Luxembourg - New attractive carried interest regime

• Broader eligibility: A wider range of professionals involved in fund management can now benefit from the favourable carried interest regime.
• Structure improvement: Carried interest structures have not only been clarified to address previous uncertainties but also simplified to enhance their attractiveness, notably by removing the initial‑capital‑recovery requirement for investors, thereby enabling genuine “deal‑by‑deal carry”.
• Attractive tax regime: Harmonised taxation for contractual carry and further clarifications of the participation‑based carried interest allowing a zero taxation under certain conditions.
• Simplified tax structuring: Neutralisation of the tax transparency rules in presence of tax‑transparent AIFs.

Carried interest generally refers to a performance-based reward granted to an individual for managing an AIF in a way that generates strong results. This form of remuneration is inherently uncertain, as it depends entirely on the performance of the fund's underlying assets and is only paid once returns exceed a predefined threshold (the “hurdle rate”, defined as an arm's length minimum return that investors must receive before sharing any additional profits with carried interest holders).

The Law has amended all previous references to “capital gain type entitlements” to now refer solely to carried interest linked to the AIF's “outperformance” in line with current market practice terminology.

Whilst the previous regime was limited to Luxembourg individuals employed by an AIFM or its management company, the Law applies to any Luxembourg individual providing genuine management services to the AIF. Unlike the previous regime, the Law applies both to individuals already residing in Luxembourg and to those newly arriving. Consequently, the Law broadens the scope of individuals eligible for the new tax regime, as it may apply to anyone who is directly or indirectly involved in the effective management, and therefore the performance, of the AIF.

To determine if there is a genuine contribution to the management of the AIF, the Law distinguish two scenarios:

• Investment Management Functions: The individual performs an investment management role for the AIF, either under an employment contract or as a partner, manager, or director. Functions such as portfolio and risk management should be included, whilst purely administrative roles should be excluded.
• Service Providers: The individual acts as a service provider involved in the management of the AIF under a consulting agreement, which may be concluded directly or through one or more intermediary entities.

In line with the previous regime, carried interest structures may be implemented either through a contractual arrangement or linked to a participation in the AIF. In each scenario, the income resulting from such carried interest must be clearly determined by reference to a predetermined waterfall at the level of the AIF. To address the lack of clarity and the interpretative challenges of the previous regime, the Law introduces a modernized and clarified regime for the various types of carried interest structures.

Contractual carried interest

Carried interest may be received solely under a contractual arrangement, which does not require the beneficiary to hold a participation in the AIF and is generally granted free of charge. However, although not required, the beneficiary may still hold an investment in the AIF, provided that the investment is made under arm's length conditions. Any return from such investment would, however, fall outside of the scope of the Law.

Participating carried interest

Regarding carried structures linked to a participation in the AIF, the Law expressly distinguishes two applicable scenarios:

• Carried interest “inseparably linked” to an investment in the AIF (the so-called “co-investment”): This scenario considers the carried interest, although granted contractually and generally free of charge, being linked to a direct or indirect “ordinary” participation in the AIF (or co-investment) that the individual must acquire at cost. This participation should have “genuine economic substance” in terms of both amount and duration to avoid requalification as an abuse of law.
• Carried interest represented by a participation in the AIF (the so-called “carried invest”): This scenario considers the carried interest being represented by a specific participation in the AIF (e.g., carried shares or units) acquired either directly or through a dedicated vehicle (e.g., a carry vehicle in the form of an SCSp). In this case, the holding by the individual of an “ordinary” participation is irrelevant. Despite any guidance regarding the valuation methods to be applied to the carried invest, each AIF could, for instance, retain the flexibility to determine an appropriate valuation method of such carried interest, relying notably on recognised and commonly used practices within the Luxembourg financial market.

• Availability of “deal-by-deal” carry structures: Under the previous regime, carried interest was available only once all investors had recovered their initial investment (i.e., whole fund model). The Law abolishes this requirement, thereby allowing “deal-by-deal” carry structures. Therefore, beneficiaries may now receive carried interest progressively as the fund's underlying assets are realized. Yet, safeguard mechanisms, which may themselves trigger tax implications, remain in place to protect investors and ensure the return of their capital (e.g., escrow arrangements; “claw‑back” clauses; etc.). 
• No participation disposal requirement: Clarification that beneficiaries do not need to dispose of their participation to benefit of the carried interest regime for both scenarios related to carried structures linked to a participation in the AIF (i.e., co-investment and carry invest). This clarification is in line with the new definition referring to carried interest as a participation in the AIF's “outperformance”. 
• Payment structure: Carried interest income might now be paid to the beneficiary either directly by the AIF or indirectly via the AIFM or the general partner (“GP”), provided that the AIFM or GP receives the carried interest on behalf of the beneficiaries and subsequently distributes it to them. For these purposes, any carried interest routed through a tax-transparent carry vehicle will be treated as if received directly from the AIF.

Contractual carried interest

Carried interest income received under a contractual arrangement will be treated as speculative gain and taxed as extraordinary income benefiting from the favourable one-quarter of the individual's standard global income tax rate (up to a maximum of 11,45% approx.).

Participating carried interest

Carried interest income received in connection with a participation held in the AIF will be fully tax exempt provided the participation is held for more than 6 months, unless the beneficiary holds a “substantial participation” as defined under Luxembourg tax law (i.e., more than 10% in the fund or underlying tax opaque entities if the fund is tax-transparent). However, income derived from the participation itself will be taxable under the general regime.

Structure simplification

Unlike the previous regime, the Law applies irrespective of the legal form and related Luxembourg tax treatment of the AIF (no look-though approach). As a result, all income derived from carried interest received in connection with a participation held in the AIF will systematically be classified as speculative income and benefit from the favourable tax treatment mentioned above, regardless of the nature of the underlying income received by the tax-transparent AIF. In other words, the AIF is deemed opaque for the purposes of applying these carried‑interest rules.