As the debate over offshore vehicles rages in mainstream media, fund managers have been painfully aware of the complexities of structuring investments across multiple jurisdictions for some time now. In our previous post, we briefly touched upon some of the diligence you’ll need to be prepared to encounter as you engage international investors including taxation. With the recent release of the Panama Papers and the concerns about emboldening enthusiastic revenue authorities, we thought it would be appropriate to highlight a couple of key takeaways regarding tax considerations to take into account when working with your investors. Capria’s inaugural Intensive has led to some interesting discussions on how to approach the complex issue of tax structuring and we anticipate fruitful conversations to continue as Cohort 2 joins us later this year.
NOTE: we are not providing tax advice – the questions below are meant to help you get smarter about what questions to ask appropriate tax advisors.
Prior to deciding on fund structure, we’d encourage you to think about (or continue thinking about) the following:
Do you plan to raise capital from both local and foreign investors spanning more than two countries?
Depending on your answer, you may need to also register a domestic fund apart from the offshore fund. There can be legal or regulatory necessities to do so, as well as issues of perception (avoidance of concerns around “round tripping” or “offshore laundering”). You want to minimize any points of friction with your investors; with a mix of local and foreign investors, you’ll have different issues to navigate.
U.S. source income brings with it a host of issues under U.S. taxation laws, including characterisation of certain income as unrelated business taxable income (UBTI). This is a concern for both investors and fund managers. Investors whose income is otherwise tax-exempt may not be inclined to invest where there is a possibility of receiving UBTI and being subject to high tax rate as a result. Although investors will seek independent tax advice, clarifications from your own tax advisors on structures that do not attract an adverse characterisation could go a long way in instilling confidence in investors.
Considering the countries you are planning to invest in for your first fund and your investors’ domiciles, would it be better to set up a pooling vehicle in a tax neutral jurisdiction or take the benefit of available double taxation avoidance agreements (DTAA) (if any) or foreign tax credits?
Where investors cannot take advantage of beneficial DTAAs when returns are routed through tax-neutral countries, it may be worth considering remitting returns from a local vehicle to the investor directly.
As we’ve been working with the teams in Cohort 1, they have raised some of their concerns with experienced fund attorneys and tax advisors that are a part of Capria’s Network. Concerns and challenges have included:
- The cost of tax advice / maintenance costs of offshore funds relative to ticket size of investments by an impact fund.
- Characterisation of income as a concern for investors making tax filings in the U.S.
- Selection of best tax-neutral venues, from cost and investor attractiveness perspectives.
Real and perceived risks of investing in funds domiciled in Mauritius, Netherlands, Cayman islands and others were also raised during discussions. Since most foreign investors still prefer to invest in familiar tax-neutral jurisdictions, it is encouraging to note global efforts towards strengthening tax transparency. Fund managers should also be aware of structures that are attracting scrutiny from local revenue authorities, particularly where capital is also being raised from domestic investors. For example, tax tribunals in certain jurisdictions take an unfavorable view of round tripping local investments through a tax neutral jurisdiction (although the structure may not necessarily be illegal). While seeking a tax-efficient structure however, you should under no circumstances attempt to evade tax.
A few takeaways from some of the experts engaged include:
- Follow the herd: As trite as this sounds, adopting a structure that is tried and tested by similar funds usually gets optimum results (although where the herd is prone to evading, it is of course not wise to follow them). It is always advisable to seek professional local tax advice for structuring your fund from someone who is familiar with navigating the various needs you will encounter with your investors. As a starting point however, you should investigate similar structures that already have the approval of the local regulators
- Think about your needs when seeking tax advice:
Where financial strategy is required, it is better to consult with accounting firms that have proven domain expertise in local market and/or international taxation than with attorneys. Tax attorneys are generally more helpful with advising on tax liability disputes.
- Leave room for change: When the laws change (as they often do), you may need to retain the ability to respond to these changes by adapting your fund structure. You should ensure therefore that your investment agreements are not unnecessarily restrictive on this front. If you wonder why this is important, ask anyone who has a fund investing into India via Mauritius as of 2016-17.
- Make life (slightly) easier for your investors: Prepare a tax memo that provides investors with an overview of the fund’s structure and their various options for making a tax-efficient investment, like tax credits or tax exemptions if any. As mentioned earlier, identifying your investors beforehand as tax-exempt pension funds or DFIs can help you address options specific to them through the memo. However the memo is not intended to be a legal or formal tax advice document. Although investors will seek their own tax advice, they will appreciate a handy outline of the possible benefits or options they can explore.
The Panama Papers episode has shown us how perfectly legal structures can be called into question, insinuating the intention is to evade tax. Even with the purest of intentions, it is essential to consider various investment structures carefully before setting up your fund and leave options for flexibility once your fund is set up.
Drop us a line at info[at]capria[dot]vc or @CapriaVC with your thoughts and suggestions!