What you should consider when setting up an Investment Fund
When it comes to setting up an investment fund there are a number of factors to consider that have a direct impact on the most suitable jurisdiction and structure model to pursue. These include not only fund regulatory aspects but also tax, business operations, cost, and commercial aspects.
From a regulatory standpoint, requirements largely differ depending on the type of fund, the underlying asset class and investment strategies, target markets, and your investor base, among many other variables. Financial Institutions such as funds are generally heavily regulated and fund managers assume significant legal liability related to the fundraising, investment strategies, investor relationships, and reporting requirements, among many others.
In this article, we have outlined some of the key aspects that one should consider when structuring their fund. Structuring a fund is a complex endeavor and this article does not intend to be a comprehensive analysis and it does NOT constitute legal or tax advice of any kind. One should certainly seek out professional and legal advice and various service providers before setting up a fund and selling or soliciting investors.
Open-ended or Closed-ended Funds
Depending on your investment strategy, you may set up your fund as closed-ended or open-ended.
For instance, if your fund will invest in illiquid assets such as venture capital funds, private equity funds or real estate – which by nature are usually illiquid long-term investments, you may choose to structure the fund as closed-ended.
In a closed-ended fund, generally, investors have their investment locked for a fixed long term, i.e. redemptions are usually not allowed and at the discretion of the fund manager – investors can’t generally withdraw their investment.
An exception to this would be a publicly listed closed-ended fund, where investors withdraw their investment by selling their shares in a secondary market.
Closed-ended funds generally raise a fixed amount of capital, have a fixed number of shares/units offered, and don’t issue new fund units on demand.
In certain cases, private closed-ended funds might not be itself subject to fund registration with the regulator. However, they may be subject to anti-money laundering legislation and the offering of fund units (such as via private placement or IPO) may be subject to certain securities legislation such as prospectus requirements. Legal requirements largely depend on the jurisdiction where the fund is domiciled and the jurisdictions where the fund is marketed and how they are marketed.
On the other hand, funds that invest in liquid assets, e.g. publicly listed stocks or bonds, are usually structured as open-ended funds. Open-ended funds usually allow for periodic redemptions and issue shares on demand. Investors can make further contributions and withdraw their investments according to the rules stated in the fund offering documents. Open-ended funds are subject to registration with the financial services regulator and should fulfill a series of collective investment schemes legal and reporting requirements.
Targeted Investors and Markets
The funds targeted investors, are one of the most important aspects when determining the fund category to pursue, the country to domicile it and the compliance requirements that a given fund will be subject in the jurisdictions where their investors are located.
For instance, in the European Union, retail funds are subject to the Undertakings for Collective Investment in Transferable Securities Directive (UCITS) which place the highest investor protection requirements. For instance, they must have their prospectus approved by the relevant authorities and may face certain limitations on the composition of their portfolio to balance investment risks, among many other requirements. Non-EU funds or EU funds managed by non-EU fund managers are generally not eligible for the UCITS and therefore not allowed to market to retail investors.
On the other hand, Alternative Investment Funds (AIF) are generally targeted to professional investors and although the fund itself is directly regulated at the jurisdictional level rather at the EU level, its fund manager may be subject to the Alternative Investment Funds Manager (AIFM) directive. For instance, Reserved Alternative Investment Funds (RAIF) are indirectly regulated via the alternative investment fund manager.
The fund’s geographic target market also matters when structuring a fund. For instance, an AIF that has an EU fund manager that is compliant with the AIFM directive qualifies for an EU ‘marketing passport’ and may be marketed across the EU while being registered in only one EU member state.
Funds managed by non-EU managers may need to comply with each member state’s national private placement regimes (NPPR) where it intends to market their fund units. There may be certain exceptions such as funds managed by Canada, Guernsey, Japan, Jersey, and Switzerland licensed fund managers.
Most EU countries allow non-EU private placements but the requirements differ among member states.
In Belgium, a prospectus approval exemption might be available for funds with minimum subscriptions of EUR 250,000, whereas Luxembourg’s minimum unit subscription is EUR 100,000.
For its part, Germany does not generally provide regulation exemptions for private placements and a cooperation agreement between the German regulator and the regulator of the country where the fund or fund manager is domiciled must be in place.
