On 22 March 2004, the Luxembourg Act of 22 March 2004 on Securitisation (the Securitisation Act) came into force, providing the general framework for securitisation transactions. Ever since, the Grand Duchy of Luxembourg has been a major market participant and a significant European hub for securitisation transactions,2 mainly because of its flexible and innovative legal and regulatory framework and favourable tax regime.
The number of active Luxembourg securitisation undertakings has been constantly growing since the entry into force of the Securitisation Act, with approximately 1,350 active securitisation undertakings as at 31 December 2018, which between them have more than 6,000 compartments and represent more than €266 billion3 in total assets under management.
Pursuant to the Securitisation Act, a securitisation undertaking may be set up either as a securitisation company4 or as a securitisation fund that has no legal personality, consists of a co-ownership of assets and is represented by a management company in its relations with third parties.
The most common form for Luxembourg securitisation companies had always been the public limited liability company until an amendment to the Luxembourg legislation on commercial companies in 2016. The private limited liability company is now the most commonly used form. We estimate that less than 80 active securitisation funds exist at the time of writing.
Only securitisation undertakings issuing securities to the public on a continuous basis are subject to the supervision of the Luxembourg financial regulatory authority (CSSF). At the time of writing, only 33 securitisation undertakings are regulated. Both regulated and unregulated securitisation undertakings benefit from the provisions of the Securitisation Act.
Deliberately broad in its scope of application, the Securitisation Act defines securitisation as the transaction whereby a securitisation undertaking acquires or assumes, directly or through another undertaking, risks relating to claims, other assets or obligations assumed by third parties or inherent in all or part of the activities of third parties, and issues securities whose value or yield depends on those risks.5 Compared with other jurisdictions or legislation at an EU level,6 the definition of securitisation is less restrictive in Luxembourg. The EU Securitisation Regulation, for instance, only applies to securitisation transactions in which a credit risk associated with an exposure or a pool of exposures is tranched.
The EU Securitisation Regulation was developed in the aftermath of the subprime crisis, as part of the package of regulatory reforms for securitisation under the EU capital markets union action plan, to foster investor protection in the European Union. It entered into force on 17 January 2018 and has applied in general since 1 January 2019 (subject to certain grandfathering provisions). It lays down a general framework for securitisation and creates a specific framework for simple, transparent and standardised (STS) securitisation. Furthermore, the EU Securitisation Regulation provides for:
- risk retention obligations for the sponsor, originator or original lender;
- disclosure requirements to the investors and the competent authority regarding the underlying assets; and
- investor-specific due diligence regimes and suitability tests.
At the time of writing, only a handful of issuances by a Luxembourg securitisation undertaking qualifying as STS securitisation have been carried out.7
The asset classes that are securitised in the Luxembourg securitisation market are mainly auto and mortgage loans, debt securities, equity (including fund units) and trade receivables. The acquisition of the underlying assets is typically financed via the issuance of debt securities. Most of the securities issued by regulated securitisation vehicles consist of structured products, the performance of which is linked to indices or swaps.
On 21 December 2018, the law implementing the Anti-Tax Avoidance Directive 1 (the ATAD 1 Law)8 was published. The ATAD 1 Law applies for fiscal years starting on or after 1 January 2019 and has introduced interest deduction limitation rules (IDLRs) into the Luxembourg tax framework, which may limit the deductibility of exceeding borrowing costs (see Section II.vii) at the level of a securitisation company.
i Luxembourg securitisation regime
For the Securitisation Act to apply, the securitisation undertaking must, in respect of each compartment under which it carries out a securitisation transaction, acquire or assume risks relating to claims, other assets or obligations assumed by third parties or inherent in all or part of the activities of third parties and must issue securities whose value or yield depends on those risks. Consequently, on the liability side, it will issue equity or debt securities, and on the asset side, it will acquire or assume risks.
