It is timely to look at the current tax and regulatory initiatives and consider their impact on offshore funds and their domiciles.
This is currently a very fluid issue. The volume of information available is vast. We have tried to focus on core considerations with the objective of identifying the most likely outcome as it relates to offshore funds and their domiciles.
Why Use an Offshore Fund?
Most successful hedge fund managers attract, and compete for, international as well as domestic investors. Typically, hedge fund investors are not retail investors but institutional investors such as sovereign wealth funds, pension plans, insurance companies, university endowments and high net worth investors. Whilst many investors are located in the US or the EU, an increasing number are located in South America, the Middle East and Asia.
In considering where to domicile its fund to collect up its international investors, the manager’s primary concern is that it will be acceptable to these potential investors. As such, the manager must consider the location of the investors, including any relevant offering restrictions, the countries in which the fund will invest, the effect of any tax or exchange controls on cash flows through the fund, the confidence, familiarity and preference of the investors and trading counterparties in dealing with the selected domicile, the regulatory position and the quality of the local service providers.
The international investors will want to invest in a tax neutral investment fund. They do not want to invest in a hedge fund based in a jurisdiction where the hedge fund would itself be subject to tax or exchange controls.
The hedge fund, although domiciled in an offshore financial centre (OFC), will still be required to comply with the laws on market manipulation, insider dealing, late trading and short selling in the jurisdictions in which it trades. Additionally, the fund itself will pay tax in jurisdictions where it invests and the investors will be liable to tax in their home jurisdictions in respect of any distributions received.
How Will the Environment Evolve?
These initiatives are very politically charged and driven by the obvious concerns in the US and the EU of the potential leakage of taxable revenues. This issue has received greater prominence recently due to the global recession and the fiscal deficits which have led to actual or threatened increases in tax rates and tax revenue policies.
The current initiatives are not new. The Organisation for Economic Co-operation and Development (OECD) began working on its harmful tax practices project back in 1996. In an OECD 1998 report, four key factors were identified as the basis for classifying a country as a tax haven:
- no or nominal tax on the relevant income (it was accepted that this criteria alone was not sufficient to classify a country as a tax haven);
- no effective exchange of information in respect of taxpayers benefiting from the low tax jurisdiction;
- lack of transparency in the operation of the legislative, legal or administrative provisions; and
- the absence of a requirement that the activity be substantial is important since it suggests that a jurisdiction may be attempting to attract investment or transactions that are purely tax driven.
Subsequent work was done to develop the international standards for transparency and effective exchange of information in tax matters culminating in the development of the 2002 Model Agreement on Exchange of Information on Tax Matters. This model has been used for more than 80 Tax Information Exchange Agreements (TIEAs). This model is now also endorsed by and reflected in the UN Model Tax Convention.
In 2008, the OECD made it known that in June 2009, it would be publishing a “green list” of jurisdictions making good progress. Then the G-20 process leading up to the recent London G-20 summit intervened and the whole issue became subject to extraordinary political pressures.
On 2 April 2009 immediately following the G-20 meeting, the OECD published its latest findings on OFCs. In its report the OECD created three tiers of jurisdictions based on the degree to which each jurisdiction has implemented the agreed international tax standards for information exchange and co-operation. The three tiers are:
- White - those jurisdictions that have substantially implemented the internationally agreed tax standards;
- Grey - those jurisdictions that have committed to the internationally agreed tax standards, but have not yet substantially implemented then; and
- Black - those jurisdictions that have not committed to the internationally agreed tax standards.
Categorisation as White required an OFC to have entered into at least 12 bilateral TIEAs.
