The ever-increasing complexity and volume of global compliance regulations related to alternative investments is putting pressure on fund managers to ensure the right level of peripheral services are attached to their funds.
Base Erosion and Profit Shifting (BEPS), the Organisation for Economic Cooperation and Development's (OECD) project, led to the most significant changes to how international businesses are taxed in a generation.
Tax legislation not keeping up with globalisation had opened opportunities for multinationals to minimise their tax burdens. This led to the Group of 20 (G20) instructing the OECD to prepare an action plan with respective reports to counteract BEPS. This comprehensive package of measures is now being adopted widely in local legislation and within tax treaties.
We have seen economic substance play a role in various parts of the BEPS project, which even caused certain jurisdictions (such as Cayman, BVI, Jersey and Guernsey) to introduce economic substance requirements for various types of activities, including fund management and holding activities.
The recent trend has focused on having qualified local decision-makers in a local entity that is engaged in true economic activities, which means having a local board of directors with sufficient expertise and industry knowledge as well as the local entity "behaving" as a company with true operations.
The principal purpose test brings location into question
Treaty abuse and in particular, treaty shopping, has been identified as one of the most important sources of BEPS concerns. Action 6 of the BEPS project recommended jurisdictions introduce a so-called principle purpose test in tax treaties. This rule is meant to deny treaty benefits if obtaining that benefit was one of the principal purposes of the arrangement or transaction.
The principal purpose test is providing (source) countries the legal instrument to deny treaty benefits, but at the same time the subjective nature of this test is causing uncertainty amongst taxpayers.
The OECD has provided some limited guidance in relation to the application of the principal purpose test with respect to Non-Collective Investment Vehicle (CIV) funds. Based on this guidance, the principal purpose test may drive the PERE industry to consider setting up a regional investment platform in one jurisdiction. This means having holding Special Purpose Vehicles (SPVs) as well as the funds in the same jurisdiction as the fund management, and to have employees in that jurisdiction as well as most of the board members. These employees should be of a different calibre; they're not traditional bookkeepers, for example, but financial controllers or treasurers actively involved in the day-to-day business. It could lead to co-locating all management in one jurisdiction.
This move also meets the needs of the Alternative Investment Fund Managers Directive (AIFMD), an EU regulation applying to hedge funds, private equity funds and real estate funds. Prior to the AIFMD, these funds fell outside of EU financial regulations for disclosure and transparency, and so it sets standards for how the funds operate, establishing overall accountability. AIFMD also recommends the fund manager, the AFM with delegation and portfolio risk management function, be in the same country.
These regulations are not new, and fund structures have known about the requirements for several years - and yet, not everyone is there or ready. Larger institutions and large PERE fund managers are moving in the right direction, but the mid-sized market is struggling to meet these new standards.
With the principal purpose test now in force, it is recommended that operating funds and SPVs pay close attention to the executive and control elements, and services in terms of portfolio and risk management.
Talk to us
With a large portfolio of clients and with a proven track record in the alternative investment fund space, TMF Group has its collective finger on the pulse of regulatory changes relating to evolving economic substance requirements. Our core services are based around fund administration, investor services, depositary services, SPV accounting and tax needs, corporate secretarial and governance services, as well as provision of highly experienced directors – together with a substance compliance health check for those unsure if they are in compliance.
Get in touch with our experts to discuss the unique economic substance needs of your fund structure, wherever it is domiciled.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