The regime of the Securitisation Act covers all types of assets. It is important, however, to ensure that the securitisation undertaking does not, in principle, generate its own risk and act as entrepreneur, but instead acquires or assumes risks generated by third parties or relating to assets of third parties. Generating and securitising own risks could be considered a transaction that is not a securitisation in the sense of the Securitisation Act.
ii Regulated securitisation undertakings
A securitisation undertaking that is subject to the Securitisation Act must be authorised by the CSSF and obtain a licence if it issues securities to the public on a continuous basis (these two criteria apply cumulatively). An issue of securities is not deemed to be made to the public if the denomination is at least €125,000 or if it is offered to professional clients only. A securitisation undertaking is deemed to issue securities on a continuous basis if issuing more than three times per year. The question of whether a vehicle issues securities to the public on a continuous basis would have to be assessed at the level of the vehicle with all compartments combined.
The status of a regulated securitisation undertaking implies prudential supervision by the CSSF and the requirement to keep its liquid assets in custody with a Luxembourg credit institution.
iii Securitising loans
A Luxembourg securitisation undertaking can carry out the securitisation of existing loans with a fixed interest rate and fixed repayment date or with a floating or variable interest rate (known as profit participation) under the Securitisation Act provided that the investor in the notes issued by the securitisation undertaking to finance the acquisition of the loans is not linked to the borrowers under those loans (in accordance with the prohibition against intra-group securitisation transactions). As explained in Section II.v, Luxembourg securitisation undertakings benefit from a carve-out from the Luxembourg Banking Act and, therefore, do not require a licence to carry out securitisation activity under Luxembourg law. If securitising loans, however, it should be clarified whether there are any licensing requirements in the jurisdictions where the borrowers are located or under the governing laws of the loans to be securitised.
iv Financial statements and auditing
A securitisation undertaking subject to the Securitisation Act must always appoint a statutory auditor chartered in Luxembourg who is in charge of auditing the securitisation undertaking's annual financial statements.
Annual financial statements are established at the end of the securitisation undertaking's financial year. Those financial statements will provide for information on the assets of each of the securitisation undertaking's compartments, as well as consolidated accounts of the securitisation undertaking and will be made available to investors.
v Banking Act
The Luxembourg Act of 5 April 1993 on the Financial Sector, as amended (the Banking Act), which regulates credit institutions and other professionals in the financial sector, contains a specific carve-out for securitisation undertakings.
vi Alternative Investment Fund Managers Directive
Directive 2011/61/EU on alternative investment fund managers (AIFMD), which was designed to regulate all entities that manage arrangements or entities covered by the term 'alternative investment fund' (AIF), has been implemented in Luxembourg pursuant to the Luxembourg Act of 12 July 2013 on Alternative Investment Fund Managers (the AIFM Act). There are a number of arguments to the effect that a securitisation undertaking would not be caught by the AIFMD (although the analysis would have to be effected in respect of each compartment of the securitisation undertaking, and a transaction carried out under one compartment may have an impact on the overall status of the securitisation undertaking).
In line with the AIFMD, the AIFM Act contains an exemption for securitisation special purpose entities (SSPE), which are defined in the AIFM Act as entities that have the sole purpose of carrying out securitisations within the meaning of Article 1(2) of the European Central Bank's Regulation (EC) No. 24/2009, provided, however, that:
- first lenders (i.e., lenders securitising loans that they themselves have granted and that issue notes to finance their securitisation activities) are not considered ad hoc securitisation vehicles, since no asset (and hence no credit risk) is transferred to or purchased by that entity; and
- securitisation vehicles issuing structured products that primarily offer a synthetic exposure to assets other than loans (non-credit-related assets), do not benefit from the foregoing exclusion.
Regardless of whether or not the vehicle qualifies as an SSPE, the CSSF has, in its revised set of frequently asked questions on securitisation, specified that securitisation undertakings issuing only debt instruments shall not be considered AIFs and thus shall fall outside the scope of the AIFM Act.