The core Ogier jurisdictions of BVI, Cayman, Guernsey and Jersey all fared well: Guernsey and Jersey are listed in the White category and BVI and Cayman in the Grey category - but the fact that both BVI and Cayman have significant additional initiatives in hand should see them re-classified in the White category within a short period of time. The G-20 declaration made on 2 April 2009 confirmed that action will be taken against those jurisdictions which do not meet international standards in relation to tax transparency. The counter-measures outlined included:
- increased disclosure requirements on the part of taxpayers and financial institutions to report transactions involving non-co-operative jurisdictions;
- withholding taxes in respect of a wide variety of payments;
- denying deductions in respect of expense payments to payees resident in a non-co-operative jurisdiction;
- reviewing tax treaty policy;
- asking international institutions and regional development banks to review their investment policies; and
- giving extra weight to the principles of tax transparency and information exchange when designing bilateral aid programs.
The EU contains 27 separate states with a diverse range of social models and political perspectives. Some states are more focused on international financial business than others and it is difficult to build a coherent EU view on tax initiatives by analysing statements from individual member states. However, the UK is the mother country to all the pre-eminent common law OFCs and so it is instructive to analyse its attitude to OFCs in the context of the current international initiatives.
The UK has launched two reviews. The first, the “Turner Report”, was a review of the financial crisis commissioned by the Financial Services Authority and is complete. The Turner Report made it clear that OFCs were not to blame for the financial crisis nor were they a major contributor to it. The second review, being a review of British OFCs (the “Foot Review”), was commissioned by the UK government. The Foot Review will not produce its final report until the end of 2009, but the likely result is a continued push for OFCs to meet international standards of financial regulation, anti-money laundering and the sharing of financial and tax information.
It should not be overlooked that as a result of the implementation of the EU Savings Directive, the EU has had the benefit of a reporting or tax collection agreement with all the leading OFCs (including BVI, Cayman, Guernsey and Jersey). As a result there is reporting and accounting to EU member states of savings income earned by EU nationals outside of their home state. In the evolving environment we may see the scope of the EU Savings Directive expanded to include more than just savings income.
It is expected that a revised draft of the Bill put forward by Senate Finance Committee Chairman Max Baucus will be issued shortly and appears to be gaining more traction than the highly publicised “Stop Tax Haven Abuse Act” put forward by Senator Carl Levin, although we will need to wait and see if some of the Levin proposals may be included in the revised Baucus Bill by way of compromise. The main provisions include:
- extending the statute of limitations from three to six years for the US Inland Revenue Service (“IRS”) tax returns that should have reported offshore transactions;
- extending the paper trail for funds going from the US to offshore;
- requiring foreign bank account reports to be filed with income tax returns;
- those enjoying the use of trust assets such as art work and jewellery will, in future, be considered to be enjoying a trust distribution; and
- fines will be doubled if they relate to certain offshore transactions.
Whereas the Baucus Bill empowers the IRS to close down tax evasion loopholes and imposes additional disclosure obligations on US citizens who use OFCs, the Levin Bill has a much broader ambit and seeks to recharacterise foreign entities managed by US residents as domestic entities for tax purposes. Some of the headline proposals in the Levin Bill are as follows:
- US-controlled foreign corporations will be treated as domestic corporations for tax purposes;
- if a corporation is publicly traded or has assets of US$50 million or more and its management and control occurs primarily in the US, it will be subject to US tax;
- non-US persons will be unable to avoid payment of US taxes on US stock dividends). At present, an offshore fund or other shareholder in a US corporation receives dividends subject to US withholding tax of 30%. This tax has been avoided through swap contracts where the offshore counterparty receives an amount similar to the US dividend, but not the dividend itself;
- expanded tax reporting requirements for offshore investment vehicles, to include reporting relating to US citizens who have formed, sent assets to, received assets from, or benefited from a foreign investment corporation;
- there is a rebuttable presumption against the legitimacy of offshore structures. This will put the burden on the US taxpayer to prove the legitimacy of a structure to the IRS;
- a director, officer or shareholder associated with an offshore entity will be presumed to control that offshore entity, unless it is proved otherwise;
- only legal opinions that are highly likely to survive an IRS review (a 70-75% chance) would continue to shield taxpayers from a significant penalty in the event that the tax arrangement is not accepted;
- there will be increased measures (eg. John Doe summons) to access offshore information; and
- there would be increased penalties for failure to disclose.
