What an administrator has to consider when acting for a Fund that permits US subscribers

A presentation by Dermot S. L. Butler
at the Joint International Bar Association and American Bar Association
"International Conference on Private Investment Funds" held at
La Meridien Hotel, London,
31st October - 2nd November 1999
 
The subject that Joel* has asked me to speak about is "What An Administrator Has To Consider When Acting For A Fund That Permits US Subscribers".
First of all, I must explain that my comments will be very much an "overview" because of time constraints. Secondly, there is one assumption that I am making with regard to all my comments today and that the type of funds that we are discussing today - "Private Funds" - are predominantly hedge funds, or alternative investment funds, targeted at professional, or very high net worth investors and that I will not be discussing any form of retail fund whatsoever.
I suppose that the first thing administrators have to consider, with due respect to the assembled company, is the occupational risk of litigation that some believe increases substantially as soon as you look at an American investor. Having bitten that bullet, the next thing for an Administrator to remember is that it is incumbent upon an Administrator, with any fund, to review all the documentation, and particularly the offering documentation, to ensure that all the "i's" are dotted and the "t's" are crossed. This is particularly important when US investors are involved. Part of this process will be achieved by ensuring that the offering documentation has been reviewed by a US attorney, with a particular brief to consider the tax and regulatory issues.
Having done that, I suggest that there are six main areas of concern, divided into three sub-headings - Regulation, Taxation and Accounting.
 
Regulation
Under "Regulation", you have to consider both the securities laws as promulgated and enforced by the Securities & Exchange Commission ("SEC") and also, in the case of funds that deal in futures, the regulations imposed by the Commodities Futures Trading Commission ("CFTC"), which often are more onerous than SEC regulations. (I suspect that this is because the CFTC always seems to want to flex its muscles, perhaps in order to prove that it is doing something worthwhile, out of fear that Congress is going to cut it off at the knees. But that is an entirely different subject).
 
Taxation
Under "Taxation" there are three areas to be considered.
Firstly, we have to consider the potential tax liabilities to the fund, if it accepts US investors.
Secondly, the tax position for these US investors; and
Thirdly, the potential advantages an offshore fund, if it has been properly structured, can offer investment managers within the context of deferment of fee income. (Although these advantages can apply to investment managers based in many jurisdictions, when I refer to "Investment Managers" in this presentation, I am specifically commenting on US based Investment Managers).
Accounting
The Administrator will have to ensure that the accounts of the fund are prepared to enable the US Investors to make the appropriate tax declarations.
SEC Considerations
Many European Managers and Promoters will not accept the risk of accepting US investors because of the perceived legal quagmire. In fact, to get a non-futures fund structured so that it can accept US investors is not a major task, providing we are discussing a fund that only accepts professional or high net worth, super qualified, super-accredited investors. It will, however, add to the costs. As I say, to structure an equity or securities fund so that it can accept US investors is not a major problem. Nevertheless, the Administrator would want to see the name of an experienced US lawyer on the offering documentation and know that certain matters have been addressed and essential wording has been included in the documentation and checked by that lawyer (now you know why it adds to the cost!).
These will be in a number of areas that need attention including, inter alia:
  1. The Blue Sky disclosures, which differ for each State of the Union in which the fund is to be sold;
  2. The wording on suitability of investors and who may and may not invest, in the context of US persons;
  3. The tax consequences to the fund and to US investors as a result of permitting US investors in the fund;
  4. The subscription documentation;
  5. Reference to Soft Dollar Payments, if applicable; and
  6. The wording relating to the Hot Issues and the necessary Hot Issue Representation Letter that has to be signed by all investors, again, only if applicable.
CFTC Considerations
As I said, none of that is particularly onerous, but it does, however, become a bit more onerous once the fund invests in futures or derivatives. Given that the fund is being sold to High Net Worth and Professional Investors, there is an exemption to the CFTC regulations, which means that the fund does not have to produce full CFTC approved offering documentation. This is the CFTC 4.7 exemption.
There is, however, one particular requirement that has to be followed in order to avail of that exemption and that is that a Commodity Pool Operator has to be appointed to the Fund. Quite often the Commodity Trading Advisor ("CTA") - the Investment Manager of the fund - will be qualified to act as a Commodity Pool Operator.
So in simple terms, providing, as always, that the offering is limited to High Net Worth and Professional Investors, it is not a major problem to accept them into the fund, from a regulatory point of view.
 
