Investment in non-performing loans and other non-performing receivables (collectively the NPLs) in Spain and other countries has become increasingly popular among investment managers in the past few years. This trend is expected to grow in the coming years, notably due to the adverse economic impact of Covid 19 over businesses’ financial position and solvency.

Without entering into technical detail, NPLs could be defined as receivables (derived from loan agreements and other agreements) which, due to the difficult financial situation of the debtor, are transferred by the initial creditor (generally a bank or another credit institution) to a third party (which becomes the new creditor) at a substantially discounted price (i.e. at a transfer price which is substantially lower than the receivable’s nominal).

The discount rate depends on several factors, such as the receivable’s expected recovery value (i.e. amount of the receivable that the creditor reasonably expects to recover in view of the debtor’s financial position). 

In many NPLs investments, the receivable is in the process of a restructuring (i.e. amendment of its terms and conditions, such as an extension in maturity, more flexible interest payment terms, etc.) between the debtor and the initial creditor and such restructuring is pursued by the new creditor.

Investments in NPLs generally entail substantial risk and may generate profitability as follows:

• Interest accrued on the principal amount.
• Gain realized due to the debtor repaying the NPL at a value higher than the acquisition cost paid by the new creditor (this could potentially amount to the difference between the loan’s nominal and the acquisition cost).
• Gain realized upon a transfer by the new creditor to another party of the NPL at a price higher than the acquisition cost paid by the new creditor (this could potentially amount to the difference between the loan’s nominal and the acquisition cost).

Let’s make a simple example:

SpainCo operates several hotels. Because of the travel restrictions implemented as from March 2020 SpainCo has seen a sharp decrease in its operating revenue and cash flows and is unable to repay a EUR 10M bank loan which becomes due in some months. Subject to the execution of certain guarantees, the bank is willing to transfer the EUR 10M loan to a third party (which will become the new creditor) at a price of EUR 8M (i.e. the transfer price is lower than the loan’s nominal value). The new creditor and SpainCo (as debtor) will amend the terms and conditions of the loan to facilitate cash recovery.

Luxembourg is a renowned jurisdiction for the establishment of alternative investment funds and other investment vehicles, including those targeting NPLs. The choice of investment vehicle (and overall investment structure) will depend on the specific features of the investment. The main factors are generally as follows:

• Features of the NPL (i.e. type of receivable, acquisition cost, nominal value, expected cash flows, maturity, guarantees available, etc.).
• Investment strategy (i.e. expected holding period, expected exit strategy, etc.).
• States where the debtors under the NPLs are located.
• Nature and states of residence of the investors.

In Luxembourg several vehicles are generally available to make and hold investments in NPLs. The choice of investment vehicle and its implementation should be carefully reviewed by professional advisors, from a tax, regulatory, legal and financial accounting standpoint.

The following is a non-exhaustive list of Luxembourg vehicles available for investments in NPLs:

• Fund vehicles such as the Luxembourg Specialized Investment Fund (SIF) and the Luxembourg Reserved Alternative Investment Fund (RAIF) which can be established under several legal forms (i.e. companies, partnerships and contractual funds).
• Regular Luxembourg limited liability companies, partnerships limited by shares, limited partnerships and special limited partnerships.
• Securitization vehicles.

From a tax standpoint, investment managers will aim to structure the investment vehicle in a way that allows the vehicle to be as tax neutral as possible. For this purpose, the following items should be analyzed in detail:

• Taxation at source (i.e. tax implications on the interest payments and repayment of principal by the debtor, which may depend on the type of investment vehicle utilized).
• Taxation of the Luxembourg vehicle in Luxembourg.
• Luxembourg tax implications of distributions made by the investment vehicle to its investors.

From a cross-border tax standpoint, the provisions of Council Directive (EU) 2016/1164 (generally as amended by Council Directive (EU) 2017/952 – which is generally referred to as the Anti-Tax Avoidance Directive) as well as the OECD Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) should be carefully reviewed. In particular, the following items should be closely monitored:

• Potential impact of the so-called “interest-limitation rule” (ILR). Without entering into technical detail, under the ILR arm’s length exceeding borrowing costs (roughly net interest expenses) incurred by a corporate taxpayer in a fiscal year should be tax-deductible up to the higher of (i) f EUR 3M and (ii) 30% of the taxpayer’s taxable EBITDA. Financial undertakings, including (i) credit institutions, (ii) alternative investment funds managed by an alternative investment fund manager and (iii) securitization vehicles established in accordance with Regulation (EU) 2017/2402 should be excluded from the ILR.
• The so-called “anti-hybrid provisions” which intend to tackle mismatches generally leading to situations of double non-taxation or taxation without inclusion.
• Existence of an economic rationale to be in Luxembourg and an adequate level of substance.

Ongoing follow-up of the structures implemented is a key to the successful implementation of these investments.