This article is sponsored by Travers Smith.
Selecting a fund domicile is driven by a number of criteria, including flexible and robust regulatory, taxation and legal regimes that adhere to international standards and support the requirements of fund managers and their investors. It is also key that any fund center has a deep talent pool of experienced service providers such as administrators, lawyers, accountants and auditors.
While tax considerations are not the sole driver when considering where to domicile a fund, it has now been over six years since the Organisation for Economic Cooperation and Development published its Action Plan on Base Erosion and Profit Shifting. The principal aim of the OECD’s BEPS project was to tackle aggressive tax planning by multinationals perceived as using strategies designed “to exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity or to erode tax bases through deductible payments such as interest and royalties.”
BEPS contains measures for governments to implement in their domestic legislation and in their double tax treaties.
While BEPS was not aimed at alternative investment funds, given that a key principle underlying collective investment is that the investors should not be subject to additional taxation beyond what they would have incurred through investing directly, tax efficiency is key. Investment funds have thus found themselves impacted by anti-BEPS measures, meaning that, when structuring investment funds, tax considerations now go far beyond choosing a tax efficient fund vehicle that is tax neutral for investors.
The key BEPS measures of relevance to investment funds are: (i) the introduction of anti-treaty shopping measures, which has resulted in access to reduced withholding tax rates and capital gains exemptions under double tax treaties becoming more difficult; (ii) measures designed to limit deductions for interest payments; and (iii) measures to neutralize the effects of hybrid mismatch arrangements, meaning that the tax efficiency of deal funding can depend on the tax attributes of fund investors and the vehicles through which they invest. In the context of the decision as to where a fund should be domiciled, it is the introduction of anti-treaty shopping measures which is having the biggest impact.
Rules for preventing treaty abuse
Alternative investment funds are typically domiciled in the major fund domicile jurisdictions (ie, the US, Cayman Islands, Luxembourg, Ireland, the UK or the Channel Islands) and will typically be structured as (i) limited partnerships that are generally treated as tax transparent; or (ii) vehicles that benefit from a special tax regime in the relevant jurisdiction. BEPS measures should not impact the tax transparency or special tax regime applying to investment fund vehicles.
However, investment funds operate and invest internationally. Where an investment fund makes an investment and receives income (typically in the form of interest, dividend or rent) or disposes of an investment and makes a gain (for example, on a disposal of shares), the source country where the investment is located may impose a tax on the income and/or the gain. The investment fund may hold the investment directly or via an intermediate holding structure. In order to mitigate tax imposed by the source country on income and/or gains, the terms of a double tax treaty will often be relied upon.
BEPS Action 6 (prevention of tax treaty abuse) focuses on treaty abuse and “treaty shopping.” The OECD’s report noted two concerns in the context of certain funds: (i) that funds may be used to provide treaty benefits to investors that are not themselves entitled to treaty benefits; and (ii) that investors may defer recognition of income on which treaty benefits have been granted.
Treaty shopping generally involves a person attempting to access the benefits of a double tax agreement without being properly resident in one of the jurisdictions that is party to the agreement. In an investment fund context this could involve a holding company being established in Luxembourg by a non-Luxembourg fund, with little commercial rationale or substance other than to allow the holding company to access that country’s wide double tax treaty network and thereby reduce or eliminate withholding taxes on payments from investments.
The implementation of anti-treaty abuse measures has been supported by BEPS Action 15 (multilateral instrument), which has introduced a mechanism (the MLI) to allow countries to amend their double tax treaties with other countries on a collective basis, rather than individually renegotiating each treaty. All jurisdictions signing up to the MLI must include a form of anti-abuse rule. The minimum standard of the anti-abuse rule, which the majority of jurisdictions have opted for, is the “principal purpose test.” This denies access to benefits under a double tax agreement if: “It is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit…”
It is important to note that the obtaining of the tax benefit only has to be “one of” the principal purposes of the arrangement in order for benefits to be denied. While what exactly makes a “purpose” a “principal purpose” is not entirely clear, many tax advisors view this as a relatively low bar and consider that the exclusion, where it can be established that granting the benefit would be in accordance with the object and purpose of the treaty, is, in practice, rarely going to be applicable.
The PPT has its difficulties – given it is largely a subjective test and open to widely differing interpretations, the PPT can create an environment of uncertainty. But what does it mean in practice for investment funds? The OECD has included examples of how it will apply to certain funds – the examples are not especially helpful, but they do highlight that, as with so much that is BEPS related, substance is increasingly important.
This emphasis on substance in a jurisdiction is increasingly leading to fund management firms scaling up their presence there. A side effect of greater resources being located in a jurisdiction (to support the residency of holding – and other – companies located there) is that fund managers are increasingly prepared to locate the fund itself in the same jurisdiction as its holding companies. As such, where a fund uses Luxembourg holding companies, fund managers are increasingly likely to domicile their fund in Luxembourg to help with the substance argument.
However, a point to watch is that Luxembourg (and other EU member states) has implemented the requirements of the EU’s Anti-Tax Avoidance Directive and will soon be implementing the requirements of the EU’s Anti-Tax Avoidance Directive II. It is, as yet, unclear the extent to which this and very recent case law developments from the Court of Justice of the European Union relating to substance will impact Luxembourg’s attractiveness.
If they have not done so already, fund managers would be well advised to take a serious look at what substance they have in their holding and fund domicile jurisdictions and, for new investments, to document the considerations factored in when choosing a fund/holding company jurisdiction.
In light of the uncertainty and challenges created by Brexit and other political developments, the asset management industry is adjusting and one way it is doing so is by undertaking additional analysis on alternative fund structures and domiciles. This is essentially making the art of fund structuring more complicated with a long list of issues to consider.
In the context of tax, the new international tax environment focuses on aligning substance and functions with the location where profits are taxed. When it comes to fund domicile, the main impact of anti-BEPS measures is likely to be the imposition of significant “substance” obligations on fund entities or their holding company structures looking to benefit from the tax regimes in, and the double tax treaties entered into by, the jurisdictions in which they are located. The days of locating a “letterbox company” in a jurisdiction for tax purposes would appear to be over. Fund managers would be well advised to consider whether investment structures would stand up to scrutiny, the impact if treaty benefits were to be denied, and the feasibility of using alternative investment structures in the future.