The world of Fund structuring, management, regulation and compliance has been transformed in the last few years.

March 2019

Dear Reader

Changes in the world of Investment Funds

By Roy Saunders, Dmitry Zapol and Igor Persidskiy 

The most recent announcement was on 5 February 2019 when the European Commission welcomed a political agreement reached by the European Parliament and EU Member States on new rules to make it easier, quicker and cheaper for EU asset managers to sell funds to a wider range of investors. We will be discussing this and many other aspects of fund structuring at an IBSA meeting to be held at The Hotel in Brussels on 2 April.

Traditional Fund structures
IFS has been involved in the creation of more than forty investment funds over the past decade, many of them in real estate in EU capital cities including Berlin, Sofia, London, Paris and many others. The typical Fund used to be a Cayman Island based limited liability company managed by a Cayman Islands Investment Manager with an Investment Advisory company located in a jurisdiction where relevant personnel were resident. These individuals, who were actually managing the Fund’s investments, were often resident in high tax jurisdictions such as the UK. The Investment Manager in the Cayman Islands administered the Fund but the real decisions affecting the investments made by the Fund were made in a higher tax jurisdiction, the structure therefore being designed to limit the tax exposure for the principals involved.

The activities carried out by these individuals are in fact core activities for the Fund, and include carrying out market research regarding potential investments, negotiating terms for an investment, preparing transaction documents, and only finally reporting to the Investment Manager when the dots and crosses ere confirmed. The Investment Manager would then only need to formally resolve whether to invest or not on behalf of the Fund. These individuals are often shareholders in both the Investment Management company and also the Fund itself, perhaps via an offshore entity, referred to as the ‘carry vehicle’. Other investors in the Fund would either invest direct or possibly through a separate collective investment vehicle such as a limited liability partnership.

The Fund itself would then invest in the opportunities negotiated by the Investment Advisor company, and this would itself require a degree of structuring to minimise the exposure to local taxation where the investment is made. This structuring would particularly address the secondary taxes that are distributed through the structure where withholding tax on dividend distributions could reduce the return to the investors. This may require the creation of interest deductions through a separate finance vehicle located in a high tax jurisdiction which would enjoy double tax treaty protection through the minimisation of interest withholding taxes. The resultant gross income would then be passed through to the Fund with or without appropriate tax rulings (which is why the finance companies were often referred to as conduit vehicles).

The investments themselves may be made through special purpose vehicles (SPVs) which would be owned through one or more holding companies owned by the Fund, again for the same purposes of minimising withholding taxes on dividend distributions and potentially avoiding capital gains tax in the local jurisdiction.

What has changed?
Current practice demands a thorough review of traditional Fund structures in view of extensive measures introduced by many OECD countries. These include:

  • denial of interest deductibility in companies in which the Fund invests as a result of the BEPS initiative;
  • conduit regulations aimed at non-recognition of companies interposed for tax avoidance purposes;
  • the elimination of tax treaty benefits according to the Multilateral Convention to Implement tax treaty related measures to prevent BEPS (the MLI);
  • the ‘substance’ requirements in low-tax jurisdictions involving a degree of personnel and office accommodation for corporate entities;
  • new regulations within the EU enabling fund managers to market their products across the EU at lower costs, giving investors more choice and better value without compromising on investor protection;

Development of Luxembourg Funds
An alternative to the Cayman Islands could therefore be an Investment Fund created under the laws of Luxembourg, one of the jurisdictions to be discussed at the IBSA meeting on 2 April (others being Cyprus and Malta). Personnel resident in Luxembourg with local offices would be employed by a Luxembourg Investment Manager, able to demonstrate proper management and control of a Luxembourg Fund. Thus the Fund could be AIFMD compliant (under the Alternative Investment Fund Management Directive). Should there be a requirement to have certain market research and other functions conducted in a jurisdiction such as the UK, the Investment Manager could contract with a separate UK company for such purpose.

