Tax attributes of investors and operational setup of fund managers will drive the tax efficiency of many alternative investments. Managers need to rethink how they operate and structure funds in order to maintain fund performance.
What has changed?
The international tax and regulatory landscape has undergone significant changes in the last few years, with a direct impact on managers of alternative assets. Many of the regulatory changes emerged from the financial crises in 2008. The changes in international taxation, however, are the result of a general understanding that the international tax system needs to be adapted to the current globalised and increasingly digital world.
The Organisation for Economic Cooperation and Development (OECD) and the G20 countries therefore decided in 2011 that it was time to adjust this tax system, as it is no longer fit for purpose. The combination of a drastically changing tax landscape and EU-wide regulatory changes due to the introduction of the Alternative Investment Fund Manager Directive (AIFMD) and the Markets in Financial Instruments Directive (Mifid) will likely have a significant impact on how asset managers operate in future.
The core of the international tax system was built after World War 2 in an era before globalisation and digitalisation. In 2013, the OECD, together with the G20 economies, started working on the Base Erosion and Profit Shifting Project (BEPS). BEPS aims to tackle “tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations” (OECD, website). BEPS contains a range of measures intended for governments to implement in their local legislation and in their double taxation treaties. BEPS has been and is still being implemented in many countries globally. As regards the European Union, the European Commission (EC) issued a directiveon 12 July 2016 with the purpose of implementing some of the outcome of BEPS in the local legislation of EU member states (EU MS) by 1.1.2019 (The Anti-Tax Avoidance Directive, ATAD I). The EC subsequently issued a second directive on 29 May 2017 amending ATAD I (ATAD II). ATAD II is to be implemented by member states by 31.12.2019.
The individual measures under ATAD I include:
- a rule restricting deductibility of interest (and equivalent) expenses;
- a rule introducing general anti-avoidance measures;
- a rule introducing controlled foreign company regulations.
ATAD II supplements ATAD I by introducing rules aimed at tackling negative tax outcomes as a result of mismatching tax treatment between two EU member states or an EU member state and a third country.
In parallel, over 80 states worldwide signed a multilateral convention (more often referred to as the multilateral instrument (MLI)) to implement double tax treaty related measures to prevent BEPS. The OECD hoped that through the MLI double tax treaties could be amended in one agreement and thereby avoid a lengthy process of bilateral treaty negotiations. The MLI is already in effect and is gradually becoming applicable as countries finalise their country-specific processes for ratification. The MLI introduces a range of rules into existing double taxation treaties by supplementing the text or through re-negotiation. The most relevant change for asset managers as a result of the MLI is the introduction of a principal purpose test that requires a business purpose for transactions and structures that is not driven by tax considerations.
Recent rulings by the Court of Justice of the EU (CJEU) are another relevant factor for the alternatives industry. The CJEU rendered two landmark decisions on 26 February 2019 referred to as “the Danish Cases”. In these cases, the CJEU took a position on beneficial ownership and abuse in relation to withholding taxes on dividends and interest in the context of private equity investment structures.
The impact of individual measures under BEPS, ATAD I/II, MLI and the Danish cases differ from strategy to strategy, but many (illiquid) strategies are likely to be impacted by these rules.
What is the impact on alternative funds?
In the past, when selecting the most appropriate investment fund vehicle for alternative asset strategies, asset managers would look at different factors such as legal and regulatory features, distribution constraints or the reputation of a fund domicile. Tax considerations would normally play a secondary role and be limited to choosing a vehicle that is tax neutral for investors and not create any tax-filing obligations for the investors in the fund’s domicile. From now on, this criteria will only be one of several relevant tax factors to consider when structuring an investment fund.
The combination of MLI, ATAD I/ATAD II and the outcome of the Danish Cases demands a more holistic approach and a certain convergence between the activities of asset managers and the funds themselves. The main drivers of this change are: (i) rules that make tax efficiency of deal funding dependent on the tax attributes of investors, (ii) higher hurdles to access reduced withholding tax rates and capital gains exemptions under double taxation treaties or EU directives, (iii) increased transparency combined with fast digitalisation of resources used by tax authorities, and (iv) investors asking managers to apply tax good governance when investing.
Investors’ tax attributes may determine tax efficiency of investment
Structuring illiquid assets internationally is often based on various business drivers such as external financing, asset segregation or other legal considerations. The fund in question would hold several legal entities that, in turn, make the investments. At times, it is legally impossible to invest directly from the fund. To ensure that the structuring of assets through several legal entities does not result in double taxation, cash traps or negative fund performance, careful legal and financial structures are required. For examples, when a real estate fund provides lending to a property company, new rules may impact the deductibility of interest at property company level, which is likely to impact the fund’s performance. The restriction on deductibility of interest is triggered by several layers of rules such as debt to equity ratios or rules limiting deductions to 30% (tax) EBITDA. From 2020, all EU member states will need to apply rules tackling the outcomes of hybrid mismatches.