The deterious effect of the Levin Bill on US fund managers has been the subject of much industry comment. If foreign investors who place assets with US managers were taxed as if they were US citizens, then it is likely that such investors will allocate their assets to managers based outside the US and may lead to US mangers moving to OFCs so that they can manage their international clients.
It is useful to use the statements from the G-20 Finance Ministers meeting held on 2 April 2009 as a base line for international consensus on these initiatives and to briefly examine developments since then.
In the “Declaration on Strengthening the Financial System” (http://www.G- 20.org/pub_communiques.aspx) issued by the G-20 following that meeting, it was proposed that hedge funds or their managers should be registered (subject to a minimum size, where appropriate) and be required to disclose appropriate information, including use of leverage, on an ongoing basis to supervisors or regulators as necessary for assessment of the systemic risks that they pose, individually or collectively. Hedge funds should be subject to oversight to ensure that they have adequate risk management, and institutions with hedge funds as their counterparties should also have effective risk management. Mechanisms should be put in place to monitor the funds’ leverage and set limits for single counterparty exposures. A newly formed Financial Services Board (FSB) (replacing the Financial Stability Forum) is to develop measures implementing these principles by the end of 2009.
In the meantime, both the EU and the US have announced their own revised regulation proposals rather than wait for the FSB report.
The Alternative Investment Fund Manager Directive (the “Directive”) published at the end of April 2009 by the European Commission for a directive on alternative investment fund managers (AIFMs) provides for the regulation of the managers of alternative investment funds (AIFs) rather than the funds themselves.
The starting point is that AIFMs are within the scope of the proposal and therefore subject to these requirements if they are established in the EU and they manage and administer one or more AIFs that together have either at least €100m in assets (including leverage) or, in the case of AIFs with no leverage and lock-in period for investors of at least five years, €500m in assets. This €500m threshold is likely to be relevant for most private equity fund managers.
Although AIFMs established and authorised in an EU member state under the provisions of the Directive will be granted a passport to market the AIF which they manage to professional investors throughout the EU, AIFMs will only be permitted under the same passport to market in the EU, AIFs which are domiciled outside the EU (such as in the Cayman Islands where approximately 9,500 hedge funds are domiciled) subject to certain conditions, including a requirement that each member state in which such an AIF is to be marketed has entered into a TIEA with the country in which the AIF is domiciled.
This requirement has nothing to do with the regulatory objective of the Directive but rather, as the Commission admits in the Explanatory Memorandum accompanying the draft, it is designed to ensure that tax authorities in the EU may obtain such information from the tax authorities in the country in which an AIF is domiciled as is necessary to enable them to tax investors in the AIF.
The passport to market AIFs domiciled outside the EU will, however, only become available three years after the rest of the Directive has come into force and until then an AIFM domiciled in one member state will be permitted to continue to market AIFs domiciled outside the EU in the other member states under the existing domestic private placement rules currently in force in those member states. It appears that this three year delay was included in the draft at the last minute in response to the French finance minister’s objection that granting the marketing passport to AIF domiciled outside the EU was a “Trojan horse”. During this three year period AIFs domiciled outside the EU will be at a competitive disadvantage when compared to an AIF domiciled in the EU, particularly in countries such as France and Italy which do not currently allow AIFs domiciled outside the EU to be marketed within their borders even on a private placement basis.
The proposal reflects the continuing fundamental difference of opinion between the European Commission and the European Parliament over the benefits and risks of hedge funds and private equity. On the one hand, the European Commission has since 2006 been looking at creating a single (professional) European market for non-UCITS funds. On the other hand, the European Parliament and some member states have a very different agenda, namely to impose much tougher regulation on hedge funds and private equity funds. Until this is resolved, it is difficult to see how a satisfactory directive can be agreed, so the expectation is that the current directive will be heavily amended. There is a two year consultation period and a major lobbying effort against the directive has already been initiated by industry groups such as AIMA, EVCA and the MFA.
