The challenge of keeping on top of global tax and regulations, and how they impact fund structuring, is akin to tackling a logic puzzle where the rules of the game shift almost on a real-time basis.
There are several axioms that underpin fund structuring. They include being able to target the investors you want for the desired product and having as tax-efficient a structure as possible, taking into account the jurisdiction and type of target assets and the investment strategy of the fund. It also includes structuring a product that will be well understood by the market – innovative structuring to solve problems is obviously a good thing, but change for the sake of change may only serve to hinder fundraising.
Finally, it means ensuring the fund has a high degree of operational ease because managers and investors will not thank you for designing the perfect structure for some purposes, but which is extremely unwieldy or costly to run.
There are various pieces of recent or prospective legislation that managers should take into account when designing fund structures. Here are three currently top of mind.
1 UK tax vs UK tax filings
A fundamental principle of fund structuring is that investors should not pay more tax than they would do had they invested in the assets directly. However, the new non-resident capital gains tax regime in the UK potentially undermines this.
April 2019 saw the first seismic change to capital gains tax (CGT) in the UK for several decades with the new rules seeking to apply CGT on gains linked to UK property for all non-resident investors. This created a fear that additional tax would be embedded throughout fund structures. This was, however, assuaged by the introduction of a system of beneficial elections, and provided you were the right kind of investor that could maintain and benefit from one of these elections, then this additional tax could be potentially avoided.
This has resulted in an even greater focus on understanding the investor universe and knowing exactly what type of investor you have in your fund, including crucially if each investor is willing and able to file UK tax returns.
At the time, little focus was paid to the ability or willingness for certain types of investors to file UK tax returns, which cuts across another key funds principle – that investors have historically not had to file tax returns outside of their home jurisdiction.
For certain types of investors, this is causing significant issues, especially for those that either cannot or will not file UK tax returns. In particular, a number of multi-manager investors or funds of funds have been caught out because they do not have the power or authority to file UK tax returns on behalf of their underlying clients.
For managers putting funds together, it is important to anticipate these issues and build as flexible a fund structure as possible in order to categorize investors properly and ensure tax-exempt investors do not have to suffer additional tax because of other investors in the fund.
2 Anti-hybrids: Feeder vs finco
As part of the OECD’s base erosion and profit shifting (BEPS) initiative and its implementation through the EU’s Anti-Tax Avoidance Directive 2 (ATAD2), there are now a suite of rules governing ‘anti-hybrid mismatches.’ These highly complex anti-hybrid rules are enough to bring a sheen to the brow of any fund structuring lawyer.
Briefly, the rules seek to prevent people exploiting differences in tax treatment between jurisdictions, whether this is because two jurisdictions view differently how an entity or how a financial instrument is treated. The effects of these differences in views could lead to a group benefiting from a double deduction for the same expenses or benefiting from a deduction of income in one jurisdiction without including that income in another jurisdiction.
There are many effects of these rules but in fund structuring terms they raise a key issue concerning how to treat internal debt arrangements for a global investor base. This is particularly sensitive for US investors with their ‘check-the-box’ regime, which can, on the face of it, cause such hybrid issues.
So, two structures to try to future proof funds are emerging in the market.
The first is the use of a corporate feeder structure above the main limited partnership fund vehicle. This can benefit those investors in jurisdictions that are known to take non-standard views on the transparent/opaque nature of common fund structures. The second is to make use of an internal financing structure – a regulated finco – so that investors simply do not receive interest payments.
The beauty of these is not that they avoid the adverse fiscal impact of the regime but that they simplify compliance both for managers and investors. Rather than having investors receiving interest, in both cases it is a fund entity that receives the interest. This allows structures to be designed to produce more consistent, predictable results before investor composition is known.
It appears that both structures are gaining traction. There are some concerns, however, that certain vehicles used as corporate feeders may not provide the commercial flexibility to which managers and investors in private equity real estate funds have grown accustomed. It is likely, therefore, that the finco structure will continue to become increasingly popular.
3 EU Sustainable Finance Disclosure Regime
Given the rise in importance of ESG in the market generally, it would be remiss not mention its impact on fund structuring.
ESG has been a key component of fund offering documents in Europe for some time, and both North America and Asia have now begun to focus more on it.
Funds based in the EU or targeting EU-based investors must now comply with the new Sustainable Finance Disclosure Regime, which came into force in March 2021. The SFDR is an effort to prevent ‘greenwashing’ and to help investors properly categorize funds they can potentially invest in.
Fund managers must classify each of their funds into one of three categories:
• a fund without environmental or social characteristics (Article 6 – No Green);
• a fund with environmental or social characteristics (Article 8 – Light Green); or
• a fund with sustainable investment as its objective (Article 9 – Dark Green)
There is still some uncertainty over these classifications and industry bodies such as INREV and AREF are pushing hard for clarity on numerous points. More certainty is hoped for before annual reporting begins in January 2022. In the meantime, managers should speak to their counsel early to ensure funds are set up to clearly fit the intended category and that they have the right disclosures in their PPM’s and on their websites.
It is worth noting that the UK will not implement SFDR but is currently preparing its own ESG disclosure regime. Similarly, US funds and managers are not directly subject to the EU rules unless they have EU-based investors. However, the US itself has made moves toward creating its own ESG disclosure regime for its financial services sector. So, managers should ready themselves for more ESG regimes they will need to comply with in