Are there opportunities for the manager?
There could be significant tax benefits for a fund manager depending on the nature of the fund. Broadly, the determining factor will be whether the fund manager is engaged in ‘hedge fund-like’ trading of debt investments or whether its activity is more akin to ‘advising’ a ‘non-trading’ fund in a manner similar to that which a private equity fund manager would do. Where the fund’s approach is to buy and sell regularly, with relatively short holding periods, then the typical structuring applicable to hedge funds would be likely to apply, meaning that management and performance fees are paid and taxable as business income at the level of the manager.
If the fund is trading then care will need to be taken to ensure that any debt investments constitute an ‘investment transaction’ for the purposes of the Investment Manager Exemption (IME). This is to ensure that any profit made by the fund on this investment is not charged to UK tax by virtue of the activities of the manager.
Where the fund’s strategy is instead to make comparatively fewer investments, with significantly longer holding periods, then the nature of the fund’s investments may be likened more to that of a private equity strategy as opposed to that of a hedge fund. Here, qualification under the IME may not be strictly necessary as the fund is not ‘trading’, and hence the manager could not be deemed to be carrying on the fund’s trade in the UK.
Where the fund manager’s activity falls under the second (non-trading) scenario, it may be possible to structure the ‘carried interest’ in a much more tax efficient manner. As you may be aware, in a typical private equity structure the carried interest is not always paid to the management company but can in certain instances be structured such that the return is taxed as capital gains to the carry participant. The ability to structure a potentially significant portion of the manager’s return in such a manner is a very important consideration.
Ultimately, the fund’s strategy will go a long way to determining the potential relevance of such structuring. Knowing where the manager is in the UK, certain anti-avoidance rules and rules that may convert capital gains into income need to be considered.
What should you be thinking about?
The tax laws surrounding the treatment of debt securities by countries within the EU are, as one might expect, not uniform. For this reason, attention must be paid every time a fund chooses to invest either in a new country, through a new instrument or potentially using a new strategy. There are numerous examples of why this is important and for the purposes of this article we have highlighted some of the questions a fund manager will need to consider:
- Are the loans secured by a mortgage?
- Is interest derived from a company that is considered as being ‘controlled’?
- Was the loan contracted inside or outside of the jurisdiction?
- Does the loan have profit participating features?
- Is the term of the loan considered short term or long term?
- Can the loan be considered as equity under the domestic countries rules?
- Is the loan traded on a public exchange?
In many countries within the EU, taxation of returns on debt investments will hinge on the answers to some of the questions answered previously. When these issues are considered in advance there may be a number of opportunities to structure the investments in a tax efficient manner, some of which are discussed in the next section.
Regarding investments in the UK, interest from privately issued debt is generally subject to withholding tax to the extent that payments relate to ‘yearly interest’. UK withholding tax on interest income may be reduced or eliminated where the interest is received by a person that is eligible for double tax treaty benefits. However, qualification for treaty benefits may not be straightforward and may be limited where parties engage in so called back-to-back transactions. For capital gains, a non-resident company would not be subject to tax so long as it does not carry on a trade in the UK through a permanent establishment.
Options to consider
Structuring investments into debt can be accomplished in a number of ways. These include the use of holding companies when tax treaty benefits may be derived, use of financial instruments such as swaps and the use of domestic holding companies which take advantage of domestic exemptions targeted for these types of investments. These options can provide a number of business and tax benefits but this article focuses on the tax side.
In comparison to investing directly from a Cayman company for example, the use of a European-based holding company to make investments can provide a number of opportunities. Where applicable, treaties or domestic exemptions apply, taxes relating to interest and capital gains may be lowered. Also, this may help mitigate certain punitive taxes that some countries apply to investments held directly by certain offshore jurisdictions. For example, Italy may apply a withholding tax on interest payments made to a company that is not listed as a specified ‘white-list’ country. Another alternative that managers have used is one of variations of total return swaps which can provide certain tax benefits when structured properly. In comparison to the use of holding companies, the use of swap instruments is considered administratively much easier. However, a fund manager should take care to understand both the underlying tax analysis to determine its level of certainty and also the legal arrangement with the counterparty as to who assumes the ultimate tax risk in the event it is challenged.
Finally, many countries have domestic entities through which local debt investments can be made in a tax-efficient manner. In certain countries, practical requirements around making debt investments may themselves dictate that these vehicles are used. From a tax perspective, including these vehicles within a larger structure developed to address issues in various EU countries can involve complex issues but are largely manageable.
Conclusion
The purpose of this article is primarily to highlight two things that managers should consider when making debt investments. Firstly, the structuring of the fund manager’s return may be different (and lead to a preferential result) from a typical hedge fund arrangement.
Secondly, local country tax rules around income from debt investments are complex and varied. There are opportunities for the fund to improve its returns by considering these issues upfront and structuring how best to address them.
Robert Mirsky is Partner, EMEIA Financial Services, Ernst & Young, London. Adam Miller is Partner, Tax, Financial Services, Ernst & Young, London
