In Luxembourg, as in many other jurisdictions, discussions have arisen on carried interest taxation: whether it should be taxed as employment income (at high rates) or as investment income (at lower rates). In the past, Luxembourg did not have clear rules on the taxation of carried interest. However, rules were introduced in 2013 together with the implementation of the Alternative Investment Fund Managers Directive in Luxembourg law.
The Luxembourg taxation rules define carried interest (l’intéressement aux plus-values) as a share in the profit of an alternative investment fund paid to employees of alternative investment fund managers or employees of management companies of an AIF. The carried interest must be paid on the basis of an incentive right, which is granted based on employees’ status and the AIF’s performance.
The tax law distinguishes between two categories of carried interest income earned by the employees of AIFMs or employees of management companies of AIFs:
- Carried interest not structured as units, shares or securities issued by an AIF.
- Carried interest structured as units, shares or securities issued by an AIF.
The return on the first type of carried interest arrangement is taxed at the progressive income tax rate of up to 45.78 percent. Capital gains on the second type of carried interest realized are subject to the same progressive income tax rate. However, if the gain is realized after a period of six months it is not subject to taxation, unless the carried interest represents a substantial shareholding in a tax-opaque AIF. Such a substantial shareholding is generally present if the carried interest directly or indirectly represents more than 10 percent of the AIF’s capital. In this case, gains are taxed at half the progressive income tax rate (maximum tax rate of 22.89 percent). To ensure that the income paid under the second type of carried interest arrangement benefits from this exemption, the carried interest holder should dispose of its carried interest, which would generally entail a buy-back of carried units by the AIF.
For employees who migrate to Luxembourg, the rules provide for substantially reduced tax for the first type of carried interest arrangement. The conditions for such individuals benefiting from the reduced tax rate are as follows:
- The employee became resident in Luxembourg in 2013 or within the five years after July 22, 2013.
- The employee in question has not, before migrating to Luxembourg, been resident for tax purposes in Luxembourg or been subject to Luxembourg individual income tax with respect to professional income in the five years prior to July 22, 2013.
- No advance payments for carried interest have been paid to the employee.
- The remuneration is paid within 10 tax years after the year when the employee began to perform the functions for which the carried interest is paid.
ll these conditions are fulfilled, employees of an AIFM, or employees of management companies of AIFs, may benefit from a reduced rate corresponding to 25 percent of the personal income tax rate, leading to a maximum tax rate of 11.45 percent.
Frank van Kuijk and Jochem van der Wal are partners and tax advisors in Loyens and Loeff’s Luxembourg office. Matthijs Haarsma is a senior associate.
This is an extract from The Definitive Guide to Carried Interest, available here. It was first published in PEI’s Global Tax Considerations in Private Fund Formation and has been updated.