The Netherlands may not require a license for Non-EU funds distributed to qualified investors if there is an appropriate cooperation agreement between the Dutch Authority for Financial Markets (AFM) and the regulator of the country where the Non-EU fund and fund manager is domiciled.
Funds targeting US accredited investors may do so via a securities offering under Rule 506(b) of Regulation D of the Securities Act. This is a private placement offering exempted from registration with the SEC without general solicitation or general advertisement, where securities must be purchased directly from the issuer and not from an underwriter. Resale is generally restricted without further registration under the Securities Act.
Funds might rely on Rule 506(c) of Reg D which allows for an exempt offering to accredited investors with general solicitation or advertisement.
A foreign fund targeting US investors may also be subject to the Investment Company Act which regulates activities of Investment Companies. Private funds generally seek to avoid Investment Company status via Section 3(c)(7) or Section 3(c)(1) of the Investment Company Act.
Section 3(c)(7) requires that a fund’s securities are owned by ‘qualified purchasers’ – individuals who own not less than USD 5 million in investments or entities that own and invest on a discretionary basis not less than USD 25 million. For its part, Section 3(c)(1) requires the fund to have no more than 100 investors.
Both Section 3(c)(7) or Section 3(c)(1) prohibits general solicitation and advertisement. Therefore, funds offering under Rule 506(c) might not be eligible for exemptions under the Investment Companies Act.
However, it is not common for foreign funds to raise capital in the US or for US fund managers to raise capital outside the US via foreign corporations because of US regulatory burden and adverse tax consequences for both their non-US and US investors. Different structures are set up for regulatory and tax optimization purposes such as master-feeder and parallel fund structures, as we will see in the organizational structure section of this article.
Definitions of qualifying/accredited/professional investors may also vary across jurisdictions. In the EU a qualifying investor may be either a legal entity, trust or individual which has net assets in excess of EUR 750,000 or which is part of a group which has net assets in excess of EUR 750,000, whereas in the US, accredited investors are those who have a net worth of at least USD 1 million (excluding primary residence) or have income of at least USD 200,000 each year for the preceding two years. In Hong Kong, a professional investor is defined as an individual with a portfolio of at least HKD 8 million or a corporation with a portfolio of not less than HKD 8 million or total assets of not less than HKD 40 million.
Definition of marketing also varies across jurisdictions, some have more broad definitions others more narrowed. What constitutes ‘reverse solicitation’ in one jurisdiction may be deemed active marketing in another jurisdiction. Some jurisdictions only allow registered broker-dealers to distribute fund units, while others may be more lenient on this matter when it comes to private placements.
Whether the fund is required to have a licensed fund manager or to have a fund manager incorporated locally largely varies depending on the type of fund, the jurisdiction where the fund is domiciled and the jurisdiction where the fund units are marketed to.
For instance, the Cayman Islands doesn’t place restrictions on administered or registered funds to have a local or foreign fund manager. Furthermore, a Cayman Islands regulated fund’s fund manager may be exempted from licensing in Cayman. That makes Cayman a jurisdiction of preference for foreign-licensed fund managers to benefit from Cayman’s fund legislation flexibility.
However, although Cayman doesn’t require a manager of a registered fund to be licensed – if you plan to market your Cayman fund interests to Singapore investors, having a licensed fund manager will be required in the case of Restricted Schemes (accredited investors) or the fund manager to hold a Capital Market License for fund management in the case of Authorized Schemes (retail investors).
Jersey requires funds regulated as Expert Funds (min USD 100,000 subscription), Listed Funds (Publicly traded closed-ended fund), Unclassified Funds (Publicly-offered), Recognized (UK Marketed) and Eligible Investor Funds (min USD 1 mil subscription) to have a fund manager regulated in an OECD member state or in certain jurisdictions where Jersey’s Financial Services Commission (JSFC) has a memorandum of understanding or has been approved by the JFSC.
Some jurisdictions allow for certain types of fund to be self-managed while others require having a separate fund manager. For instance, a BVI professional, public or private fund must have an external fund manager, whereas a Malta professional investor fund can be self-managed, subject to certain limitations.