In the event that a securitisation undertaking cannot rely on any of the above-mentioned exclusions, it could potentially be considered an AIF. If a Luxembourg securitisation undertaking is subject to the provisions of the AIFM Act, one consequence is the requirement to designate an AIF manager for the purpose of managing the securitised assets. Depending on the type and amount of assets under management, the board of directors of the securitisation vehicle may itself act as internal AIF manager, or the securitisation vehicle has to appoint a fully licensed external AIF manager. A fully licensed AIF manager is required to appoint a depositary in relation to securitised assets. This will inevitably result in an increase in the fees, costs and expenses of a Luxembourg securitisation undertaking, payable to various parties.
vii Tax aspects
Tax aspects applicable to a securitisation company
A securitisation company is a fully taxable Luxembourg company. As such, it is subject to corporate income tax at a rate of 17 per cent, municipal business tax at a rate of 6.75 per cent (in Luxembourg City (the rate varies from one municipality to another)) and a contribution to the unemployment fund of 7 per cent. The overall combined corporation tax burden thus currently stands at 24.94 per cent (in Luxembourg City).
The securitisation company is assessed on the basis of its global profits, after deduction of allowable expenses and charges, determined in accordance with Luxembourg general accounting standards (subject to certain fiscal adjustments) and subject to the provisions of applicable tax treaties. Expenses that relate to an item of income that is not taxable in Luxembourg are not deductible for tax purposes.
However, the Securitisation Act provides for specific rules applying to a securitisation company in relation to tax deductibility. Indeed, the Securitisation Act states that the obligations assumed by a securitisation company towards the investors (including shareholders) and any other creditors are to be considered tax deductible expenses. In other words, a securitisation company should be able to deduct any payments due or made to any investors, or to any other creditors, from its taxable profits, subject to the IDLRs, which have recently been introduced into Luxembourg tax law under the ATAD 1 Law (see 'IDLRs' below).
Investors may generally hold either equity or debt securities issued by a securitisation company. Therefore, any payments to the investors (whether they hold shares or notes issued by a securitisation company), whether in the form of dividends or interest, as well as any commitments to the investors, whether in the form of due and unpaid dividends or accrued and unpaid interest (regardless of the actual date of payment), will be deductible for tax purposes, subject to the IDLRs.
Therefore the securitisation transaction entered into by a securitisation company should not give rise to any corporation tax burden in Luxembourg, if properly structured (i.e., if it is ensured that, during each financial year, any income realised by a securitisation company may be offset by corresponding deductible expenses, including interest paid or accrued to the investors under the debt securities it has issued). The Luxembourg tax authorities do not require a securitisation company to realise any minimum profit margin that would be subject to tax.
The IDLRs have been introduced into Luxembourg tax law pursuant to the requirements under the ATAD 1 Law, which themselves are largely based on the work realised by the Organisation for Economic Co-operation and Development and the G20 in the context of the base erosion and profit shifting project, specifically on the 'Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 – 2016 Update'.
The IDLRs have been applicable since 1 January 2019 with respect to accounting years starting on or after 1 January 2019 (subject to the grandfathering clause). The IDLRs provide that taxpayers are only able to deduct 'exceeding borrowing costs'9 of up to 30 per cent of their earnings before interest, tax, depreciation and amortisation (EBITDA).
For the purposes of the IDLRs, EBITDA is adjusted according to tax criteria and thus corresponds to net income, as increased by the adjusted amounts for exceeding borrowing costs, depreciation and amortisation. Tax-exempt revenues, as well as expenses related to such revenues, are excluded from EBITDA.
The ATAD 1 Law grants taxpayers a de minimis threshold of €3 million for deductible exceeding borrowing costs. Moreover, the ATAD 1 Law has introduced a grandfathering rule for loans granted before 17 June 2016. It also contains a carve-out for loans used to fund long-term infrastructure projects and financial undertakings. Financial undertakings are defined broadly, in particular to include securitisation undertakings as defined under Regulation (EU) 2017/2402. Luxembourg has also provided the option to deduct borrowing costs on a stand-alone basis if a taxpayer can basically demonstrate that its deduction ratio is higher than the equivalent ratio at its group level.
Finally, Luxembourg has opted for the full deductibility of borrowing costs for standalone entities. In other words, the IDLRs do not apply to stand-alone entities.
Net wealth tax
The Securitisation Act fully exempts securitisation companies from net wealth tax.10
There is no withholding tax on interest payments or on dividends paid by a securitisation company.
Tax analysis of a securitisation fund
Corporation taxes, withholding tax and net wealth tax
The Securitisation Law provides that a securitisation fund is subject to the same tax regime as a collective investment fund in the form of a mutual fund. Therefore, it should be treated as transparent for Luxembourg tax purposes. Consequently, it should not be subject to Luxembourg corporation taxes, withholding tax or net wealth tax.