Taxation
Tax, however, is another subject altogether.
The major consideration here is the structure of the fund. As I mentioned above, I don't have time to go into all the different considerations, suffice it to say that there are, basically, three structures that you have got to consider from a taxation point of view, if you accept US investors:
  1. Is the fund going to be deemed a Foreign Personal Holding Company, which would be the case if there were five or fewer subscribers, including US subscribers, in the fund.
  2. Is the fund to be deemed a Controlled Foreign Corporation, which would be the case if US persons, each owning at least 10% of the voting shares, owned more than 50% of the entity's shares by value or vote. There also would be tax penalties on any of those US persons who own more than 10% of the equity of the company.
  3. Finally, there is the PFIC or Passive Foreign Investment Company, which the fund is most likely to qualify as, if it accepts US taxpayers as investors.
By the way, there is no problem about accepting US tax exempt investors, providing you have covered the regulatory aspects, however, they will not necessarily wish to invest in the same vehicle as the US tax-payers - I'll come back to that later.
Most US investors invest in partnerships (or partnership-like structures, which are taxed as if they are partnerships) so that the investors become liable to pay tax on the income of that entity on an annual basis. If we, at Custom House, are establishing a fund to accept US tax paying investors, then it is likely that we would, in fact, establish a Master-Feeder Fund structure. This is because US tax paying investors (as opposed to most non-US investors) would want to have a partnership-type structure and this can be done by either establishing a partnership or by "checking the box". This phrase means that, under current US law, you can elect to have the financial records and accounting of a company carried out as if was actually a partnership, whether or not it is a partnership. If you make that selection, then all the shareholders would be taxed as if they were partners, but the company would not, itself, be a taxable entity in the US (which could be the case if it was not set up as a partnership).
A US investor in a PFIC can defer his tax liabilities, but at a high cost. For example, on the sale of the shares he would be paying tax at the higher rate which, I think is currently circa 40% ordinary income tax. Furthermore, he would not get any long-term gains, even if there were any, and the profit would be deemed to be equally spread over the holding period.
Therefore, if a US investor held a position for four years and made 40%, it would deem that he made 10% in the first year and, because he should have paid tax on that at that year-end, he would incur an interest penalty for the three years deferral. In the second year he would have again be deemed to have been due to pay his tax and so he would incur interest on the two years deferral, etc.
This is not attractive.
There is an alternative, which is called a "Qualifying Electing Fund" election, commonly referred to as a "QEF Election". This allows the Investor to look at the character of the income and analyse it between ordinary and long-term gains and pay the tax annually, at ordinary or long-term gain rates, as applicable. The disadvantages are that losses are not rolled forward and they are not "passed through", so that, if you make losses in one year, they can't be offset against other investment income.
In order to make the fund a Qualifying Electing Fund, all the books and records have to be prepared and accounted for in accordance with US tax standards. The fund must be known to the IRS and finally, the IRS reserves the right to look into the fund and inspect its books and records.
This, of course, is going to give the absolute 'screaming abdabs' to foreign investors in the fund, therefore, it is normally incumbent upon whoever is establishing the fund, if they wish to accept US tax paying investors, to establish a Master-Feeder Fund structure. This is a structure whereby one fund - the Master Fund - is established in, say, the Caymans. That fund "checks the box". The Master Fund will accept US taxpaying shareholders and those shareholders will report their income, as if it was a partnership.
The only investor into that fund, other than the US taxpaying shareholders, will be the Feeder Fund. This is a second fund, established, often in the same jurisdiction, to accept non-US investors and US tax exempt investors.
In passing, some advisors prefer a triangular Master-Feeder structure, with an offshore Master fund into which a US partnership (for US taxpayers) feeds. An offshore feeder fund will also be established for non-US investors and US tax exempt investors, which will feed into the Master fund. This has the advantage of completely separating the US taxpayers and non-US investors, but it does add to the administrative costs, just because there are three entities. Furthermore, such a structure may provide a US based Investment Manager with greater US tax planning flexibility.
In summary, the advantages of either Master-Feeder structure are:
  1. To enable US tax paying investors to prepare their accounts and records and reporting in accordance with IRS requirements; and
  2. To protect non-US persons from the roving eye of the IRS and US State Department;
  3. By establishing the Master Fund as a partnership so all US tax payers become individually liable for their taxes and isolating the non-US investors in the Feeder Fund you avoid the risk of the fund being taxed in the US as a separate corporate entity; and finally
In certain circumstances, to enable US tax-exempt investors to avoid UBTI.
UBTI is "Unrelated Business Taxable Income", which can be levied on US tax exempt Investors, if they participate in an "Unrelated Business", which can include certain leveraged or margined transactions. This liability can be avoided if they invest in shares of an investment company, which enters into the transactions, because the tax liability on these transactions will not "pass through" to the investors, as would be the case with a partnership.
Investment Manager Fee Deferral
The third broad area that I referred to earlier, under the heading of "Taxation", is the ability of a US based Investment Manager to defer current tax recognition of its own fee income. The best way to do this for a fund established as a partnership is to have the Investment Manager treated as a "partner" of the Master Fund and for the Investment Manager to receive an "Incentive Allocation" as a partner, as opposed to an "Incentive Fee". In the case of a fund formed as a corporate entity in a tax haven jurisdiction the best way for a US investment manager to do this is to adopt a cash method of tax accounting and enter into a formal agreement with the Fund to defer its incentive fee for a stated period of years with the provision that such deferred fee be paid in the future plus or minus the return of the Fund or some other benchmark return.
This ability to, in effect, reinvest the incentive fee on a pre-tax basis in the fund managed by the Investment Manager with any income thereon also compounding on a pre-tax basis is a powerful tool. However, the US tax laws will prevent most Investment Managers formed as corporations or as partnerships with corporate partners from adopting a cash method of tax accounting. Therefore, this tax planning opportunity is generally limited to individuals and to transparent entities, such as partnerships, comprised only of individual members.
I have greatly simplified the tax issues and the economic analysis and by no means suggest that a fee deferral arrangement will always be the most appropriate structure for every situation. For those funds with a predominate buy and hold strategy with the prospect of realising long-term capital gains, a partnership allocation arrangement may produce a better after-tax result. It goes without saying that you should consult with a US tax law specialist for assistance in this matter.
In the case of an incentive payment structured as a partnership income allocation there are benefits to both the Investment Manager and to the Fund's US individual limited partners.
- First of all, the Investment Manager who is entitled to an incentive payment based upon both the realised and unrealised appreciation of fund assets generally is subject to tax currently only on the realised portion of the incentive allocation. The unrealized portion of the incentive allocation is taxed in the year the underlying investments are sold and gain or loss is realised.
- Second, to the extent that the realised portion of the incentive allocation represents a portion of the Fund's long-term capital gain income, the character of such income passes through to the Investment Manager ( and to its beneficial individual owners) with the potential to be taxed at the lower favourable US capital gains tax rate ( currently 20% ). This arrangement also helps the US taxpaying investor.
It may seem somewhat arcane, but the US tax regulations have a rather extraordinary regulation that says that investment management fees are not deductible by the investor to the extent that those fees exceed 2% of Adjusted Gross Income (and Joel* is here to tell you what that is). What this means is that, if an investor in a fund makes US$100,000 profit on his own interest in that fund and there is a 20% incentive fee, which is deducted, so his net income is US$80,000, he will, nevertheless, be taxed on US$100,000 income, because it is likely that the incentive fees are in excess of 2% of his gross income.
However, if the Investment Manager is shown to have received an "Incentive Allocation" as a partner in the fund, rather than an "Incentive Fee" then the profit within the partnership due to the investor will only be US$80,000 and, therefore, he will only be taxed on US$80,000.
- Finally, in a triangular master-feeder fund structure it is possible to structure the incentive payment at the non-US feeder entity level as a deferred fee and at the US limited partnership feeder entity level as a partnership income allocation.
 