If the Investment Manager wishes to expedite the creation of the Fund prior to becoming AIFMD compliant, there are many AIFMD regulated companies who would delegate the portfolio management to the Investment Manager whilst itself providing the service of risk management and fund administration. In addition to the AIFMD, there is a venture capital directive (EuVECA) which is within the overall EU regulatory environment of AIFMD, but was a 2013 regulation designed to create the opportunity to establish a European venture capital fund under a new regulatory directive. The EuVECA is less regulated than the AIFMD and recognises that venture capital funds may invest in specialised portfolio undertakings and other speculative investments which the AIFMD would not permit. Thus, up to 70% of aggregate capital contributions may be invested in small undertakings in the initial stages of their corporate existence, clearly evidencing the requirement to develop small and medium sized enterprises. Such Funds can only be marketed to investors who are professional clients or otherwise sophisticated high net worth individuals.

Tax Status of the Fund
We should then consider the taxability of the Fund in the country where it is incorporated. A UK Fund would normally be subject to UK corporation tax on its profits if created as a corporate vehicle (as opposed to a limited liability partnership where the investors would be taxed only in relation to UK source income if they are non-UK resident). The Fund, however, could rely on the Investment Manager Exemption (IME) which enables non-residents to appoint UK based investment managers without the risk of UK taxation, and is known as one of the key components of the UK’s continuing attraction for investment managers.

Application of the IME provisions is restricted to certain transactions which include stock exchange securities, but there are limitations regarding investments in land. The IME was particularly set up for hedge funds where trading activities take place on a daily basis.

If the Fund is to be created in Luxembourg, a SICAR (Société d’Investissement en Capital à Risque) may be incorporated which has specifically opted to own investments with the principle of risk spreading, marketing only to well informed investors. These are defined by law to be institutional investors, a professional investor or any other investor who meets certain conditions. The SICAR regime is designed for private equity/venture capital type investments that bear a significant amount of risk. Subject to that provision there are no further restrictions on the investments a SICAR can make in terms of geography or instruments e.g. debt, equity, warrants etc. A SICAR can be a common contractual fund (FCP) which is like a unit trust, or a corporate entity

SICAVs or SICAFs are corporate entities which are subject to risk spreading requirements, meaning that they could not be used to hold just a single asset, but must have no more than 30% of its total assets in a single asset. The benefit of a corporate entity is that it will be able to benefit from the wide range of double tax treaties entered into by Luxembourg, which is a key consideration when comparing Luxembourg (or Cyprus) with somewhere like the Cayman Islands, which does not have a double tax treaty network enabling income to be received gross of foreign withholding taxes.

The above type of Funds are exempt from Luxembourg tax in respect of dividends and capital gains, and are not subject to withholding tax on dividend distributions or liquidation proceeds, or indeed interest payments made to the Investors. Thus the Investors can be located in any onshore or offshore jurisdiction regardless of the existence of a relevant double tax treaty.

Securitisation Vehicles
Investors may require a Fund which enables certain assets to be held in a ‘compartment’, the profits of which will benefit only that individual investor. Thus, protective cell companies (PCCs) were a feature of (initially) Guernsey law but often were not recognised outside of the Island, i.e. foreign jurisdictions would regard the individual assets of the PCC as available for claims made against the company in respect of other assets held by the PCC. An alternative to the PCC is the securitisation vehicle (SV) established under the laws of Luxembourg.

The SV was introduced by the Law of 22 March 2004 to create different compartments within its own assets and to issue to investors Participating Notes or specific classes of shares which give the investor the rights to the compartment’s revenues. In relation to the compartments:

  • each compartment is an individual entity on a tax and legal basis;
  • the rights and obligations of a compartment are limited to the assets of this particular compartment;
  • the assets of a compartment cannot constitute any guarantee for other compartment’s commitments;
  • the rights and obligations of a compartment are limited to the assets of this particular compartment;
  • the assets of a compartment cannot constitute any guarantee for other compartment’s commitments;

and investors are entitled through the Participating Notes or classes of shares to the income received by the compartment which would therefore be fully tax deductible against the corporate income received by the SV itself.