The IDLRs should not adversely impact the securitisation fund itself, given its tax transparent status under Luxembourg tax law. Indeed, a securitisation fund is not itself subject to Luxembourg corporation taxes and, therefore, does not rely on deductibility, for tax purposes, of interest paid under the debt securities it issues to reduce its tax base in Luxembourg.
III SECURITY AND GUARANTEES
Pursuant to the Securitisation Act, a securitisation undertaking can only create security interest over its assets or transfer its assets for guarantee purposes to secure the obligations it has assumed for their securitisation or in favour of its investors, their fiduciary representative or the issuing vehicle participating in the securitisation.11 Any security interest or guarantee created in breach of this rule is void by operation of law.
Because of the segregation and limited recourse features and the bankruptcy remoteness of a securitisation undertaking, securitisation transactions in the Luxembourg market are often unsecured. For secured transactions, the most common Luxembourg law governed security package consists of a pledge over the cash or securities (or both) in a bank account of a Luxembourg based bank or a pledge over receivables being subject to the securitisation. All other types of security interest may be granted under foreign law.
There are rights of preference (e.g., tax payments, social security charges and wages) existing by operation of law and ranking prior to the ranking of security rights.
The Luxembourg Act of 5 August 2005 on Financial Collateral Arrangements, as amended (the Collateral Act) provides an attractive legal framework for security interests, liberalised rules for creating and enforcing financial collateral arrangements and protection from insolvency rules. It applies to any financial collateral arrangements and covers financial instruments in the widest sense, as well as cash claims and receivables.
The Collateral Act also provides for transfers of title by way of security and recognises the right of the pledgee to rehypothecate pledged assets. It enables the pledgee to use and dispose of the pledged collateral. Contractual arrangements allowing for substitution and margin calls are expressly recognised by the Collateral Act and are protected in insolvency proceedings in which security interests granted during the pre-bankruptcy suspect period can be challenged. Furthermore, under the Collateral Act, financial collateral arrangements are valid and enforceable even if entered into during the pre-bankruptcy suspect period.
Under Luxembourg law, collateral can be provided directly to the investors or to a security agent or security trustee acting for the benefit of the investors.
IV PRIORITY OF PAYMENTS AND WATERFALLS
Pursuant to the Securitisation Act,12 the articles of incorporation or management regulations of a securitisation undertaking and any agreement entered into by a securitisation undertaking may contain provisions by which investors and creditors accept the subordination of the maturity or the enforcement of their rights of payment to that of other investors or creditors. Therefore, it is generally recommended to insert in the articles of incorporation or the management regulations of a securitisation undertaking, as well as in any relevant agreement to which the securitisation undertaking is a party, a statement to the effect that by subscribing to the securities to be issued by the securitisation undertaking, or by entering into an agreement with the securitisation undertaking, both the investors and the creditors expressly acknowledge and accept that the securitisation undertaking is subject to the Securitisation Act and that provision has been made for subordination and payment waterfalls.
Care should also be taken with the fact that, under the Securitisation Act, it is not possible to simply use the proceeds resulting from the issue of securities to make a deposit in a bank (as there would not be securitisation in the sense of an assumption of a risk). However, if, for example, the sale proceeds of loans were deposited for a limited period in a bank account pending their application, on the next payment date in accordance with the waterfall provisions to redeem securities, this would, in our view, not give rise to concern under the Securitisation Act. Similarly, the securitisation undertaking could operate a cash reserve ledger or, instead of making a deposit of cash with a bank, buy 'risk-free' assets and enter into a synthetic transaction with a counterparty to give investors exposure to an index (the risk-free assets serving as collateral in that instance).
According to the Securitisation Act, a securitisation undertaking must be financed by the issue of transferable securities whose value or yield depends on the risks assumed by the securitisation undertaking. However, it is accepted by the Luxembourg authorities that a securitisation undertaking can also be financed by way of loans as long as such financing remains ancillary.
