Tax concerns remain top of the agenda

What are some of the key concerns and issues about the tax structure of a fund? What advice do you give on the tax structure of a fund or fund of hedge funds?

As the debate about on/offshore and regulated/unregulated hedge funds continues, one thing remains clear: the need for tax neutrality for the fund. How the conflicting demands of investors, fund management company and others involved in the fund are balanced is a tricky business and one in which accountancy firms excel.

Lachlan Roos, UK hedge funds tax leader at PricewaterhouseCoopers (PwC), believes the first consideration when building a fund structure is choice of domicile. This leads straight into the debates of regulation versus no regulation and tax havens versus taxable territories. “Therefore, we are considering for clients whether they want to be a typical offshore fund in a tax-free territory such as Cayman Islands, with no regulation on the fund vehicle itself; or, do they want to appeal to a different type of investor and maintain a regulated or lightly regulated vehicle in locations such as the UK, Luxembourg or Ireland and run Ucits III/IV products for retail and institutional markets,” he says.

Roos confirms PwC is currently talking with the UK Financial Services Authority (FSA) and association bodies such as the Alternative Investment Management Association (AIMA) and the UK Treasury on the ability to establish a pure UK onshore hedge fund structure. This would create yet another option for fund establishment.

Another key factor according to Roos is central management and control of the funds. By this he means who sits on the board of the fund and makes the key strategic decisions.

“There are important questions to be asked such as: are these people sufficiently skilled and knowledgeable to operate in their positions? Are they independent of the managers? Are they operating from the UK or outside of the UK? If out of the UK, where are they? All of these questions contribute to the assessment of whether a fund is recognised for tax purposes as tax resident in say the UK or its actual offshore domicile of choice, for example Cayman Islands,” explains Roos.

This may be an area where the UK tax authorities will begin to place more focus, especially since there are new information exchange agreements signed between the UK and the Cayman Islands.

The substance of the funds and their special purpose vehicles (SPVs), platform vehicles, deal vehicles and other forms is a concern, points out Roos. He confirms PwC has already seen the UK tax authorities challenge the private equity structure from a VAT perspective with a general partner in relation to substance. “This is an issue high on our clients’ agenda given the current market with cost-reduction measures being pushed into operations and subsequent staff cuts. It is not inconceivable that the funds and SPVs are running light on substance which can, if not monitored closely, potentially create concerns over the valid application of double tax treaty access and hence the impact of withholding taxes on fund transactions,” he concludes.

Roos also believes it is vital to consider the management house structure and the interplay between the two. “Funds need to question whether there is any trading safe harbour for tax in their choice of manager location and if not, is the fund at risk of a taxable presence because of the manager function? The trading safe harbour utilised, such as the UK investment manager exemption, must be satisfied through constant monitoring of the fund’s/managers’ activities and finally those activities must be carried out without any amendment to the initial created fund structure,” he states.

To see or not to see?
Another necessity for consideration is investor taxation. This, says Roos, comes down to what the investor wants: transparency for tax purposes or a blocked opaque vehicle. Investors will want to know, for example, whether a fund will derive trading income as it may create a taxable receipt for a tax-exempt entity, as opposed to capital gain or investment income receipt which may be exempt from taxation for the same investor. Hence appropriate structuring of income and profit flows is key to the facts and circumstances of differing investors.

Finally there is structuring for unidentified tax exposures. “This has been brought to light by the recent introduction of FIN 48 into US GAAP [generally acceptable accounting principles] accounting and the exposure draft for IAS 12 under IFRS [International Financial Reporting Standards] accounting,” notes Roos.

Issues arise when the underlying investment is in a territory that imposes a tax which so far has been unidentified.
“There are planning techniques available to structure all these issues but these plans will not typically work retrospectively,” he says.

At PwC in the Cayman Islands, Colin Hanson cautions that tax needs to be reviewed from a number of different aspects. As most funds are Cayman-based, domicile is not generally the concern, believes Hanson. He says there is a risk that an offshore fund could be taxed in another jurisdiction if the fund is considered to be carrying on a business in another jurisdiction based on its activities or those of the investment manager.

