Different tax regimes can influence the provisions of fund agreements. The structure of US, European and Asian funds is often driven in part by tax concerns. Due to the different ways taxing authorities in the US and Europe treat private funds and tax participants in private funds, the taxation provisions in the limited partnership agreement are often drafted and structured differently to cater for this.
In most cases, the location of the GP and its executives determines which approach is followed. This obviously becomes more complex where GPs have pan-global teams and is one of the factors driving the continuing convergence of these provisions in fund agreements. For example, funds with US investors that intend to invest outside the US need to take into account the US “passive foreign investment company” and “controlled foreign corporation” regimes; frequently this involves the use of non-US vehicles. The US tax consequences to non-US and tax-exempt investors of being treated as engaged in a trade or business also need to be considered on the establishment of a fund, frequently by using entities that are fiscally opaque for tax purposes and often referred to as “blocker” corporations. Throughout the UK and the EU, value-added tax presents a concern that does not exist in the US and that can involve complex mitigation structures, such as structuring the management fee so that it is paid a priority share of the fund’s profits.
For US tax purposes, executives who are entitled to receive carried interest are generally taxed on the allocation of fund profits before receiving any corresponding distributions. It is, therefore, common in US funds to provide that these executives receive so-called “tax distributions” from the fund in advance of receiving distributions of carried interest in order to pay taxes on the allocation of income. In the UK, the allocation of profits between partners in the partnership is treated differently for tax purposes and these tax distributions are not typically required.
Choice of law
There are several jurisdictions that have laws and regulations suitable for establishing and operating private investment funds, and substantially all of them have legislation that permits the establishment and operation of limited partnerships.
The UK Limited Partnerships Act (which governs limited partnerships in England and Wales, and Scotland) dates back to 1907 although it has recently been revised to provide some useful clarity in respect of private investment funds. Others, such as Delaware, Jersey, Guernsey and Luxembourg, have more recent legislation, which is updated and revised from time to time. In some countries, such as in France, Spain, Italy, Mauritius and Australia, other forms of collective investment schemes and structures are provided for in law, which will also have a significant impact on the provisions of a fund’s constitutional documents.
The choice of law under which a fund is established also determines, to some extent, the content of a fund’s constitutional documents including, among others:
• Providing for specific filing obligations.
• Influencing how investors’ commitments to the fund are structured and drawn down.
• The role and function of the limited partner advisory committee.
• The ability for LPs to transfer their interests in the fund.
• Content and frequency of reports and valuations.
• Conflict management procedures.
• Disclosures required to be included in a fund’s constitutional documents by the regulator, if any, by which it and the GP may be regulated.
The most common jurisdictions in which private investment funds structured as limited partnerships are established include the Cayman Islands, Luxembourg, the US State of Delaware, Jersey, Guernsey, England and Scotland and, to a lesser extent, other European jurisdictions, such as the Netherlands, France, Italy and Sweden, which also have forms of limited partnerships or other types of entities that can be used as investment vehicles under their local laws. Regulation such as the EU’s Alternative Investment Fund Mangers Directive, tax developments in a number of European jurisdictions and Britain’s decision to leave the EU are important factors influencing the choice of jurisdiction for many European-based fund managers. In particular, there continues to be a significant number of GPs that would have historically set-up their funds under English or Scottish law that, for various reasons — often driven by where their investor base will be — have shifted their more recent funds to Luxembourg, and a number of Scandinavian GPs that would have historically set up their funds in Jersey or Guernsey, are now using structures in their own jurisdictions such as Swedish limited companies.
Some examples of differences between jurisdictions that have an impact on LPA terms and how they are drafted include:
• The ongoing registration and filing requirements imposed on a GP or fund manager.
• The structure of investors’ contributions into a fund.
• Obligations imposed on investors to return distributions under the law governing the investment vehicle.
• The role of the LPAC and the ability of LPs/investors to be involved in the business of the limited partnerships without compromising their limited liability status
David Tegeler is a partner and global co-head of the private funds group at Proskauer, and also head of the Boston office. Nigel van Zyl is a partner and head of the European private funds group at Proskauer, based in London. Lynn Chan is a consultant in the private funds group at Proskauer, resident in the Hong Kong office.
This is an excerpt from The LPA Anatomised (2018), published by Private Equity International, and available for purchase here.