In the EU, as a general rule, if the fund’s assets under management surpass EUR 500 million – an AIFM licensed fund manager or having a regulatory approval as a self-managed investment fund may be required. Some states require an AIFM licensed fund manager regardless of the size of the fund.
Requirements and limitations may also vary if the fund has borrowed capital, such as lower thresholds for fund manager’s licensing requirement (EUR 100 million) and additional transparency requirements such as proving that leverage has been limited to a reasonable amount.
In the US, fund managers are subject to the Advisers Act and must register with the Securities and Exchange Commission (SEC) if their assets under management surpass USD 150 million. Exempted advisers may still be required to comply with registration requirements in a given state. Non-US private fund managers may be exempted from registration if they don’t have a place of business in the US, have less than 15 US clients and investors investing in their funds with a total amount of assets under management of less than USD 25 million, do not present themselves to the US public as an Investment Advisor and do not manage public funds registered under the Investment Company Act.
Furthermore, funds entering into futures, options on futures and/or swaps may be considered ‘commodity pools’ under the US Commodity Exchange Act and other regulations supervised by the US Commodity Futures Trading Commission (CFTC). Operators and investment advisors of commodity pools may need to register as commodity pool operators (CPOs) or commodity trading advisors (CTAs) with the CFTC. Several exemptions from registration exist based on the type of investors, commodity amount of trading and marketing, among others.
Requirements for obtaining a fund management license also vary across jurisdictions. Generally, a fund manager may be required to have sufficient financial, technical, and human resources with enough experience, remuneration rules, proper risk management and internal controls and have adequate capital for the intended amount of assets under management, which varies among jurisdictions.
For instance, in the European Union, an AIFM would be required to have a minimum of EUR 125,000 capital plus an additional 0.02% of the assets under management over EUR 250 million capped at EUR 10 million, whereas a fund management company licensed in Switzerland must have CHF 1,000,000 of paid-up liquid capital. AIFMs also face certain regulatory requirements such as using only brokers and service providers that are subject to regulatory supervision.
In Singapore a licensed fund manager may need to fulfill certain risk-based capital requirements – financial resources must be 120% of operational risk requirement, starting at SGD 250,000 (for accredited investors funds) or SGD 1,000,000 (for retail funds).
Licensed fund management companies may also be required to have economic substance and physical presence within the jurisdiction in which they are licensed.
Other Service Providers
Funds may be required by law, or otherwise freely elect, to outsource their back-office operations to third-party service providers. The main service providers of a fund are typically fund managers (discussed above), fund administrators and custodians.
Typically speaking, fund managers are not allowed to fulfill the role of fund administrator – as this may cause a conflict of interest to investors and would not provide adequate checks and balances.
Fund administrators’ roles usually involve accounting, KYC/AML/FATCA/CRS compliance, and registrar/transfer agent activities. These may include calculating periodic NAV, preparing financial statements and reports for investors, control funds’ bank accounts, AML reporting and monitoring, managing investor subscription and redemption processes, and maintaining records of fund units’ owners, among many others.
Fund custodians or depositaries generally provide custody of financial assets that are held directly by the fund and/or provide record keeping and ownership verification of assets held directly by the fund manager on behalf of their clients. Fund administration firms usually also provide custody services. Funds may also use prime brokerage services, in which the prime broker provides settlement, custody, securities lending, cash financing and risk management advisory services, among others.
Requirements related to the fund’s Service Providers may also vary depending on the jurisdiction and the fund’s category.
For instance, in the BVI, private, professional and public funds are required to appoint a manager, administrator and a custodian licensed in the BVI or in a recognized jurisdiction. Cayman Islands registered funds (minimum subscription of USD 100,000) are not required to appoint an administrator licensed in Cayman but administered funds (no minimum subscription) are required to do so.
In Guernsey, all funds are required to engage with a Guernsey licensed administrator or trustee, open-ended funds also require a Guernsey custodian. For its part, Irish and Luxembourg regulated funds are required to appoint a locally based administrator and custodian.
In Hong Kong, fund administration providers are not directly regulated, and although a given fund manager may outsource certain services, it will bear the ultimate responsibility. The lack of a carried interest regime makes Hong Kong less commonplace for certain funds.
