The world could be on the cusp of a historic event if Scotland votes for independence on September 18, potentially severing a 300 year-plus union with the UK.
An event of this significance and magnitude always carries with it a number of ramifications, which raises an important question: what’s the impact of Scottish independence on private fund managers?
To be sure, a vote in favor of independence would take years to crystallize and involve lengthy negotiations between the UK government, European Union and a new Scottish government. But that doesn’t mean GPs shouldn’t be thinking ahead about what happens if Scotland does end up breaking from the UK in the meantime.
Do you take Scottish notes?
Starting with currency risk, there’s the question of whether or not an independent Scotland will be allowed to keep the UK pound sterling.
Fortunately for managers’ legal expenses, a change in currency probably wouldn’t result in UK-based GPs, from either side of the Scottish border, having to redraft their limited partnership agreements in most instances.
“Partnerships choose the currency that they want to be denominated in…and so if it’s a Euro denominated partnership it would remain Euro, and if it was sterling it would remain sterling,” says one UK-based funds partner.
However if, say, a UK-focused GP wanted to make investments in Scotland using the new Scottish currency as a way of hedging currency risk, it probably doesn’t have the legal authority to do so under most LPAs, says Sam Kay, partner in the investment funds team at law firm Travers Smith.
Another issue related to currency hedging is that currency derivative contracts require GPs to comply with the UK’s Regulation 7, which “some fund managers may not have the right regulatory provisions to do”, continues Kay.
There’s also the matter of what the LPA has to say on investment strategy and focus.
“If an existing fund has power to invest in Scotland that probably continues [even if Scotland becomes independent],” says Bridget Barker, head of the investment funds group at law firm Macfarlanes.
Nonetheless Barker warns that the definition of the UK may change because of the vote, meaning a safeguard would be to gain permission from the LP advisory committee to continue investments in an independent Scotland. And if language in the investment policy needs to be altered, legal sources say this typically requires the support of at least 75 percent of LPs.
Outside the AIFMD bubble
Another lingering question is whether or not an independent Scotland will be invited to join the European Union. If so, some legal experts estimate the process taking at least 18 months.
In the meantime an independent Scotland would result in its local GPs losing the ability to seamlessly raise capital across EU borders. One of the main features of authorization under the Alternative Investment Fund Managers Directive (AIFMD), which took effect in July, is access to a pan-EU marketing passport. But managers from non-EU countries must continue using the messy patchwork of private placement regimes across the continent until at least 2015.
However a case could be made that some Scottish fund managers would welcome this development, on the grounds that they’d be free from the directive’s onerous rules on reporting, finding a depositary, paying partners and other areas.
But if Scotland were to become independent, one of its first actions would likely be to create its own financial securities watchdog, which could ultimately mean Scottish managers wanting to market under the AIFMD regime would have to go through the hassle of authorization again. That could take significant time.
In a white paper, Scotland’s government touched on the issue, saying it would liaise with UK officials to quickly set similar regulatory standards on various cross-border financial matters. And UK sources say there doesn’t appear to be much appetite for targeting fund managers during the rulemaking process.
On regulation though, a few lingering questions may not see answers for some time, including how quickly a new Scottish regulator would answer industry enquiries, how soon it could authorize various legal structures for use and what type of fees it would charge for its blessings.
GPs using a Scottish limited partnership – where the general partner in the setup has a separate legal personality able to invest in English limited partner funds – would appear to be particularly sensitive to the creation of a new Scottish regulator operating alongside a separate English counterpart. Fund of funds also make use of this structure. The specific risk here is that the Scottish regulator may want to bring all Scottish limited partnerships under its jurisdiction.
Tax boon or bust?
On the tax front, there’s a few possible wins and losses for the industry if Scotland breaks away.
Scotland wants to simplify the tax system and also reduce corporation tax by 3 percent, a benefit of course for the strength of portfolio company financials.
Any of the manager’s office or operations located in an independent Scotland will also no longer be in the same variable added tax (VAT) group as those located in the England. As it stands, there is a reduction in administrative costs as one VAT group member pays VAT on behalf of the whole group.
The likely tax treatment of transactions across the new border will also have to be considered. For example, as Scotland is currently part of the UK, it does not have a double tax agreement with the rest of the UK. Such a treaty would have to be negotiated and brought into force before independence, or a fund could incur double taxation on investments it makes. Likewise, an independent Scotland may not have access to UK tax treaties negotiated with third party countries, meaning Scottish funds could take a double taxation hit when investing outside of Scotland.
Businesses should also consider their position on tax residence and identify what (if any) cross-border transactions may be vulnerable to change.
No matter what the outcome of the vote, Scotland will have its own tax authority as of April 1, 2015. For GPs, this raises questions about how the new agency may audit tax receipts of the firm and its portfolio companies. Scotland is already mulling its own general anti-avoidance rules, which throws further doubt on how the new tax agency would review Scottish funds using Luxembourg and other fund domiciles as intermediaries for cross-border acquisitions. And unlike the UK’s HMRC, managers will not have a wealth of existing literature and tax cases for purposes of tax planning.
Whether the Scottish people say “Yes” or “No” to independence, Scotland will therefore undergo substantial changes, at least directly on the issue of tax. But in the meantime, it won’t just be those GPs with an active interest in politics who’ll be anxious to discover which way the vote goes this month.
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