Hybrid mismatches are situations that result from two countries viewing certain transactions or situations differently from a tax perspective. Under the new rules, whenever there is a hybrid mismatch, the source (EU) country needs to deny a deduction on a payment.
In the context of investment funds, the tax attribute of individual investors may drive the deductibility of payments in investment vehicles held by the fund. This means that when structuring investment funds, you need to know and understand the tax attributes of investors in order to ensure efficiency of investments.
Rules aimed at preventing treaty abuse may increase withholding and capital gains taxes and result in economic double taxation
BEPS introduces measures to the OECD model tax convention aimed at preventing inappropriate use of double taxation treaties. In practice, this is effected through the MLI, as it introduces restrictions for access to tax treaty benefits. Specifically, most OECD model based tax treaties will include a principal purpose test (PPT). We can expect that the hurdles for benefiting from tax treaties will increase, potentially substantially, in future. This may result in companies claiming treaty benefits having to demonstrate that they are the beneficial owner and that one of the principal purposes for the transaction is not tax. Local countries where investments are made may apply additional criteria such as minimum substance and beneficial ownership requirements.
As regards beneficial ownership, the recent decisions in the “Danish Cases” issued by the CJEU in February 2019 may have risen the hurdle even further. This is because in these decisions the CJEU takes a position on cases of beneficial ownership and links it to the question of abuse. In one of the cases, a portfolio company was held indirectly by a private equity fund through a string of Swedish and Luxembourg companies. The court questioned if the Luxembourg/Swedish companies were the beneficial owner of dividends and interest distributed by the portfolio company. Furthermore, the court listed several indications for abuse, one of them being the absence of beneficial ownership. As a consequence, the companies could not benefit from reduced withholding tax rates applicable under the EU Parent Subsidiary or Interest and Royalty Directives.
It is too early to tell how exactly the countries implementing Anti-Hybrid Rules and the OECD MLI will apply these rules to transactions relevant for alternative investment funds. And it is also not yet clear how countries will react to the decisions in the Danish Cases in practice. However, what is sure is that fund and investment structuring will need to change as a result of the rules mentioned above, be it to manage fund performance or for compliance purposes.
Tax Transparency is changing how tax authorities perform tax audits
A range of measures have been implemented in recent years worldwide. Examples include the obligation to file country by country reporting (CBCR) documentation in certain cases, the automatic exchange of information on tax rulings and the most recent amendment of the EU Directive on Administrative Cooperation (DAC).
In many countries, financial statements are publicly available, including tax information, and there is an ongoing debate at EU level about the introduction of public CBCR. Under an iteration of the EU Anti-Money Laundering Directive, the EU has introduced a registry of ultimate beneficial owners that is scheduled to become public in 2020 in EU member states. Given the ongoing discussions around tax governance and aggressive tax planning by media, politicians, non-governmental agencies, (even) more transparency will lead to further analysis of the tax affairs of alternative managers and their funds.
Tax good governance matters to investors
The push for increased tax transparency comes at a time when environment and social governance (ESG) is high on the agenda for regulators, managers and investors alike. Although tax is generally not one of the ESG criteria that asset managers look at when investing, it may be wise to consider tax good governance as one of them when structuring investments. Many institutional investors and, in particular, pension funds have adopted a policy around tax governance they expect to see when investing. As a result of this trend, asset managers may see more detailed and focused tax questions as part of investors’ due diligence processes. Where tax governance is taken into account from the outset when structuring assets, it may prove a much easier and more efficient exercise to lay out what the tax policy is when it comes to taxes.
What does this mean for alternative funds?
As the new international tax environment focuses on aligning substance and functions with the location where profits are taxed, there will likely be a change in operating models for alternative asset managers. It is expected that there will be a certain convergence between the manager and the fund, as some of the functions currently exercised in the location of the manager may need to be exercised by the fund and its subsidiaries itself or at the location of the fund if the fund is domiciled in a different country than the manager. For many asset managers, this will seem incompatible with general asset management business models today and even with regulatory requirements. However, with regulatory substance requirements increasing at the same time, the shift is already happening in practice. Now is the moment to step back and revisit existing operational/structural setups, identify gaps and reflect on what the model may look like in the coming next years in order to maintain fund performance and keep tax costs and reputational risk under control.
What’s next?
Asset managers may want to review the potential impact of the changing international tax system on their organisation and prepare for the need to change their operating model. Documentation of business purpose and processes between operating and investing entities will become crucial.
