The Anti-Tax Avoidance Directive (ATAD I) and its amended version (ATAD II), implemented in 2019 and 2020 in most EU countries, have had wide-ranging effects on alternative investment funds, irrespective of the alternative asset class. ATAD II in particular is changing fund structuring for EU investors and investments fundamentally. Although funds of funds do not structure their investments most of the time, this new era of fund structuring has, nonetheless, direct impacts on funds of funds and how they conduct investment due diligence.
ATAD II introduces a set of anti-avoidance rules targeting cross-border situations where income flows are taxed differently between the relevant countries. ATAD II can impact funds in several ways, but mostly (1) at the level of return on investments in case of directly investing alternative funds and (2) at the level of taxation of the fund itself.
I will try to elaborate on these examples from the perspective of a fund of funds.
1. Impact on performance of investments held by a target fund
Funds with a European private equity, debt or real estate focus structure their target investments often directly or indirectly with internal shareholder loans for various reasons. The target investments may be relying on tax deductions to generate efficient returns. Until ATAD II was introduced, it was fairly irrelevant how the recipient of the deductible items treated them in its tax returns.
ATAD II changes this and tax deductions for payments may only be claimed if the recipient of the payment includes the income in its taxable basis. This may seem straightforward, but in fund structures these rules trigger extraordinary complexity as, from a tax perspective, the first challenge of this approach is to identify who the recipient of the payment is.
The following example may help illustrate this:
In this example, a fund of funds has invested in a target fund with the legal form of a limited partnership (Target Fund LP) with an EU focus. Target Fund LP structures its investments in European real estate with a mix of equity and shareholder loans carrying interest. Assume the income from the property is €10 million and the interest expense on the shareholder loan is €2 million p.a. (we ignore other loans and interest limitation rules for this illustration for a moment).
If EU country 2 levies corporate tax at a rate of 25% on the income from the property, the cash distribution after tax would be €8 million considering tax-deductible interest of €2 million (Income €10 million - deductible interests €2 million = tax assessment base €8 million -> x tax rate 25% = tax burden €2 million). However, if the interest were not tax deductible, the distribution would be €7.5 million (Income €10 million - deductible interests €0 = tax assessment base €10 million -> x tax rate 25% = tax burden €2,5 million).
Since the introduction of ATAD II, deductibility depends on the question of how the interest payment on the shareholder loan is taxed by the recipient of the payment. From a tax perspective, however, it is not always clear who the recipient is.
In the example above, the property company, in order to sustain the deductibility of the interest expense, needs to look at the recipient from a pure tax perspective under the rules where it is established (in our example EU 2). If the latter considers Target Fund LP in EU 1 transparent from a tax perspective then the recipient is the fund of funds, unless, from an EU 2 tax perspective it is also tax transparent. Only if the recipient includes the income in its taxable basis within 12 months following distribution can the property company deduct the interest. In practice, the manager of Target Fund LP will not know whether Fund of Funds LP includes the interest income in its taxable basis. Therefore, the manager of Target Fund LP needs to request this information from Fund of Funds LP. Fund of Fund LP, in turn, is an entity considered tax transparent in its country of residence, so it needs to request this information from its own investors and perform the inclusion analysis.
Many managers of funds of alternative funds have been receiving amended onboarding requests asking a range of questions around transparency in an effort to collect information that allows them to assess deductibility in their funds. In addition, in many cases, managers will include penalties or an obligation to restructure or structure the investment through a special purpose vehicle to avoid any impact on their fund’s performance. It is therefore key that funds of funds analyse their own ATAD II position so that they can communicate it to their target managers and avoid negative impacts on returns or being forced to restructure their holding. This analysis needs to be kept up to date as the deductibility test is, in principle, a real-time test.
2. Impacts on the performance of the target fund of funds itself
The other angle of ATAD II is the potential taxation of the fund vehicles themselves. As from 2022, ATAD II will require that EU member states tax partnerships and similar vehicles to the extent they earn income that is not taxed by way of transparency in the hands of the investors.
This new rule can be illustrated based on the following example: a fund of fund established in an EU country receives a dividend distribution from a target fund. The fund of funds is a capitalising fund so it reinvests the proceeds in another target. Today, if the fund of funds is established in the form of a limited partnership or FCP, in most EU countries it will not pay tax on this income as it is considered transparent and not a taxpayer. Depending on the country, it may also be exempt from tax. As from 2022, however, the fund of funds will need to pay tax on the income, to the extent the investors have not included the income, on a transparency basis, in their taxable income, even if the fund of funds did not distribute the income.
In this example, if the income received is 100 and there are 2 investors with equal holdings, one needs to look at each of the investors to assess if the income is taxable at the level of the fund of funds or not. Assume investor 1 is an Italian insurance company and investor 2 is a German corporate. In order to assess if any of the 100 of income becomes taxable in the hands of the fund of funds, the manager of the fund has to analyse the tax position of its investors. He may need to ask his investors for information on the taxation and potentially proof that the income is included in their tax return within 12 months after the fund of funds (not the investor) received the income. It is irrelevant if the fund of funds distributed the income or reinvested it.
Going back to the example above, it is likely that the Italian investor does not include any income from the fund of funds until the latter distributes it. It is likely that the German investor includes the income in its taxable basis at the moment the fund of funds receives the income, with or without subsequent distribution to the German investor. As a result, the fund of funds needs to tax 50 out of the 100 of income. This obviously makes the entire fund structure very inefficient and can have a significant impact on its return.
Various solutions may be considered to tackle this challenge and as these rules only come into effect in 2022 in most countries there is still time to look at this. At the same time, funds that are being set up now should already take ATAD II into account, as well as the required tax information flow.
3. What should funds of funds be doing about ATAD II?
Managers of funds of funds need to consider different aspects of ATAD II: they should take into account these rules for new fund structures, deal with the income requests from target funds and adapt their own processes to these changes. In order to successfully manage these changes now and in the future, managers should look at raising awareness of the changes in fund structuring with various internal stakeholders, such as marketing, legal and compliance functions. Managers may consider internal training and proactively reflect on what their fund structures should look like in the future. Managers further need to review their onboarding process and documentation to capture the tax data that they require from their investors right from when they subscribe.
Conclusion
It will be important to amend investment due diligence processes to make sure ATAD II impacts are identified and the Fund of Fund manager is prepared to communicate its own ATAD II position to the target fund when this is required.
