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AIFMD: Beware the tax impacts:

Interviewers Opening Remarks

In November 2010, the European Parliament approved the Alternative Investment Fund Managers Directive, known as the AIFMD, as part of its efforts to improve the overall stability of the financial system. Its aim is to introduce higher regulatory standards and to improve transparency and consistency in the management and operation of alternative funds -- which are those outside the Undertakings for Collective Investments in Transferable Securities, or UCITS, framework.


While the Directive does not target tax issues, it will stimulate strategic business decisions that could raise serious tax issues that companies will need to factor into their planning.


Joining me today to provide their insights on the impact of AIFMD and its tax implications are Nathalie Dogniez and Georges Bock from KPMG in Luxembourg, Seamus Hand from KPMG in Ireland, and Dan Roman from KPMG in the United Kingdom.


Interviewers

To start things off, could you provide us with an overview of the AIFMD? What are its objectives and how is it designed to achieve those goals?


Nathalie

The AIFMD creates an authorizing and monitoring regime for managers of non-UCITS funds. By this we mean alternative funds but also traditional funds that have not adopted the UCITS form. So, it will apply to all fund managers established in the EU or a manager from outside of the EU who manages non-UCITS funds as well as those who use or market non-UCITS funds in EU. The fund managers will have to adapt and to change their operating model to ensure compliance with the Directive and the Implementing Measures. It is therefore an opportunity to review the structure of their European business and to align it with their product manufacturing and marketing strategy. The scope of the Directive may reach further than what is immediately apparent. For instance, in Germany, the authority uses AIFMD to enact a complete new regulatory law for both UCITS and alternative investment funds and their managers. Another example, existing unregulated investment structures meeting the definition of an Alternative Investment Fund will now be coned off by regulatory requirements.


Interviewer

Even though the Directive isn’t about tax, fund managers will need to take tax considerations into account in developing their compliance strategy. What particular tax and business issues does the Directive raise?


Dan

Many of the strategic and operational issues that fund managers will need to consider in their response to AIFMD will clearly have significant tax issues. The directive isn’t principally a tax directive and we've heard about many of the things fund managers will need to think about. But they will clearly need to assess tax implications on future operating models. And one of the key areas for strategic decision-making is going to be that of the domicile or residency, both of the fund itself but more importantly, of the manager. This is because the residents of the manager will impact, well, it will impact on both European and non-European managers. For example, fund managers outside the EU who wish to distribute funds within the EU may consider appointing a European manager, or set up a European fund. Similarly, EU operations will need to determine or review where the fund and its manager should be located and whether that is a different jurisdiction within the EU or whether that involves moving altogether outside the EU. Clearly these aren't straightforward decisions or issues, and there will be commercial constraints on what managers may be able to achieve.


Interviewer

Most fund structures aim for tax neutrality, avoiding double taxation through the use of tax treaties. How will the Directive effect the ability to achieve treaty relief?


Seamus

The tax treatment of a fund from a treaty perspective is generally based on facts and circumstances and essentially looks to where the fund is effectively managed. It's important that the activities of the investment manager are consistent with these tax requirements to ensure that the fund is effectively managed in the jurisdiction of its residents. Under the AIFMD the implications in terms of activities of the manager and how they will be carried out could influence that question and where the effective management is exercised. For example, in an offshore fund such as a Cayman fund, there is a risk that the activities of an EU AIFM could result in that fund being effectively managed in the jurisdiction of the AIFM. Alternatively, where you have an onshore fund located in the EU which is intended to be resident in a jurisdiction and entitled to a tax treaty network in that jurisdiction for example, a QIF or a SIF in Ireland or Luxembourg, the activities of an AIFM could again result in the effective management being carried on in a different jurisdiction and thus mean that the fund would not be entitled to the benefits of that Irish or Luxembourg tax treaty network in that example. In addition, it is necessary to consider whether the activities of an AIFM could result in a tax exposure in the jurisdiction of the AIFM even where the AIF is not held to be resident in that jurisdiction but rather the fund is held to have a taxable presence in the form of a permanent establishment in that jurisdiction. We are also seeing an increasing number of AIF's looking at the broad implications of the AIFMD and considering whether it does lead, from a tax perspective, to a preference for the use of an onshore AIF as opposed to an offshore AIF. While this could generally be beneficial and result in lower tax exposures including those described, it is worth noting that such preferences are typically driven by non tax reasons, particularly where there would be an investor preference for a regulated fund.