Singapore regulated funds may be required to have an independent Singapore-based service provider to carry out a valuation of the fund’s assets under management. In certain instances, the valuation may be carried out in-house. The requirement of having a fund administration provider based in Singapore does not emanate from the Securities and Futures Act (SFA) – it is a requirement to benefit from Singapore funds’ tax incentives.
Other service providers required may also include external auditors, local directorship, secretarial services, distributors and compliance and money laundering reporting officers, among others.
Investment portfolio restrictions or spread of risks may also apply to different fund categories or type of investors targeted in certain jurisdictions and the investment strategies may also be an important factor when determining the regulatory category of the fund and the regulatory requirements to meet.
For instance, in the EU, each state may have different fund categories for different types of investment portfolios such as venture capital or private equity, with different requirements, investment restrictions, limitations, and compliance burdens.
Generally, professional and private funds enjoy the most relaxed investment restrictions and/or limitations because they do not sell to retail investors whatsoever.
In Cyprus, although an AIF has no restrictions related to the type of investments, certain risk spreading and liquidity requirements must be met, which will largely depend on the investment strategy and class of investors.
Jersey funds do not have investment restrictions but they may be subject to various different borrowing restrictions.
Traditional offshore funds such as those domiciled in the Cayman Islands, Anguilla, Seychelles, BVI or Bermuda are not subject to any restrictions or limitations.
As opposed to professional investor targeted funds, retail funds usually face the highest investment limitations and restrictions.
In Hong Kong, retail funds investing in stocks and/or bonds are required to comply with certain restrictions including but not limited to not holding securities issued by the same issuer that surpasses 10% of the fund total NAV, not holding more than 10% of ordinary shares issued by the same issuer, or not having more than 15% of its total NAV in securities neither listed, quoted nor dealt in on a market, or making short sales which may result in the fund’s liability to deliver securities exceeding 10% of its total net asset value, among many others.
In Singapore, open-ended retail funds can only invest in transferable securities, money market instruments, eligible deposits, units in other funds and financial derivatives. They can also invest in unlisted shares or other securities. However, investments in unlisted securities, undated debt, and unlisted derivatives are restricted to a maximum of 10% of the fund’s NAV. There are also concentration limits of 10% for instruments issued by the same issuer, among other investment restrictions and borrowing limitations.
EU UCITS are generally allowed to invest only in listed securities and money market instruments, other units of UCITS, units of non-UCITS funds subject to a maximum of 30% of NAV, deposits with credit institutions and financial derivative instruments and face other restrictions such as not investing more than 10% of the non-voting shares or debt securities or money market instruments of any single issuer, no more than 25% of the units of any single Fund, or not investing in precious metals or related certificates, among many others.
Investment funds can be set up via a variety of legal structures and arrangements, the availability of which largely depends on the jurisdictions. These include investment companies limited by shares, incorporated cell companies, segregated portfolio companies, limited partnerships, limited liability companies/partnerships, unit trusts and contractual funds.
Companies limited by shares are commonly used for open-ended funds in jurisdictions where corporate legislation allows to make distributions from both the profits and capital of the entity to enable fund units’ redemption.
For instance, SICAVs in Malta, Luxembourg, Cyprus, open-ended investment companies (OEIC) in the UK, the Channel Islands, Liechtenstein, and Abu Dhabi or Exempted Companies in the Cayman Islands, BVI and Bermuda.
The main advantage of using investment companies is that shareholders’ liability over the debts of the company is limited, and the liquidity provided, as investors have the ability to redeem their shareholdings.
In this legal structure, the fund manager usually owns the voting, non-participating management class of shares. Control and decision-making of the entity fall on the board of directors, while investment decisions are usually made by the fund manager.
The Memorandum & Articles of Association determines how the company is governed and the Offering Memorandum is the contract between the issuer and the investor. The offering memorandum usually includes relevant aspects of the fund offering such as the terms of the offering, investor suitability, risk factors, tax implications and the subscription agreement.
Investors obtain non-voting, participating class of shares which are issued each time new investors are onboarded. When investors redeem their shares the fund may sell assets to match the present fund share price.
The fund pays management and performance fees to the fund manager while distributing dividends to participating shareholders.
Corporations are also used for closed-ended fund purposes such as fixed capital investment companies in Cyprus and Luxembourg (SICAF) or closed-ended fund vehicles in the UK, Guernsey and Jersey.