As a matter of Luxembourg law, the investors would have no right to the underlying assets (the assets themselves will be owned by the SV); the SV is therefore different from a Protected Cell Company. Each investor or group of investors is in effect the creditor of one or more compartments dedicated to the assets. Furthermore, the investors have no control over the management of the Company’s assets. Thus the principals remain in full control of the company and its assets, but may raise funds from investors who wish to benefit only from specific investments/assets acquired by the company. The company could raise funds generally from the public, perhaps by way of IPO, in which case shares may be issued in the company giving those IPO investors sub-ordinated rights to income from all the assets of the company, subject of course to the prior rights of the compartmental Investors. The SV therefore provides flexibility as regards raising finance from a variety of investors.

The corporate form of a SV is in principle fully liable to Luxembourg income tax on taxable profits and should therefore benefit from Luxembourg’s network of double tax treaties. The distribution of dividends to investors is not subject to taxation on the basis that, for tax purposes, amounts paid to investors are treated as a deductible expense of the SV (being the agreed return for the assets securitised). No withholding tax applies on such payments. Therefore, essentially the company has no corporation tax base in view of the fact that its distributions are tax deductible.

Cyprus Funds
Cyprus amended its Fund regime in 2018 to place itself as an alternative to Luxembourg for Fund structuring and management. Cyprus Funds are generally created as companies subject primarily to the Cyprus corporate income tax rate of 12.5%. As a fully taxable entity, a Cyprus Fund incorporated as a company would in principle be able to benefit from Cyprus’ extensive double tax treaty network with 64 countries, subject to the comments below regarding the changes as a result of BEPS.

Cyprus Funds are fully tax exempt in respect of gains from trading in securities, as well as dividend income (irrespective of the participation in paying entities), capital gains from sale of non-Cyprus situs real estate as well as shares in foreign companies. Although interest income is subject to the 12.5% corporate income tax rate, there is a notional interest deduction allowed of up to 80% of interest income, reducing the effective tax rate therefore to 2.5%.

Cyprus also has an alternative to the Luxembourg SV with compartmentalised Funds, although in Cyprus the compartments are not legally treated as separate entities, giving rise to issues referred to above with PCCs. However, for tax purposes, each compartment is indeed treated as a separate entity.

Other jurisdictions who have a network of double tax treaties are vying with each other to attract investors to subscribe for Funds in their jurisdiction, such as Malta for example. And of course more ‘traditional’ countries including Jersey and Guernsey have significant Fund management providers, although here structuring to maximise income which would otherwise be subject to withholding tax, will rely on intermediate holding companies being created, which then may be affected by the changes detailed below.

Changes in ‘Substance’ requirements
The level of substance of corporate entities is a feature of new EU regulations and has been adopted in many countries. The Netherlands has actually suggested a figure for personnel costs in a particular jurisdiction to justify a corporate entity’s existence for the benefit of double tax treaty arrangements and unilateral law, so that if personnel costs are less than €100,000 and there is no office available for the corporate entity, the provisions of unilateral law dictate that the corporate entity should be disregarded and effectively treated as a nominee for the ultimate beneficial owners.

Jersey and Guernsey have now incorporated substance requirements which state that to meet the economic substance test, a company should be directed and managed in the Islands. There are specific requirements regarding the number of board meetings, composition and competence of the board, keeping the minutes etc. Although similar to the management and control test, which determines where the company is tax resident, the new test emphasises the procedural aspects that reflect that the company is physically directed and managed in the Islands. For example, it is expected that even for companies with a minimal level of activity there will be at least one meeting of its board of directors in the Island.

This approach signifies a marked departure from the pre-2019 customs, when corporate stakeholders were content with having board meetings anywhere other than in the countries where they did not want the company to be tax resident. In this paradigm, most Island-hosted board meetings would be perfunctory affairs run by corporate services providers to rubberstamp the decisions taken elsewhere.

Fund management companies in places like the BVI, Cayman Islands, and indeed the islands of Jersey, Guernsey and the Isle of Man, should be aware of these new requirements of the EU, effective from 1 January 2019. Under these requirements, competent local directors need to be appointed to administer Fund Management companies and make decisions on behalf of relevant Funds.

Changes as a result of BEPS
The Multilateral Convention to Implement tax treaty related measures to prevent BEPS (MLI) is now in force as of 1 July 2018, and identifies which entity has the ultimate right to income and what is the principal purpose of a structure or transaction. Whilst over 78 countries have now signed the MLI, interestingly the US has not yet participated in the project. Apparently it is of the opinion that it currently has sufficient national anti-abuse legislation to counter treaty abuse, which is what the MLI aims to prevent.