A Luxembourg securitisation undertaking cannot actively manage the assets it has securitised. The management of the underlying portfolio of financial assets should not be such as to fall within the scope of the regulations on the functioning and management of undertakings for collective investment in securities and AIFs. The management of the securitised risks should be limited to a prudent and responsible person and may not create an additional risk, which would be in addition to the risks inherent in the underlying assets being securitised. However, the CSSF has accepted the investment by a securitisation undertaking in a proprietary index that is actively managed in the past. The above applies irrespective of whether the management of the portfolio has been delegated to a third party or is carried out by the securitisation undertaking itself.
V ISOLATION OF ASSETS AND BANKRUPTCY REMOTENESS
i Forms of risk transfer
The transfer of the risk of the assets or rights to be securitised to the Luxembourg securitisation undertaking can be achieved either through a true sale or a synthetic transaction. In a true-sale securitisation transaction, the securitisation undertaking acquires legal and beneficial ownership of the underlying assets. In a synthetic securitisation transaction, the securitisation undertaking does not acquire legal and beneficial ownership of the underlying assets but assumes the risk related to the assets using derivative instruments (e.g., credit derivatives or swaps). In this context, the Securitisation Act exempts such securitisation transactions from the application of the Luxembourg laws governing the insurance sector.13
The Securitisation Act provides for the possibility to structure a securitisation with an issue vehicle (providing for the financing via the issuance of securities to investors) and an acquisition vehicle (acquiring the assets to be securitised). In a double layer structure, the issue vehicle pays for the performance of the underlying assets held by the acquisition vehicle by means of back-to-back financing. This is mainly being used to create an investment mix at the level of the acquisition vehicle (the issue vehicle being invested in different acquisition vehicle compartments containing different asset types, for example) or to issue shariah-compliant financial instruments.
The Securitisation Act allows the board of directors of a securitisation undertaking to set up separate ring-fenced compartments. Each compartment forms an independent, separate and distinct part of the securitisation undertaking's estate and is segregated from all other compartments of the securitisation undertaking. Investors, irrespective of whether they hold equity or debt securities, will only have recourse to the assets encompassed by the compartment to which the securities they hold are allocated. They have no recourse against other compartments. In the relationship between the investors, each compartment is treated as a separate entity (unless otherwise provided for in the relevant issue documentation).
The compartment structure is one of the most attractive features of the Securitisation Act, as it allows the use of the same issuance vehicle for numerous transactions without investors running the risk of being materially adversely affected by other transactions carried out by the securitisation undertaking. This feature allows the securitisation transactions to be structured in a very cost-efficient way without burdensome administrative hurdles. It is important to note that there is no risk-spreading requirement for the compartments. It is hence possible to isolate each asset held by the securitisation undertaking in a separate compartment.
Furthermore, compartments are ring fenced during their lifetime, but also in the case of liquidation. Each compartment may be liquidated separately without entailing the liquidation of other compartments or the entire securitisation undertaking.
Finally, a compartment has no legal personality and so no agreement may be signed by, nor can any action be brought against, it in isolation.
iii Bankruptcy remoteness and limited recourse
A securitisation company is structured as an insolvency-remote (but not insolvency-proof) vehicle. The ring fencing of compartment assets, priority of payments, limited recourse, non-seizure of assets and non-petition for bankruptcy are protected not only by contractual arrangements, but are also expressly recognised by the Securitisation Act.14 Legal proceedings initiated against a securitisation undertaking in breach of these provisions should, therefore, in principle, be declared inadmissible by a Luxembourg court.
A securitisation undertaking will aim to contract with all parties in respect of a compartment on the basis that they accept the applicable priority of payments and limited recourse provisions, and that they will not be allowed to make an application for the commencement of the winding-up, liquidation or bankruptcy against that securitisation undertaking. A creditor who has not accepted these provisions may potentially initiate insolvency proceedings against a securitisation company, but its recourse should, in principle, be limited to the general estate of the securitisation company or, if its rights relate to a particular compartment, the assets allocated to that compartment only. If the assets are insufficient to discharge all liabilities relating to a compartment, claims of creditors for any shortfall will be extinguished and they may not take any further action to recover the shortfall. The failure of a securitisation company to make a payment because of insufficient assets in a compartment will not usually trigger an event of default under the terms and conditions of the securities issued by the company.