Certain jurisdictions for the incorporation of structures which segregate several pools of assets and liabilities, maintaining different legal status, avoiding cross-liability between segregated portfolios and providing the ability to launch different fund products with minimal cost.
BVI, Cayman and Bermuda Segregated Portfolio Companies (SPC) theoretically protects investors and creditors from incurring into losses by other share classes or investor groups i.e. a creditor or investor may only have recourse to the assets attributable to the segregated portfolio in which they have been involved.
Protected cellular companies (PCC) are available in the Isle of Man, Guernsey and Jersey. They are made up of a core and several ring-fenced protected cells with different portfolios of assets and liabilities which are statutorily segregated. Creditors of a cell may be unable to seek recourse from the assets of any of the other cells or of the core.
Incorporated cell companies (ICC) are available in Malta and the Crown Dependencies. They are similar to PCCs, but in an ICC each cell is a separate legal entity.
When using an SPC, PCC or ICC, it is paramount that contracts are entered for and on behalf of a specific identified portfolio or cell – including separate bank, custody and brokerage accounts, derivative contracts, loan agreements, service provider agreements, etc. Otherwise, the structure may fail to serve the protection purpose for which it was created.
There are also certain other caveats that must be considered when incorporating these cell structures. They add a level of complexity that may provoke issues with service providers and other risks such as director’s liability risk if the structure is not properly operated.
Limited Partnerships (LP)
Limited partnerships are commonly used for closed-ended funds to hold long-term investments such as private equity funds, venture capital funds and real estate investment funds. Virtually all jurisdictions have limited partnership structures available.
Limited Partnerships (LP) do not have their own legal personality. LPs are formed by a General Partner (GP) who manages the LP and enters into contracts on its behalf and has unlimited liability for its debts and obligations of the LP and Limited Partners who have limited liability and have rights on the profits but are not allowed to participate in the management. If the LP becomes insolvent, the GP is liable for all the debts of the LP, whereas Limited Partners are only liable up to their commitment amount.
In this structure, the Fund Manager might be the GP, which is usually a corporation whose board has a fiduciary duty to act in the best interest of the limited partners of the LP.
However, fund managers may create a separate entity to act as GP for each of the funds they manage for liability purposes.
An LP is governed by the Limited Partnership Agreement (LPA). The limited partners are onboarded into the fund by signing up to the Limited Partnership Agreement (the LPA) which states the commitment amount to invest in the fund.
Another key difference between Investment Companies and LPs is that LPs are tax transparent i.e. not subject to taxation. Profits from an LP are directly taxed at the partner level (whether personal or corporate). LPs can be used for tax efficiency purposes to avoid double taxation (corporate taxation at the underlying company level and at the fund level).
LPs are commonly used for funds investing in highly illiquid assets and with long fund terms and for fund of fund strategies and master-feeder funds targeting US investors where the US onshore feeder is usually structured as a Delaware LP as we will see in the next sections.
Limited Liability Partnership (LLP)
Unlike LPs, Limited Liability Partnerships (LLP) have separate legal personality from the partners and all partners’ liability is limited to their capital contributed. LLPs are available in a number of jurisdictions such as the UK, Singapore and USA, among others. An LLP is governed by its Limited Liability Partnership Agreement and is generally tax transparent.
In certain instances, LLPs may also be used as closed-ended fund vehicles. However, in many jurisdictions, they are not that common for funds due to the fact that by law partners may have voting rights and may share day-to-day control over the entity. Therefore, LLPs are more suitable for private funds with a limited number of investors which retain control and decision-making such as family offices or certain venture capital funds.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a hybrid between a corporation and a partnership. It has separate legal personality and provides for limited liability of its members like corporations but has greater structuring flexibility than a corporation. It does not issue share capital and is treated as a partnership for tax purposes. LLCs are available in the US and in British Overseas Territories such as the Cayman Islands, Bermuda, and Anguilla.
The LLC can be managed by an appointed managing member or by a third-party and is governed by the LLC agreement, which provides significant flexibility to determine things such as voting interests, how income and expenses are allocated to members or the manager’s fiduciary duties.
