Funds: Structuring for Substance

One of the key motivators behind the tax and regulatory pressures is "substance". Put simply: are you carrying out any business activities, what are they and where are these being done? In a funds context, substance might include concepts of:

  • Managing, controlling and investment decision making
  • Analysing, buying and selling investments
  • Carrying out risk management and compliance functions
  • Raising money from investors
  • Valuing the assets of a fund and reporting to investors.
Substance and tax

Substance may determine where a fund, its investments and its investors are taxed. Tax reduces profits and profits are what drive investors. As the business of running a fund almost always involves cross border issues, there is the possibility that a fund may be taxed several times on the same money. There are generally three levels at which tax substance issues arise: in the fund, for investors and in a fund's investments (see the diagram below which shows the different levels). Investors generally take care of their own tax position.

The investments of a fund are where substantive activity occurs. The investment manager also carries out substantive activities, like making investment decisions, risk management and raising capital. Investments can be in businesses or real property bought by private equity or real estate funds. They can also be financial instruments (shares, bonds etc) bought by hedge funds. Funds do not seek to avoid paying taxes on their investments, it is only right that they be treated like any other similar investor carrying out this activity. But if tax is also paid by the holding companies and the fund vehicle (in our diagram), there will be "leakage" on the profits available to investors.

So, funds do aim to have a tax neutral fund vehicle where investors pool their money. This can be achieved by using a tax transparent structure often in a low tax jurisdiction (an offshore financial centre). Given its flexibility and track record of use, this is a popular form for alternative investment funds. It is also common to use fund vehicles in places like Luxembourg and Dublin, higher tax jurisdictions that have special regimes which exempt certain kinds of funds from taxes. In Singapore, a fund can be established which achieves tax neutrality if it meets certain investment type and investor parameters. Holding company structures are also used to give funds access to double tax treaties and greater legal certainly and clarity in terms of their investments into a range of countries (for example, pan Asian investments).

Consider some developments where funds have used holding companies for cross border investments into China. Several decisions by Chinese tax authorities have required transactions involving offshore holding companies to have 'substantive operating activities" and 'reasonable business purposes', and have also scrutinised whether offshore companies should be treated as tax resident in China because they are managed by persons working in China. Failing to meet these requirements means paying local or withholding taxes.

If you refer back to the diagram above, it becomes apparent that it might be difficult to have "substance* in holding companies. The fund manager, fund vehicle and holding vehicles might be set up in different countries. What form substance takes also needs to be looked at carefully. Some fund managers have taken steps to place people, functions and roles at each of the different levels in a fund's structure, across different countries and time zones. This requires discipline in terms of internal management and procedures. Structures do not only need to be set up properly, they need to be implemented and followed on a daily basis - so there is evidence of how they work in practice.

The OECD's Base Erosion and Profit Shifting Project (BEPS) poses some new challenges for fund structures. The aim of the project is to rewrite international tax rules to prevent abuse of tax treaties by "allocation of taxable profits to locations different from those where the actual business activity takes place*. The recommended rules will eventually make their way into local laws across the globe. This will have a direct impact on cross border fund structures. However, funds may be penalised if they are subject to some of the same rules as global corporations. Heavy lobbying by the private funds industry has meant that the latest BEPS report on treaty benefits has left open the possibility of specific carve outs for funds (collective investment schemes).

The die, however, has been cast in terms of the general themes set out in the BEPS recommendations. Treaty benefits will be limited to vehicles which satisfy substance tests (beneficial ownership etc). The principal purpose of a structure also must not be for tax purposes. It remains to be seen how funds will be treated against this backdrop.

Substance and regulation

Substance is also important because it determines where a fund may be regulated

Substance is also important because it determines where a fund may be regulated. The role of investment management is an activity that requires a licence in most countries. Recent regulations have gone even further in capturing some of the other things mentioned in our "substance" list at the start of this article. The European Union's AIFMD regulation requires alternative investment fund managers based anywhere in the world to register with and report to EU authorities, if they seek to market their services to EU based investors. The US Advisers Act does the same for fund managers who manage funds for US investors. Both these pieces of regulation affect fund managers who may not even have a place of business in the US or the EU.

AIFMD calls for a division between the portfolio management and risk management activities of a fund manager. While this requires clear internal policies about which people carry out which roles, this also gives opportunities for fund managers to split functions across different offices and countries. Singapore now regulates fund managers by requiring them to have in place compliance policies and procedures, among other things. To be effective, these policies and procedures must filter across a fund structure (like the one set out in the diagram above). For example, the requirement to independently value assets will apply to an investment made in China (possibly via an offshore company) by a fund vehicle managed by a Singapore headquartered fund manager.

The bottom line

Fund managers and investors crave certainty, particularly when it comes to tax and regulatory matters. While these areas are subject to much uncertainty at the moment, the money will be with fund managers who have taken time to anticipate and plan for these risks. Substance in fund structures can be planned for and actively managed. After Kali Yuga, the world will begin a new golden cycle.