Accounting and Administration Issues
Finally, one brief word on Accounting and some Administration Issues.
In simple terms, the Administrator (with the co-operation of the brokers and auditors of the fund) will be required to prepare the accounts of the Master Fund, so that the US investors have all of the necessary information to complete their tax returns - i.e. provide the K1s, etc.
There are other factors that an Administrator must consider, not only in the context of funds that accept US investors, but perhaps more in the context of the world, post "Long Term Capital". These include such matters as transparency, valuations (particularly in the case of private equity and other illiquid funds) and the amortisation policy of the fund.
Demands from investors for greater transparency is likely to mean that funds will have to provide investors with valuations - or at least estimated valuations - on a daily basis. This will not increase liquidity as redemptions for most hedge funds will still probably be limited to, at the most, monthly redemptions. However, many larger investors may insist upon having access to view the portfolios, so that if the performance declines, or they feel nervous for any other reason, they can hedge the position in the market. Reporting on a daily basis and providing information on a portfolio to investors will probably mean, for many administrators and particularly in the case of the more active and esoteric funds, a technology upgrade.
On the subject of valuations, I will only today that the valuation policy must be clearly stated in the offering documentation and must be carried out independently from the Investment Manager.
Finally, one comment with regard to amortisation. In the past year or so, both the US GAAP and the International Accounting Standards ("IAS") have dictated that the organisational expenses of a fund have to be written off in the first year of operation or in the year which they were incurred. I know that there is a strong technical accounting argument in favour of this policy, but we (and for that matter most people that we have discussed this with) believe that this unfairly penalises the initial shareholders into a fund, particularly if it is a small fund and, furthermore, their penalty is to the benefit of subsequent shareholders, who do not have to bear the set-up costs. We have, therefore, agreed with the auditors of most of the funds that we administer, that the accounts of those funds will be maintained with US GAAP or IAS protocols, as applicable, except with regard to amortisation, which may be deferred and/or extended beyond the deadline imposed under the relevant accounting protocols, at the sole discretion of the directors of the fund. This may result in a minor qualification (i.e. effectively a note) in the accounts, but that will only occur if the sums involved are "material", in the context of the Net Asset Value of the fund. This is unlikely to be the case.
Ladies and Gentlemen, I will finish on that mildly rebellious note - as I mentioned at the beginning of this presentation, these remarks will, by necessity, be only a general overview because of time constraints and as I have now, very definitely, overstayed my welcome, I will sign off.
*Joel Press, Partner of Ernst & Young, NY, moderator of the panel at which this presentation was made.
Dermot S. L. Butler is Chairman of Dublin based Custom House Administration & Corporate Services Limited (formerly Custom House Fund Management Limited), whose primary businesses are helping clients establish their own customised offshore funds and, once established, providing a full administrative service.
Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is authorised by the Financial Regulator, formerly the Central Bank of Ireland, under the Investment Intermediaries Act, 1995.

Tue 02.Nov