In some jurisdictions, LLCs can be formed as a Series LLC, consisting of a master LLC and separate subunit divisions with segregated assets and liabilities. Each division can have different assets, members and managers. Liabilities and obligations incurred by one division will not affect assets held by other divisions.
The level of flexibility and simplicity of LLCs may make them suitable for family offices, private equity funds ,and venture capital funds.
Unit Trusts are commonly used for retail open-ended investment funds in Ireland, British territories such as the UK, Channel Islands and Isle of Man and ex-British colonies such as Singapore, Malaysia, New Zealand, Australia, and South Africa. Unit Trusts are also popular in Asian countries such as Japan.
The investment fund is established under a Trust Deed whereby the Trustee holds the legal title of the fund’s underlying assets and appoints and oversees the fund. The Unit Trust holders (investors) are the beneficiaries of the trust.
Unit trusts are legal instruments, they are not legal entities and do not have a separate legal personality. The Trustee usually enters into contracts on behalf of the trust unless the powers are delegated to the fund manager. The legal liability of the trust is borne by the Trustee, although the fund manager has the fiduciary duty to make decisions in the best interests of the unitholders.
The Unit Trust issues participating, non-voting units to investors at a buying price, which may be repurchased by the trust at NAV per unit or a selling price. Whenever investments flow to the trust, more units are issued to match the unit buying price. When units are redeemed, underlying assets are sold to match the unit selling price.
Unit Trusts’ underlying assets returns are directly distributed to unitholders instead of being reinvested back into the fund.
The liquidity and regular return features make unit trusts suitable for retail funds, but at the same time, they may not be ideal for high-risk investments or sophisticated investments.
Offshore unit trusts such as Cayman or Bermuda trusts are also popular for investment funds. The fact that they are not legal entities and the tax neutrality enjoyed by offshore trustees may make them interesting for onshore investors in certain jurisdictions – beneficiaries of the trust would report, declare and be taxed on the trust income only at the personal level.
Funds in the form of offshore unit trusts may provide more confidence to investors. The legal title of the underlying assets is held by a professional Trustee, instead of an incorporated entity largely controlled by the fund manager (who holds the management shares and appoints the board). The trustee has a fiduciary duty against investors, which is more easily enforced than with directors of a company, and also oversees the fund manager.
Offshore unit trusts may be set up as a stand-alone or as an umbrella trust – establishing several sub-trusts by arranging supplemental trust deeds to conduct different investment strategies and objectives. Each sub-trust issues its own units providing more flexibility to investors. However, each sub-trust liability may not be separated from the other.
Contractual Funds are a legal form of funds available in Ireland, Luxembourg, Liechtenstein, Malta and Japan that are usually targeted to large and institutional investors. Contractual funds do not have legal personality – they are established via a public deed entered by the fund manager and the custodian whereby they have a contractual obligation with investors, that in turn have direct ownership of the fund’s underlying assets in a pro-rata basis.
Contractual funds are tax transparent and may potentially provide a number of tax benefits. For instance, in certain contractual funds when the underlying company pays dividends to the fund, the withholding tax rate may be determined by the tax treaty with the country where the investor is located rather than with the country where the contractual fund is established.
If you plan to structure the fund as a non-tax-transparent entity i.e. via a corporation, then corporate income tax implications should be taken into account in order to avoid unnecessary additional tax liability.
Furthermore, one may look at where their targeted investors are located and set up in a jurisdiction to effectively minimize or avoid withholding taxes on dividends distributed by the fund to its investors and whether funds are eligible from exemptions from withholding taxes.
Many jurisdictions offer tax-exemptions for regulated funds. For instance, investment funds in Luxembourg are usually exempt from corporate tax, municipal business tax and withholding tax but may be subject to an annual subscription tax of 0.05% of NAV, with the possibility to reduce it to 0.01% or even 0% for shares subscribed by certain types of investors.
Liechtenstein also provides tax exemptions on corporate and withholding taxes and there are no capital duties.
In Malta, a tax exemption on income and capital gains may be available if the fund’s assets located in Malta does not reach 85% of total assets, subject to certain conditions and excluding Maltese immovable property income.
In Cyprus, although investment funds are subject to corporate tax, in practice this tax burden may be limited due to the fact that Cyprus may not tax dividend income. Capital gains from disposals of securities may be exempt from taxation and there is no withholding tax on dividends.
