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.
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.
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.
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: