoidance when a specific anti-avoidance rule targets ‘‘wholly artificial arrange-ments’’ aimed solely at escaping national tax normallydue. Considering that the PPT imposes a lower‘‘abuse’’ threshold than the standard set by the CJEU,serious doubts can be raised on the compatibility ofthe PPT with EU law.

This concern has been confirmed by a more recentcase of the CJEU that may be helpful when analyzingthe potential scope of the PPT in an EU context. OnSeptember 7, 2017, the CJEU issued its decision in theFrench case C-6/16 regarding the application of a(former) French anti-abuse provision that automati-cally denied the withholding tax exemption on divi-dends under the EU Parent-Subsidiary Directive whendividends were paid to an EU parent company thatwas controlled by one or more entities established innon-EU countries. Under this provision, the recipientof the dividends only qualified for the exemption if itcould prove that benefiting from the exemption wasnot the main purpose or one of the main purposes ofthe structure. Accordingly, this provision has beenbroadly designed as the PPT in the OECD Model.

In the case under review, a French company paid adividend to a Luxembourg holding company whichwas indirectly held by a Swiss parent company. Ac-cording to the French tax authorities, the Luxem-bourg company was not able to demonstrate that themain purpose or one of the main purposes for estab-


lishing the structure was not to benefit from the with-holding tax exemption. The French court finally askedwhether this rejection was in accordance with EU lawand referred the case to the CJEU.

The CJEU ruled that the French anti-abuse provi-sion infringed both the EU Parent-Subsidiary Direc-tive and the freedom of establishment as it only tookinto account the taxpayer’s motive for the structure. Itdid not, however, make an individual examination ofthe whole operation and it did not contain an ‘‘eco-nomic activity’’ (or ‘‘substance’’) test as required underEU law. In addition, the burden of proof automaticallyrested with the taxpayer, whereas the French tax au-thorities did not even have to evidence tax avoidancewhen denying the dividend withholding tax exemp-tion.

German tax law also provides for an anti-abuse pro-vision that denies withholding tax exemptions (or re-ductions) granted under domestic tax law or taxtreaties unless the recipient of the income complieswith certain (excessive) substance requirements. OnDecember 20, 2017, the CJEU gave its decision in twoGerman cases (Cases C-504/16 and C-613/16) thathave been referred by the Finanzgericht Koln (FinanceCourt Cologne) and which were joined for the pur-poses of the judgment.

In the first case, a German company paid a dividendto a Dutch holding company which was a wholly-owned subsidiary of a German resident individual. Inthe second case, a German company paid a dividendto a Danish holding company that was owned by anindividual resident in Singapore. In both cases, theGerman tax authorities refused a refund of withhold-ing tax levied on these distributions.

In line with its decision in the French case, theCJEU ruled that the German anti-abuse provision in-fringed both the EU Parent-Subsidiary Directive andthe freedom of establishment, re-emphasizing its‘‘wholly artificial arrangement’’ standard. Indeed, ageneral presumption of fraud or abuse cannot justifyeither a fiscal measure which compromises the objec-tives of the Parent-Subsidiary Directive or a fiscalmeasure which prejudices the enjoyment of the fun-damental freedoms guaranteed by the treaty.

When assessing the existence of fraud and abuse,tax authorities may not rely on predetermined generalcriteria as set out in the German anti-abuse provision.Instead, tax authorities have to carry out an individualexamination of the whole operation at issue. The im-position of a general tax measure automatically ex-cluding certain categories of taxable person from thetax advantage, without the tax authorities being re-quired to provide even prima facie evidence of fraudand abuse, goes beyond what is necessary to preventfraud and abuse. Moreover, when applicable, the

German anti-abuse provision establishes an irrebut-table presumption of fraud or abuse.

The aforementioned decisions of the CJEU are atestimony to its ‘‘wholly artificial arrangement’’ stan-dard and should have a significant impact on the inter-pretation of anti-abuse provisions in an EU context.The CJEU made clear that neither a mere motive testnor excessive substance requirements are in confor-mity with EU law.

Going Forward

Luxembourg is a prime location for the structuring ofalternative investments in and through Europe.Therefore, the question as to whether Luxembourgcompanies involved in these investment structuresmay benefit from tax treaties concluded by Luxem-bourg is of utmost importance. While it would havebeen preferable to explicitly exclude non-CIV fundsand their subsidiaries from the scope of the PPT, theguidance provided in the Commentary to the OECDModel seems to significantly limit the scope of appli-cation of the PPT in case of these bona fide investmentactivities.

There remains, however, some uncertainty as towhen foreign tax authorities may deny tax treaty ben-efits. Given the current diverging attitudes of foreigntax authorities in regard to the application of anti-abuse provisions, it might be expected that the PPTwill also be interpreted differently by different tax au-thorities. Therefore, it would be wise for taxpayers toestablish the reasoning of their choice to invest via aLuxembourg company or fund so as to be preparedfor potential questions from foreign tax authorities.

In an EU context, the jurisprudence of the CJEU isparticularly helpful for the interpretation of anti-abuse provisions such as the PPT. Apart from estab-lished CJEU case law, the more recent decisions onFrench and German anti-abuse rules confirm theCourt’s adherence to its longstanding ‘‘wholly artificialarrangement’’ tenet which puts strict limitations tothe scope of anti-abuse legislation. Both decisionsshould have a major impact on EU lawmakers and taxauthorities alike, paving the way for greater legal cer-tainty in cross-border investment structures.

Oliver R. Hoor is a Tax Partner (Head of Transfer Pricing and theGerman Desk) and Keith O’Donnell is the Managing Partner of ATOZ

Tax Advisers (Taxand Luxembourg).The authors wish to thank Samantha Schmitz (Chief Knowledge

Officer) for her assistance.The authors may be contacted at:[email protected];

[email protected]


mailto:[email protected]

mailto:[email protected]

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