Funds structures in certain jurisdictions may be taxed only on certain types of income e.g. income from local immovable property in Jersey and Guernsey.
Investment funds incorporated offshore, e.g. Cayman, Bermuda or BVI, are exempt from all taxes. However, one should carefully look at where the investment manager is a tax resident of. As the fund manager may hold 100% of the voting rights of the corporation, it might trigger controlled foreign company rules of a foreign corporation. Therefore, care should be taken in properly structuring the fund management entity when a foreign fund manager manages offshore funds.
Also, the investor location may also affect the tax treatment of a given fund. One class of investor may negatively affect the tax status of other classes of investors in the fund, and proper structures must be in place to avoid it, as we will see in the next section.
One should also look at the location of the underlying investments of the fund and how dividends, interests or other income distributed to the fund are treated for tax purposes.
Operating Structures for funds with US and non-US investors
As we discussed previously, funds targeting US-accredited investors may do so via an exempt offering to accredited investors under Reg D and an exemption as Investment Company under Section 3(c)(7) or Section 3(c)(1) of the Investment Company Act. If the fund raises capital globally (US and non-US) via a stand-alone entity, it might need to apply for these restrictions globally, regardless of the location of their investors.
From a tax standpoint, US domestic funds established as corporations are subject to federal income tax and non-US corporations are subject to US federal income tax on the portion of its earnings that are effectively connected with a US trade or business (ECI). This means that non-US investors in both US and non-US funds may be subject to US federal income tax and income tax related to ECI.
To avoid the US federal tax burden, tax-transparent entities such as LPs are set up. However, other issues related to US partnership tax accounting provisions may arise, which could be adverse for non-US investors if they are investing directly into the LP. As they may be treated as engaging in a US trade or business and will need to file a US tax return and be liable to US taxation.
In addition, US tax-exempt investors (such as pension funds or charities) may be taxed on the receipt of their unrelated business taxable income (UBTI) if investing directly in an LP, and may prefer to invest in a corporation.
Other additional tax burdens related to Controlled Foreign Corporations (CFC) and Passive Foreign Investment Companies (PFIC) may also arise if 50% of the voting power or value of the stock of a non-US corporation is owned by US persons and/or 75% or more of the non-US corporation gross income is passive income or 50% or more of its assets produce passive income.
Furthermore, foreign funds are classified as foreign financial institutions (FFIs) under FATCA, and withholding tax on certain payments may be applied if certain requirements are not met, among other potential issues.
The above may negatively affect both US and non-US investors jointly investing in US and non-US funds and certain operating structures may be put in place in order to avoid these negative US tax implications. These operating structures may involve setting up a US domestic fund and offshore fund to shield non-US investors from unnecessary US tax liability as well as provide a tax optimized structure for US investors.
A careful analysis made by professional should be made considering the tax status of investors and investments, as well as considering other variables, in order to select the proper structure.
Parallel Fund Structure
The Parallel Fund Structure consists of two different funds which are managed by the same fund manager and invest in the same positions. US taxable investors generally invest in a Delaware LP whereas US tax-exempt (such as pension funds) and non-US investors invest in an offshore fund.
In general terms, US taxable investors might avoid additional federal corporate tax, while US tax-exempt avoid UBTI. On the other hand, non-US investors are isolated from negative tax consequences of sharing an investment vehicle with US taxable investors.
However, having two different investment companies may involve higher administrative burden – different brokerage accounts, trades must be split between the US and the offshore fund and executed separately, and duplicate paperwork needs to be completed. A parallel fund structure might not be suitable for trading intensive funds but an option to consider for Fund of Funds Strategies i.e. a fund that invests in other funds.
Parallel fund structures allow to adopt different investment tax planning strategies for both US taxable investors and non-taxable investors but may be of little benefit or detrimental to U.S. tax-exempt investors and non-U.S. persons.
A Master-Feeder Structure consists of different Fund Feeders e.g. a US LP fund feeder vehicle (for US taxable investors) and an Offshore corporation feeder vehicle (for US tax-exempt investors and non-US investors) that jointly invest in a Master Fund set up offshore, which may take the form of a partnership or corporation depending on certain circumstances.