Interviewer

And beyond income tax, the AIFMD will also create indirect issues. What are the implications of the rules in terms of VAT?


Georges

Well, the main question when it comes to VAT is what is the cost to operate on the AIFMD platform. And in determining the cost there are two elements; one is the overall nominal rate that is applicable; the second is is there a recovery that is applicable or is there an exemption that is applicable. In many countries, funds that are subject to supervision of a regulatory body like the UCITS, those benefit from an exemption when it comes to the delivery of management services but that is at the cost of not recovering input VAT. That can be of major importance when it comes to alternative classes like real estate, arts and wine where the recovery is very important. Now, we speak about cross-border activity and so it is very important to find out what is the location of taxation of an operational service delivery and the rule there says that, generally speaking, it is the place with the fund is located. So what is very important is that in considering your decision where to establish the fund you would have to look at the best rates applicable in those. Last but not least, just to make it also clear, from time to time the exception to the principle of location of the fund, and that is more specifically in asset classes like real estate where the property is the leading characteristic to define, where the service is taxable. And then as a result the location, the choosing of the location of the fund, is an important factor as we have VAT rates varying in Europe from 15% in Luxembourg, for example, to 27% in Hungary and it is very important to analyse that question before you decide where to implement your funds.


Interviewer

Obviously, managers will need to carefully consider the future structure, operation and location of their business under AIFMD. What are some of the key questions that managers will need to answer?


Nathalie

Well, first managers will have to take strategic decisions such as:


  • Who will become the fund manager?
  • Where should the manager be most effectively located?
  • Should the model be to maintain just one global fund manager in a given country and reduce the number of managers or the number of management companies in other countries? Or is it better to maintain one manager per fund as a means of managing complexity or liability risks?
  • Should there be one global manager but with branches in various fund jurisdictions?
  • What will be the impact of existing set-ups on the manager’s location? For instance, could the existence of a Luxembourg or an Irish UCITS management company influence the decision to also locate the manager in Luxembourg or in Ireland?
  • Should functions such as central administration be outsourced?

Then, once all strategic decision have been taken, the Manager will also have to align their processes to the new requirements. By processes we mean, portfolio investment, risk management, reporting. And here, again, at this operational stage, tax implications should be considered. For instance, managers need to think about how delegation should be organized and the related potential tax implications linked to the substance question. It’s also important, as we've just said, to consider possible VAT implications when restructuring processes and drafting new contracts between the manager, the funds and the delegate (such as investment managers) and the service providers, in order to ensure that the new structure remains efficient from a VAT standpoint.


Interviewer

Fund managers obviously have their work cut out for them as they prepare themselves and their funds for the Directive’s implementation. Before we sign off, do you have any final words of advice for our listeners on this topic?


Georges

The Directive, for sure, is going to profoundly affect the alternative investment market in Europe and beyond and will lead to a fundamental review of structures, business models and operations and that's both for EU-domiciled funds as well as for non-EU domiciled funds. This is going to be even increased to the effect that going forward we expect further restrictions in the EU on private placement regimes. In determining their response, the funds and fund managers have they must clearly pay attention, of course, to the fundamental factors governing their businesses. So first there must be a good business setup. But in doing so, one should not forget about tax as tax might have a very significant implication on the decision. Then we would say last but not least, AIFMD could be seen as burden or as an opportunity. We in KPMG, we see signs and we strongly believe it’s more about and opportunity than about a burden as the AIFMD is going to create a passport in the EU for distribution of Alternative Investment Funds. And several indicators and several reasons make us believe that AIFMD is going to be not only European brand but a globally recognised brand and first movers will, for sure, have a better reward than the ones that are following.


