Luxembourg tax updates

1. New Luxembourg carried interest tax regime

On July 24, 2025, the Luxembourg Government submitted draft law No. 8590 (the Draft Law) to the Luxembourg Parliament, providing for a new tax regime applicable to carried interest granted to managers of alternative investment funds (AIFs).

The Draft Law materially amends the current carried interest regime and is expected to apply from the 2026 tax year. It broadens the category of eligible beneficiaries, specifies the types of carried interest arrangements covered, and establishes a permanent preferential regime intended to align with comparable frameworks in other jurisdictions.

Scope of the reform 

The Draft Law defines carried interest broadly as performance-based remuneration derived from the outperformance of an AIF, received based on specific rights over the fund’s net assets and income. The “outperformance” of the fund is described in commentary to the draft Law as the remuneration received above a set hurdle rate agreed with investors which must reflect market practice to avoid potential challenges under the abuse of law principle.

The new Draft Law extends eligibility beyond employees of the AIF manager (AIFM) or management company to any individual directly or indirectly involved in the management of the AIF. This expressly includes those employed by other entities (e.g., the investment adviser) and those in non-employment relationships such as independent directors, consultants, or shareholders of the management company.

Contractual vs. participation-based carried interest 

Two distinct tax treatments are introduced, depending on whether the carried interest involves holding an equity participation in the fund or a related vehicle.

• Contractual carried interest: this regime applies to profit-sharing rights based solely on contractual arrangements (such as those in the limited partnership agreement) without any requirement to hold a participation in the AIF or an interest mirroring its performance. Payments may be made by the AIF itself or another entity (e.g., the general partner). The amounts received are treated as extraordinary income and taxed at one-quarter of the recipient’s global income tax rate, resulting in an effective maximum rate of approximately 11.45% based on 2025 rates.
• Participation-based carried interest: this regime applies where the beneficiary holds a direct or indirect interest in the AIF (such as carried shares) or in another vehicle conferring carry rights. Income is taxed under the ordinary capital gains rules as speculative gains. A full exemption applies if the participation is held for more than six months and does not represent a substantial shareholding (i.e., exceeding 10%) in a corporate entity. The potential tax transparency of the issuing AIF is not taken into account, avoiding complexity where the carry vehicle is a partnership and disregarded for tax purposes.

In both cases, the favourable regime applies only to amounts linked to outperformance. Other income derived from the participation remains subject to the ordinary tax regime.

Key takeaways 

If adopted, the Draft Law will repeal the current carried interest regime with effect from the 2026 tax year. The new framework provides greater clarity and a more comprehensive approach for beneficiaries who currently rely on the current rules, while also addressing gaps and uncertainties identified in practice.

The Draft Law introduces, among other measures:

• a broader scope of eligible beneficiaries, extending beyond employees of the AIFM or management company;
• recognition of both contractual and participation-based carry, with preferential treatment for contractual rights and capital gains exemption (subject to certain conditions) for participation-based carry;
• removal of the prior capital repayment condition, thereby allowing deal-by-deal distributions;
• neutralisation of the legal form of the carry vehicle for capital gains qualification; and
• safeguards on hurdle rate levels and the economic substance of participation-based carry to mitigate requalification risks.

By consolidating and expanding the existing rules, the reform is expected to enhance legal certainty for AIF managers and related professionals, while maintaining consistency with market practice and anti-abuse standards.

2. New Circular issued by the Luxembourg direct tax authorities clarifying reverse hybrid rules

On August 22, 2025, the Luxembourg direct tax authorities released Circular n° L.I.R. n°168quater/2 dated August 12, 2025 (the Circular) which brings further clarifications concerning the conditions of the specific carve-out under the so-called "reverse hybrid rules" introduced in the context of the implementation of EU Directive 2017/952 of May 29, 2017 as regards hybrid mismatches with third countries (ATAD 2). Such clarifications are welcomed and are in line with the parliamentary works.