In certain cases, the Offshore feeder fund will be treated as a foreign corporation (thus avoiding UBTI for US tax-exempt investors) and the Master fund to be treated as a partnership for US tax purposes.
The Master Fund issues voting shares to the Fund Manager and non-voting participating shares to the Feeders. The Feeders, in turn, issue non-voting participating shares to investors. Management and performance fees to the investment manager are paid at the feeder level which might also allow for further tax optimization for the fund manager.
This structure is preferred for funds with trading intensive investment strategies. In this case, there are no duplicate trading vehicles which lead to a more administratively and operational efficient structure with lower transaction costs but still allows the fund to adapt to specific jurisdiction regulations. Furthermore, having a single portfolio may lead to greater leverage ability by the fund.
Furthermore, a greater level of flexibility is also achieved. For instance, a Master-Feeder structure can be efficiently used for umbrella structures to conduct different investment strategies or at the feeder level where each feeder can adopt different currency, subscription and fee structures.
Reporting and Compliance Requirements
Each jurisdiction applies different fund reporting requirements both to their investors and to the regulator such as periodic statements of the Net Asset Value (NAV) of the fund, audits, annual returns, and other financial reporting, which may also vary on the type of regulated fund.
For instance, Bermuda may require quarterly NAV statements for regulated funds, whereas BVI and Cayman may have more lenient requirements on this matter. Hong Kong regulated funds must make available to their investors offer and redemption prices or NAV on every dealing day. Cayman requires accounts to be audited by a local auditor, whereas BVI allows audits to be conducted by an auditor from any recognized jurisdiction.
As financial institutions, funds are also subject to KYC/AML & CTF regulations, FATCA and CRS reporting. Foreign funds fall under the scope of FATCA reporting requirements as Foreign Financial Institutions (FFIs) and under the scope of CRS as Reporting Financial Institutions (RFIs).
Generally, funds are required to conduct compliance checks on and collect tax status self-certification forms from their investors (whether via a third-party fund administrator or in-house) and appoint Compliance and Money Laundering Reporting officers.
Under FACTA, funds must report US investors information to the relevant authorities, establish a Compliance Program, Register with the IRS and receive a GIIN and appoint a principal point of contact.
Under CRS, funds must identify the jurisdictions where a given investor is resident for personal income and corporate income tax purposes, apply certain due diligence measures outlined in the CRS framework and report such information to the relevant local authorities which in turn may share it with foreign authorities.
The Bottom Line
As we have seen, there is a myriad of factors and requirements to be considered when structuring and operating a fund. In this article, we have just covered a few in a general manner.
Capital markets are some of the most regulated sectors and the legal liability assumed by a fund’s sponsors for non-compliance is significant. Some jurisdictions have more flexible fund regimes whereas other jurisdictions have greater regulatory burdens.
Your targeted investors and investment strategies may be some of the most important elements that may have an impact on the regulatory requirements to meet and suitable legal structures to pursue, which may also largely differ between jurisdictions.
Furthermore, when structuring the fund, you have to not only consider laws and regulations of the country where your fund is domiciled – also those from the country where your investors are located and even where your employees are.
In certain jurisdictions, marketing fund units have a more broad definition, meanwhile others definitions are more narrow. What constitutes ‘reverse solicitation’ in one country may be considered active marketing in another.
If you want to solicit to investors in a given country, even private placements offered to professional investors may be subject to filing an offering memorandum and other requirements to obtain the permission to do so. You may also be obliged to engage with local brokers and other securities dealers.
Funds with investors of certain countries may need to fulfill additional structuring, administrative, operating and reporting requirements. You must seek the appropriate legal advice in each of these countries to make sure your fund is compliant.
In addition, other commercial and operational factors may also have an important role when exploring and determining the most suitable structures for your fund.
This is why a careful holistic assessment of the strategies and objectives of the intended fund should be done in order to determine the most suitable jurisdiction to establish it and the fund regulatory category to pursue.
At Flag Theory, we can help you select the most suitable structure and jurisdiction to set up and sell your fund. We will explore and compare jurisdictions side by side taking into account your unique investment strategies, target markets, requirements, and priorities, among many others in order to empower you to make the right informed decisions and operate your fund according to your objectives. Contact us today, it will be a pleasure to help you.