The BEPS initiative has fifteen action points to combat tax avoidance. One of the action points, and a major target of the OECD, is to prevent the abuse of double tax treaties to create double non-taxation, or minimise withholding and other tax impositions if this does not accord with the intentions of the bilateral parties to the double tax treaty. The recommendation in BEPS has now been embodied in the so-called MLI which is intended, at a stroke, to implement the BEPS recommendations without bilateral parties having to re-negotiate each and every of the 2,500 plus double tax treaties that exist.

The problem is that when adopting the MLI, countries are entitled to elect to amend or exclude certain provisions, and thus it may be that where the adoption of the MLI is not identical between two countries, one would have to revert to the original double tax treaty to clarify taxing rights and rates of taxes. The international tax consultant will have his or her work cut out to identify whether the MLI is relevant or not!

Besides the uncertainty of whether a particular double tax treaty is covered by the MLI, my main objection is that although Articles 16 and 17 discuss the mutual agreement procedures where dispute resolution cases should be brought before either Competent Authority, and the principle of reciprocal adjustments should be accepted, there is no binding requirement of the bilateral party to agree on disputes, nor is there a mandatory arbitration clause. Undoubtedly, even if the MLI is applicable to, for example, the definition of a permanent establishment, where the two countries cannot agree on relevant adjustments to tax assessments that may have been made, the rights of the taxpayer cannot be automatically enforced through the MLI.

Article 6 of the MLI states that there should be a preamble to all treaties to include as its intention ‘to eliminate double taxation with respect to the taxes covered by the agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions)’. Do transparent Funds create the opportunity for non-taxation if untaxed in Luxembourg or Cyprus, and should they therefore be able to benefit from the provisions of their treaty network? Would the above mentioned SICARs or SVs be able to utilize double tax treaty provisions to minimize withholding tax deductions, for example, if they do not pay tax themselves in Luxembourg or Cyprus, creating the opportunity therefore for double non-taxation?

Article 7 introduces the ‘principal purpose test’ (PPT), which states that the treaty is inapplicable if obtaining the relevant treaty benefit was one of the principal purposes of an arrangement or transaction, unless in accordance with the object and purpose of the treaty. It should be arguable that collective investment vehicles are not created to obtain the benefits of any one specific treaty, but clearly tax mitigation must be one of the considerations when establishing relevant Funds.

So, besides the subjectivity around substance, we now have the uncertainty around the applicability of the MLI to double tax treaties, and indeed the principal purpose test only requires there to be a tax objective (even if the structure otherwise is entered into fully for commercial reasons) for the treaty to be inapplicable. Such subjectivity (the principal purpose test and substance) is undesirable and their interpretation may only be understood in future once court cases have been adjudicated.

Reputation and AML requirements
It would be wrong to conclude this article without mentioning the anti-money laundering directives (AML) which require an extensive review of the sources of wealth of the individual investors who may otherwise be subject to UWO (unexplained wealth orders). The KYC compliance requirements are extensive and Fund investment managers have to realise that they cannot simply accumulate funds from Investors without undertaking full AML investigation.

So the world of Fund structuring and management has significantly changed in recent years, with the emphasis on tax transparency and substance demanding the creation of both Funds and Investment Management companies in reputable jurisdictions which have the expertise of adequate personnel to meet the demands of new laws and Directives. The corollary of this is that some countries, wishing to demonstrate the benefits of establishing Funds and their management companies in their jurisdiction, have relaxed certain regulations for specific entities. This is an encouraging feature for the development of sophisticated collective investment vehicles for financing entrepreneurial ventures, making it easier for EU alternative investment fund managers to test the appetite of professional investors in new markets, and helping them to take more informed commercial decisions before entering that market.

I look forward to seeing any of our Readers interested in this fascinating topic at our Brussels meeting on 2nd April – please don’t hesitate to contact me if you would like to attend as my guest.

With warm regards.

Roy, Dmitry and Igor


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