Interviewer

Thank you Nathalie, Dan, Seamus and Georges.


Listeners can find more details on this topic in the December 2012 edition of KPMG’s frontiers in tax publication. Other podcasts in this series include the impact of regulatory responses on financial institutions in the Asia-Pacific region.


Thank you and we look forward to you joining us again next time.

AIFMD: Beware the tax impacts 

In November 2010, the European Parliament approved the Alternative Investment Fund Managers Directive (AIFMD). Its aim is to introduce higher regulatory standards and to improve transparency and consistency in the way alternative funds – those outside the Undertakings for Collective Investments in Transferable Securities (UCITS) framework – are managed and operated. To this extent, AIFMD sits firmly within the context of improving the overall stability of the financial system.

With the Directive approved, the focus in coming months will be on the forthcoming ‘Level 2’ measures covering technical details.


The Directive is expected to be implemented into national law in Member States by 22 July 2013. AIFMD creates an authorizing and monitoring regime for managers of alternative funds. It will apply to all alternative fund managers established in the EU or which manage EU alternative funds from outside the EU. In order to comply with the AIFMD rules, fund managers will have to adapt, and change their operating model to ensure compliance with the Directive and the Implementing Measures. It should be noted that the scope of the Directive may reach further than is immediately apparent: for example, traditional investment management companies with a holding company structure may find that other parts of their business draw them into the AIFMD net inadvertently. Further, Germany for example uses AIFMD to enact a complete new regulatory law for both UCITS and alternative investment funds and their managers (so-called “Kapitalanlagengesetzbuch”).

AIFMD and tax

The Directive is not principally concerned with tax at all. However, many of the strategic and operational issues which fund managers need to consider in responding to it will have significant tax implications which need to be taken into account in developing a compliance strategy. Fund managers will need to focus not only on complying with the new regulatory requirements themselves (for risk management, portfolio management, liquidity control, remuneration policies, conflict of interest, delegation requirements etc.); they will also need to assess the potential tax implications for their future operating models.


One of the key areas for strategic decision-making raised by AIFMD is that of domicile or residency, both of a fund itself and of its manager. This will impact on both European and non- European managers: fund managers outside the EU who wish to distribute funds within the EU may choose to appoint a European manager, or set up a European fund; AIFMD-compliant EU operations will need to determine or review where the fund and its manager should be located. These are not straightforward decisions and there will be substantive constraints on what managers may be able to achieve.


Most fund structures aim to achieve tax neutrality, avoiding double taxation through the application of tax treaties. As far as fund manager taxation is concerned, the objective is to receive management and advisory fees in a country with moderate income taxation and, if possible, in a VAT-neutral manner.


However, while the Directive will create a level playing field for fund management across Europe, including EU passporting, the tax treatment of funds and managers will remain the prerogative of national fiscal authorities. Tax considerations will therefore be increasingly important in determining location and residency.

Residency

Depending on circumstances, the inconsistency between AIFMD and tax treatments may offer fund managers double exemption from tax, threaten double tax liability, or generate a complex and unpredictable tax regime.


From a tax point of view, a fund is generally tax resident where it is effectively managed; this is a matter of fact and of substance. Tax residency claims are increasingly being challenged by foreign tax authorities on grounds of substance. They may seek to deny the application of tax treaties by trying to demonstrate, for example, that a Luxembourg company (with a holding, financing or management activity) is effectively managed from outside of Luxembourg, for example in Germany, and therefore taxable there. Alternatively, while not challenging the basic tax residency as such, they may argue that the company has a taxable presence (in the form of a permanent establishment) in their jurisdiction, creating a liability to tax on a significant part of the profits.

VAT

A further important consideration is that of VAT. In many circumstances, funds subject to the supervision of a regulatory body (such as UCITS funds) are not able to reclaim VAT but benefit from a VAT exemption for management services, whereas alternative funds may reclaim VAT depending on their activity but do not benefit from the VAT exemption for management services (to be verified in each Member State involved).