The bankruptcy remoteness of a securitisation company is strengthened if the securitisation structure is orphaned (i.e., the securitisation company's shares are held by a trust or a foundation (typically a Dutch stichting)). Such a setup minimises the risk that the securitisation company could be affected by the financial situation of its holding company or otherwise subject to shareholders' decisions that may have a negative impact on the interests of investors.
A bill of law amending the Securitisation Act is currently being prepared to take account of the requirements of a changing market, to implement the EU Securitisation Regulation and to provide for even more flexibility to structure and collateralise securitisation transactions, among other reasons.
On 8 August 2019, the Luxembourg government submitted a bill of law implementing the Anti-Tax Avoidance Directive 2 (ATAD 2)15 to Parliament. The bill of law extends the existing anti-hybrid rules applicable within the European Union as introduced by the ATAD 1 Law to cover hybrid mismatches involving non-EU countries and certain additional hybrid mismatches. The anti-hybrid rules may, under certain circumstances, result in a disallowance of the deductibility of expenses at the level of a securitisation company. In a nutshell, a hybrid mismatch (i.e., double deduction or deduction without inclusion) may result from the difference in the characterisation of a financial instrument or of an entity in different countries. Most of the ATAD 2 provisions must be implemented into Luxembourg tax law before the end of 2019 and apply as from 1 January 2020. The developments in this respect should be closely monitored.
1 Frank Mausen, Paul Péporté and Jean Schaffner are partners, Serge Zeien is a senior associate and Zofia White is an associate at Allen & Overy.
2 According to a publication from Deloitte ('Luxembourg Securitization Vehicles: An attractive Solution', September 2018), approximately 25 per cent of the European securitisation transactions are performed via Luxembourg.
3 This figure only takes into account the publicly available statistics of the European Central Bank based on the reporting of financial vehicle corporations; the reporting threshold being €70 million.
4 The following corporate forms are available: public limited liability company, partnership limited by shares, private limited liability company and cooperative company organised as a public limited liability company.
5 Article 1 of the Securitisation Act.
6 Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No. 1060/2009 and (EU) No. 648/2012 (the EU Securitisation Regulation).
8 Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
9 Under the ATAD 1 Law, exceeding borrowing costs are defined as 'the amount by which the deductible borrowing costs of a taxpayer exceed taxable interest revenues and other economically equivalent taxable revenues that the taxpayer receives'. Under the Law, borrowing costs mean 'interest expenses on all forms of debt, other costs economically equivalent to interest and expenses incurred in connection with the raising of finance, including, without being limited to: payments under profit participating loans; imputed interest on instruments such as convertible bonds and zero coupon bonds; amounts under alternative financing arrangements, such as Islamic finance; the finance cost element of finance lease payments; capitalised interest included in the balance sheet value of a related asset, or the amortisation of capitalised interest; amounts measured by reference to a funding return under transfer pricing rules where applicable; notional interest amounts under derivative instruments or hedging arrangements related to an entity's borrowings; certain foreign exchange gains and losses on borrowings and instruments connected with the raising of finance, guarantee fees for financing arrangements, arrangement fees and similar costs related to the borrowing of funds'.
10 Except for the minimum net wealth tax of €4,815 where the securitisation company's financial assets, intra-group receivables, bank deposits and cash in the bank exceed 90 per cent of its total balance sheet (which is generally the case) and €350,000. In all other cases, the securitisation company would be subject to a minimum wealth tax ranging between €535 and €32,100, depending on its balance sheet total.
11 Article 61(3) of the Securitisation Act.
12 Article 64(1) of the Securitisation Act.
13 Article 53(3) of the Securitisation Act.
14 Pursuant to Article 64(1) of the Securitisation Act, 'the articles of incorporation, the management regulations of a securitisation undertaking and any agreement entered into by the securitisation undertaking may contain provisions by which investors and creditors accept to subordinate the maturity or the enforcement of their rights to the payment of other investors or creditors or undertake not to seize the assets of the securitisation undertaking nor, as the case may be, of the issuing or acquisition vehicle, and not to petition for bankruptcy thereof or request the opening of any other collective or reorganisation proceedings against them'.
15 Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries.