Fund domiciles: There’s no place like home?

In some ways it’s actually more art than science”, answered David Williams of law firm DLA Piper when asked how GPs should go about selecting a jurisdiction for their funds.   

Williams, who has experience providing legal advice on both sides of the onshore/offshore debate, explains the choices for GPs are many. But he admits that by and large, the selection of a given territory is sometimes less based on some novel new structure or reasoned argument than on habit, and in some cases, something as simple as proximity. The Caribbean wins business from the US on this point and the Channel Islands are often popular among Europeans for the ease of coordinating efforts with an office within their time zone.

Of course offshore domiciles offer certain tax and regulatory benefits with the right investment model and investor base. But some market sources are questioning the strength of these advantages as the US and Europe embark on a number of regulatory initiatives. 

THE TAXMAN’S OFFSHORE REACH

Contrary to the popular myth of offshore centres’ exotic fiscal tricks, the reality is GPs structure funds offshore to enjoy nimble fund structures suitable for a diverse body of LPs that range from tax exempt to foreign, from private individuals to public pension funds. 

Really what the offshore fund provides is an efficient tax neutral platform for investors, says one offshore-based funds lawyer. And despite what critics of “tax havens” would lead you to believe, the goal isn’t tax avoidance, he says, but rather to efficiently eliminate any tax burden at the fund-level, which is just simply a vehicle for investors to remit income and gains back home. 

Nonetheless, perhaps spurred by shrinking state coffers following the banking meltdown, onshore jurisdictions are more aggressively cracking down on offshore financial centres. On the tax front, no regulation is more ambitious than the Foreign Account Tax Compliance Act (or FATCA) put forth by the US. Over the next few years the bill aims to achieve an information exchange network covering virtually any foreign financial firm with ties (either direct or indirect) to the US. Foreign private equity firms and other financial institutions will need to disclose tax details around their US clients or stomach a 30 percent tax penalty on certain US-connected payments. 

Foreign firms are decrying the law as overstepping its jurisdictional reach, a complaint somewhat muted as foreign governments signal a willingness to implement the tax disclosure rules under a multilateral arrangement. 

In the end FATCA may strip offshore centres from one of their key advantages, namely greater privacy for investors. Already in the UK, the epicentre of Europe’s private equity markets, more fund managers are relocating the fund vehicles offshore to avoid UK tax authorities’ recent demand for greater details around non-UK limited partners, observes Lee Jefferson, a tax partner at advisory firm BDO. Being forced to divulge this type of information can be an investor relations nightmare for firms as LPs often arrange side-letter agreements restricting the release of information to third party entities or tax authorities, he adds. If multijurisdictional tax reporting takes off, as FATCA progress suggests it might, offshore domiciles may have little choice but to enter into more comprehensive information exchange arrangements with onshore governments.    

DISAGREEMENT SURROUNDING AIFMD

An equally ambitious piece of regulation is the Alternative Investment Fund Managers Directive, Europe’s grand regulatory and marketing framework for private equity and hedge funds. As EU regulators and policymakers formulate technical rules around the Directive’s core language passed in late 2010, an internal debate has surfaced as to whether or not the bill will be a boon or bust for offshore domiciles. 

On one side of the debate, industry players argue the Directive’s complexity and less than perfect understanding of the private equity model will leave frustrated GPs gazing offshore. Why spend a bundle in compliance costs when offshore funds can continue marketing their funds to EU investors (through member-states private placement regimes) until 2018? And for GPs ensnared by AIFMD with few actual ties to Europe, it could make sense to relocate to the Channel Islands – which have developed a sophisticated network of support services – in order to bypass the Directive’s restrictions on “asset stripping” portfolio companies, fund managers’ pay and cumbersome rules on risk management. 

On the other hand, some point out AIFMD compliance is an inevitable reality for EU-focused fund managers; better to accept the Directive’s standards now than drag your feet. Expanding the argument, offshore funds registering under the AIFMD framework are not granted the option of choosing which EU jurisdiction is responsible for their oversight. Sure the regulation covers the entire continent, but better to domicile the fund in Luxembourg or Ireland, the argument goes, than risk more stringent oversight from, say, France. Most of all, an AIFM-compliant fund is rewarded access to a pan-EU marketing passport designed to harmonise the continent’s patchwork of varying national private placement regimes, a benefit not available to offshore funds until at least 2015. 

HERD MENTALITY 

A legitimate debate exists about the usefulness, or even logic, of a number of rules being written for the industry, but one undeniable advantage they’ll provide is greater comfort for a segment of investors who enjoy strong oversight. Onshore funds win points on this mark, especially so when considering the popular perception of offshore centres as the ‘Wild West’ of the funds’ industry. 

The perception is no doubt wrong, at least in most locales. Channel Island jurisdictions and other offshore zones are increasingly adopting international standards to combat abuses, including harmful tax practice initiatives mounted by the Organisation for Economic Co-operation and Development. 

Still, some investors would rather avoid offshore vehicles because of their low public opinion. Public pensions and other quasi-public investors may see a dilemma in participating in offshore vehicles while other arms of the state actively campaign against perceived abuses. 

Again, a blend of art and science: Some UK GPs for example prefer domiciling offshore to exploit potential tax advantages with respect to their management or performance fees; others may prefer the home market to avoid irregular flights to Guernsey or other ways of demonstrating “substance” in the decision to domicile offshore. 

Then add to the equation the increasing critical question of what investors from different geographies want, and how they feel about investing in certain jurisdictions, which all come with their own political baggage and flavours. Regulations and transparency efforts may be diminishing the competitive advantage of offshore funds, but they provide a neutral market when investing in for instance the EU.

Some investors may even question why a real estate fund was placed in Guernsey, when everyone knows Jersey has been the traditional market leader in the asset class – there may be no real material reason to choose one island over the other, but it’s an easy distraction to avoid during fundraising, say sources. In short, Williams concludes on the choice of fund domiciles, “there is no easy answer to this question”.