Many commentators have speculated that this new regulation will drive a wave of ‘redomiciliation’, as funds and managers migrate to more favored locations. There are indeed some grounds for this belief. At the same time, though, the effect may be more muted than expected. And the real impacts on the sector will flow from the complexity of the new environment, and from the drive to minimize tax liabilities and optimize tax reporting and management.
Transparency and stability
One of the key themes behind the developments initiated within the G20 and regional and national frameworks is the need to bring financial transactions, especially those which appear exotic or risky, into more controlled and transparent environments. So derivative over-the-counter trading is being moved onto regulated conventional markets. In the alternative investment sector, ‘offshore’ jurisdictions are being identified in a number of ways and may cause funds and their managers to adopt the constraints of the established onshore financial centers.
In Europe, the new Alternative Investment Fund Managers Directive (AIFMD) is aimed at bringing hedge funds, private equity and other types of funds without a UCITS passport within the scope of regulatory supervision, and of bringing transparency and stability to the way these funds operate. The Commission is concerned to control and minimize a wide range of risks which they believe such funds may present, including:
- macro-prudential (systemic) risks
- micro-prudential risks
- investor protection
- market efficiency and integrity
- impact on market for corporate control
- impact on companies controlled by Alternative Investment Fund Managers and Alternative Investment Funds.
Following approval in principle by the European Parliament, sector specific committees and regulators are now finalizing the details with the expectation that the Directive will be transposed into national law during the first half of 2013. Once AIFMD is in effect, all AIFMs operating on European soil will have to be authorized by the relevant home Member State, and demonstrate that they are suitably qualified to provide AIF management services. AIFMD could have the effect of encouraging fund managers to move to other global financial centers; smaller and start-up funds, traditionally a major source of innovation, may be forced out of business as the cost of the regulatory burden increases.
In the US, the Foreign Account Tax Compliance Act (FATCA) is principally aimed at tightening sanctions against offshore tax abuse (see frontiers in tax May 2011). Under the Act, ‘foreign financial institutions’ (FFIs) will need to identify the direct and indirect owners of their accounts to determine whether they are ‘US accounts’ and, if so, disclose them to the IRS and report annually on each account. FFIs that do not agree to do this will suffer a 30 percent withholding tax on all US withholdable payments.
Among other features, FATCA addresses the perceived excesses of off-shore jurisdictions. These FATCA provisions are in addition to anti-money laundering (AML) and know-your customer (KYC) rules, which are already having an impact on some off-shore funds.
The impact of FATCA will be wide ranging and potentially serious. In some cases it may force changes in firms’ core strategy and business model. The dilemma FACTA poses to the investment fund industry is that making US investments available via non-US-domiciled funds involves many independent operators. FATCA appears to be founded on a different principle: the FFI holding US investments should have all the information necessary, on a stand-alone basis, to comply with the regulations. Faced with the need to introduce new, and potentially costly and complex systems for information gathering and management, some funds may at least be tempted to consider withdrawing from the US market altogether.
Redomiciliation: trends and counter-trends
In the light of these regulatory developments, some commentators conclude that the inevitable consequence of AIFMD is that fund managers will come under increasing pressure to modify their business models and change their domiciliary configuration to comply with and/or avoid the requirements of impending new regulation. In this reading, certain jurisdictions could benefit such as Luxembourg, Ireland and Malta in Europe; the net losers could be traditional off-shore centers such as the British Virgin Islands, Bermuda or the Cayman Islands. Conversely, FATCA may cause hedge fund managers to shed US investors.
In practice however, the impacts are likely to be more nuanced. From a hard commercial perspective, established offshore locations are unlikely to accept an accelerating drift of business away to other jurisdictions. They can also, with some justification, point to solid and valuable experience in fund management, infrastructure and backroom operations. While these may need to be developed in particular directions to comply with forthcoming regulation, this is unlikely to prove prohibitively difficult.
There is a further, more strategic reason why offshore centers are likely to continue to play an important role in fund management, even though it may appear somewhat paradoxical. It is that they are increasingly themselves adopting internationally accepted standards to combat abuse of the financial system. Initiatives such as those mounted by the OECD’s Financial Action Task Force (FATF) have ensured that the implementation of measures to improve transparency and exchange of information has been substantial. These now often stand comparison with those in the best of traditional centers.
Here the various regulatory imperatives which initially may begin to work against each other. If low tax offshore centers increasingly adopt best-practice norms of transparency, disclosure and compliance, then the case for forcing funds and investments away from them is substantially weakened; the impact on domiciliation decisions could be comparably slight. What would be left would be a level playing field, where decisions on domicile may be driven less by considerations of regulatory arbitrage and more by fundamental questions of business models, efficiency and above all perhaps – tax treatment.
Tax and complexity
Hedge funds and their managers are facing a much more complex and demanding environment, whether they are domiciled off-shore or onshore, regardless of whether they are considering moving from one to another. The structural challenges are becoming greater, for example with respect to feeder entities. Greater transparency over tax reporting will impose new and more arduous requirements. FATCA, for example, is not simply about clamping down on tax abuse, but is also directed at improving transparency. Multijurisdictional tax reporting will grow to meet the increasingly stringent requirements of different territorial regimes.
Individual issues of domicile, while strategically important, may not be the most significant issues for funds to address. More challenging could be the changes to operating models, systems and processes which will flow from the new regulatory climate.