Tax concerns are based on assets held – for example, each underlying country must be examined to determine whether income, withholding taxes or capital gains taxes apply.

Quite often certain foreign securities are held via holding companies domiciled in the third country to legitimately avoid certain taxes,” notes Hanson.

“Under US GAAP, FIN 48 raises the bar for accrual when certain tax uncertainties exist. It is important that each fund’s activities are carefully reviewed by competent and experienced tax professionals to ensure a particular fund is structured and business is conducted in the most tax-efficient manner possible,” he concludes.

Anthony Pace and Noel Mizzi at KPMG in Malta note that funds (collective investment schemes) with a value of Maltese assets no more than 15% of the value of total assets and that do not derive income from immoveable property in Malta, are fully exempt from income tax in Malta. They say specific non-Maltese tax structuring considerations may be applicable depending on the residency and tax status of the investors.

Barry Winters and Garrett O’Neill at KPMG  in Dublin think there are two key concerns. Withholding tax is a significant concern for funds. They say there is a general trend emerging that is making it more difficult for onshore investment funds in Ireland and Luxembourg to benefit from the reduced withholding tax on income.

In addition, capital gains tax on the investment returns of offshore funds is becoming more common. Understanding the impact on new and existing fund structures is critical, they conclude.

The second growing trend Winters and O’Neill see is the number of jurisdictions implementing investor-based tax reporting of one form or another. The most common are US tax reporting, German tax certification and UK distributor status.

However, tax reporting can impact on investors in Belgium, Austria and Switzerland. It is important, declare Winters and O’Neill, that processes and procedures are put in place to ensure the required reporting/certification can be delivered.

In London the KPMG team says the key to tax structuring has always been to ensure that the structures are efficient in three aspects: the tax position of the fund; the tax position of the underlying assets; and the position of the individual investors.

The team says it is currently advising clients looking for an EU domicile for their funds. Recent changes to the UK funds tax regime mean the UK is now viable as an alternative to Luxembourg or Dublin.

Avoid high tax
If funds are directed at UK tax payers, it is critical to ensure they are structured so the taxpayer is subject to capital gains tax levied at 18% rather than income tax now at 50% in the UK.

Stuart McLaren at Deloitte in London acknowledges fund structures can be based on the tax profile of their targeted investor base such as the master-feeder structures used where both US and non-US investors are investing in the same fund. “Operational taxes can also prove a major cost to funds set up in tax haven locations, depending upon the contractual relationship with the prime broker or the exact nature of the underlying investments,” notes McLaren.

“If a fund is a fund of funds, this may not be as much of an issue if the investments are only in other ‘tax haven’ funds,” he adds. 

There are also compliance issues, notes McLaren. Any fund with US-taxable investors will, most likely, have US tax filing obligations. Even without US-taxable investors, certain investments and activities may give rise to a US tax-filing requirement.

Fiona  Carpenter, hedge funds tax partner at Ernst & Young in London, puts the emphasis in a slightly different area. She says the principal drivers in determining the tax structure of a fund are meeting the requirements of investors and maximising performance while negotiating the fiscal requirements of the fund and its investors.

“Specific issues to consider will vary considerably between funds, depending on, for example, the type of investor the fund is looking to attract, the strategy of the fund and where the fund manager is based. Broadly speaking, the main issues to resolve are what legal form the fund should take, for example, corporate, partnership, trust, and where the legal entities should be domiciled,” she says. “Tax will not be the only factor that determines the answer to these questions, but it will be a significant one.”

Historically  Carpenter says hedge funds have predominantly been structured as corporations domiciled in zero-tax jurisdictions, often as part of a master-feeder structure that allows investors to choose whether to invest in a corporate or partnership vehicle. Now things are changing.

“We are seeing a steadily increasing shift away from this paradigm as a number of recent trends, such as the popularity of Ucits products and the launch of new types of onshore fund vehicle, have made onshore jurisdictions such as Ireland and Luxembourg more attractive,” she says.

“Tax matters are complex and therefore it is critical that tax advice is considered as an integral part of any fund set-up,” she concludes.