Depending on how AIFMD will be implemented in each Member State, it should be verified the extent to which the input VAT recovery right of alternative funds and the VAT exemption for management services should be affected, i.e. whether alternative funds are covered by the exemption or not.


If the fund is considered as a taxable person for VAT purposes, the services received by a fund from a supplier established outside the country where the fund is established are generally deemed to be located where the fund is established and the VAT applicable (unless a VAT exemption is given) should therefore be that of its country of establishment. However, exceptions may apply for real estate funds where property related services are provided.


Hence, it is relevant to carefully choose the location of a fund considering that VAT rates vary significantly across the EU, from 15 percent in Luxembourg to 27 percent in Hungary at the basic rate; a wide range of reduced rates and exemptions also exists.

Consequences

The obvious conclusion is that fund managers need to consider in depth the future structure and operation of their business under AIFMD, and determine the appropriate location and domiciliary characteristics, both from a strategic and from a tax perspective, bearing in mind that the tax treatment will depend on real issues of substance and not simply on formal legal structures. Critical questions which will need to be answered include:


  • Who will become the AIFM? Where should the AIFM be most effectively located? Should the model be to maintain just one global AIFM in a given country and reduce the number of AIF managers and/or management companies in other countries; or maintain one manager per fund as a means of managing complexity or liability risks?
  • Should there be one global AIFM with branches in various fund jurisdictions? Are we likely to see more self managed funds (the AIFM being then the AIF itself) to facilitate tax planning?
  • What will be the impact of existing set-ups on the AIFM location? Could for example the existence of a Luxembourg UCITS management company influence the decision to also locate the AIFM in Luxembourg?
  • Should central administration functions be outsourced? Could certain (smaller) fund managers decide for costs reasons to use a readily available AIFMD-compliant architecture implemented by another (larger) fund manager, and could we see more master/feeder structures in the future?
  • Are the fund products offered by the fund manager still efficient and marketable under the AIFMD or does the fund manager need to think about new fund products and business models?

Systems and process issues will also be important: since tax residency and related substance aspects depend on facts and circumstances, documenting processes and decision-making policy will be essential (for example, who does what and report to whom, where are decisions prepared and taken, how is delegation organized in practice?). In a similar fashion, how should delegation be organized and what might be the tax implications? Is risk management likely to be delegated more easily than portfolio management (for tax and strategic purposes the latter may be kept as a direct and more centralized function of the AIFM)? Managers should consider the potential difference between control and substance under national tax regimes and under the definition of the AIFMD, the definitions can be contradicting to each other and should be identified and dealt with during the strategic decision-taking process when identifying the AIFM set up and required passport regime. The second possible tax related issue that needs to be considered together with the identification of the location of the AIFM is possible VAT implications when restructuring processes and drafting of contracts between the AIFM, the AIF’s, the delegate (such as investment managers) and service providers take place, in order to ensure that the structure remains efficient from a VAT standpoint.


The AIFM Directive will have a profound impact on the alternative investment market in Europe, and will necessarily lead to a fundamental review of structures, business models and operations, both for EU-domiciled funds and others. In determining their response to the new environment, funds and fund managers must clearly pay prime attention to the fundamental factors governing their business. But in doing so, they must not neglect the significant tax implications of the decisions they will be contemplating.


The upside is that AIFMD will provide an opportunity and a stimulus to rationalize structures, operations and responsibilities. As ever with the wave of new regulation directed at the financial services industry, the companies which will gain the most advantage will be those who identify the routes to streamlined operations and the most effective new business models.


For further information, please contact:

Georges Bock

Partner
KPMG in Luxembourg

Tel: +35 222 5151 5522

Ravi Beegun

Partner
KPMG in Luxembourg

Tel: +352 22 51 51 - 6248

Seamus Hand

Partner
KPMG in Ireland

Tel: +353 1410 1437

Jürgen Bauderer

Partner
KPMG in Germany

Tel: +49 89 9282 1544

Heleen Rietdijk

Senior Manager
KPMG in the UK

Tel: +44 20 7694 4510

Dan Roman

Partner
KPMG in the UK

Tel: +44 20 7694 5726

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