Applicable rules

A reverse hybrid entity is an entity treated as tax transparent in its country of incorporation but seen as opaque for tax purposes in the country of residence of its partners. This qualification is applicable only where the Luxembourg entity is considered a taxable company at the level of its direct and indirect associated enterprise(s) holding at least 50% of the voting rights or capital of the Luxembourg entity or are entitled to receive at least 50% of the entity’s profits. As a result of this hybridity, such entities may be subject to Luxembourg corporate income tax on their net income.

Collective investment funds are excluded from the scope of this rule provided that (i) they are widely held, (ii) hold a diversified portfolio of securities and (iii) are subject to investor-protection regulation in their country of establishment. These concepts were not formally defined before the Circular, which has triggered uncertainty and divergent interpretations in the Luxembourg market.

Key aspects of the guidance provided by the Circular

The Circular confirms that for (i) undertakings for collective investment governed by the Luxembourg law of December 17, 2010 on undertakings for collective investment, as amended, (ii) specialized investment funds governed by the Luxembourg law of February 13, 2007 on specialized investment funds, as amended, and (iii) reserved alternative investment funds governed by the Luxembourg law of July 23, 2016 on reserved alternative investment funds, as amended, it is not necessary to determine if the three conditions above are complied with, as they should qualify by nature as collective investment funds.

For Luxembourg investment funds or vehicles not benefitting from the automatic qualification, the Circular provides further guidance with respect to the three cumulative conditions to be fulfilled to benefit from the specific carve-out.

(i) Definition of “widely held”

According to the Circular, an entity is considered to be widely held if it is marketed with the intention of being distributed to multiple unrelated investors. Concerning master-feeder structures, it is now clarified that such assessment should be made at the level of the feeder fund, based on the investors in the relevant feeder.

This first condition should be assessed on the basis of all facts and circumstances. In certain obvious situations, the Circular notes that an entity that is designed to raise capital from multiple unrelated investors may only have a limited circle of investors, and that this does not necessarily mean that the “widely held” condition is not fulfilled. This is notably the case (i) at the time of the ramp-up phase for up to 36 months, if it can be reasonably considered that the condition will be met afterwards and (ii) during the liquidation phase, assuming that the absence of multiple unrelated investors is due to the liquidation of the relevant entity.

Therefore, in practice, the presence of a limited number of investors should not automatically disqualify an entity from meeting this requirement. Moreover, the Circular introduces a new presumption which should be presumed met where there is no individual person holding or controlling, directly or indirectly, more than 25% of capital rights or voting rights of the entity or controlling the entity by other means. The Luxembourg tax administration may in this context check the information included in the Luxembourg Register of Beneficial Owners.

Finally, the Circular provides further guidance with respect to instances in which two investors should be considered as related investors, in particular in the presence of a direct or indirect 50% ownership threshold, when they are part of the same family, when they control each other or are under the common control of the same individuals or entities.

(ii) Definition of “diversified portfolio of securities”

According to the Circular, the term “securities” should be understood broadly and should encompass the following non-exhaustive list of securities:

• shares, equity interests, and other comparable securities granting rights to the capital of an entity;
• beneficiary shares;
• bonds and other debt instruments;
• shares or units in investment funds or vehicles;
• deposits with credit institutions; and
• derivatives if the underlying assets are securities.

Furthermore, the Circular clarifies that the diversified nature of a securities portfolio should be assessed on the basis of (i) the entity’s investment policy as set out in its management regulations or constitutional documents and (ii) its exposure to market risk, including direct and indirect counterparty risk, in view of the investment strategy pursued.

(iii) Definition of “subject to investor protection”

Finally, the Circular outlines that this condition may equally be complied with by (i) entities supervised by the CSSF, the Luxembourg regulator supervising the financial sector or (ii) AIFs managed by an AIFM duly approved in compliance with the Directive 2011/61/EU on alternative investment fund managers.