The US Department of the Treasury presented its initial proposals on financial regulatory reform on 26 March 2009 (http://www.treas.gov/press/releases/tg7 1.htm), with some specific proposals relating to hedge funds: Registration with the SEC of all advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds above a certain as-yetunspecified size (Private Funds).
Every Private Fund advised by a SEC-registered investment adviser would be subject to investor and counterparty disclosure and regulatory reporting requirements. It is not clear exactly what the regula- tory disclosures would be, but in broad terms they would include information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The information would be reported to the SEC on a confidential basis, but would be shared with the systemic risk regulator, who would use the reports to determine whether the Private Fund could pose a systemic threat and should thus be subject to the stricter capital and risk management requirements imposed on systemically important firms.
In May 2009, AIMA and the MFA, in a reversal that reflects the reality of the new regulated environment, added their support to the registration of investment managers - including hedge fund managers - with the Securities and Exchange Commission pursuant to HR711, a bill sponsored by Representatives Michael Capuano, (D-Mass) and Michael Castle, (R-Del). This Bill would resurrect an SEC rule that took effect in February 2006 before being vacated four months later by the US Court of Appeals for the District of Columbia Circuit.
The House bill is considered the least stringent of several approaches to hedge fund regulation under consideration by Congress. In the Senate, the Hedge Fund Transparency Act, introduced in January by Senators Chuck Grassley, (R-Iowa), and Carl Levin, (D-Mich), focuses on the regulation of fund entities rather than advisers and is strongly opposed by the industry.
Past efforts to bring hedge funds under greater oversight have been opposed by the industry on the grounds that costs would outweigh benefits, given that wealthy hedge fund investors are financially literate and generally less in need of regulatory protection than less sophisticated investors.
The proposals for regulatory reform published by the Obama administration on 17 June 2009 are consistent with the proposals made on 26 March 2009. This is compelling evidence that the Hedge Fund Transparency Act is unlikely to progress.
In light of these changes, will offshore funds still be appropriate? If so, how will offshore funds and their domiciles have to adapt to survive?
What criteria will be applied for an OFC to be an accepted member of the international financial system in the future? Both the current drive for a global standard of regulation and the original OECD criteria published in 1998 (see above) are instructive. For the purposes of this discussion we have used Cayman as the model but the comments mostly also apply to the BVI.
The trans-national co-ordination of regulatory efforts that will be required by the G- 20/FSB mandated regime will lead to a harmonisation of standards. It will be essential that all leading OFCs are members of the International Organisation of Security Commissions (IOSCO) and follow IOSCO’s principles and regulatory guidelines. The International Monetary Fund (IMF) has undertaken reviews of regulatory regimes in leading OFCs, including Cayman, and we can expect more of the same.
Once the revised regulations in both the US and the EU are known and the FSB has published its recommendations at the end of this year, each OFC will need to consider amendments to its regulatory regime. In Cayman, this could mean amendments to the Mutual Funds Law and the Securities Investment Business Law. Possible changes may be needed to provide for the disclosure of material considerations for assessing systemic risk and bringing large private equity funds within the scope of the statute.
to benefit from the marketing passport under the draft EU directive, each OFC will need to have entered into TIEAs with all EU countries into which its funds are generally marketed.
Anti-Money Laundering and Counter- Terrorism Financing
Each OFC will need to continue to meet or exceed international standards as they relate to AML and CTF laws and regulations. In particular, focus may be needed on the level of enforcement of these laws and regulations.
To illustrate the level of commitment that will be required it is helpful to look at Cayman’s standards as an example. Cayman is a member of the CFATC, itself an Associate Member of the Financial Action Task Force (FATF). By joining CFATF, CFATF members
“agree to adopt and implement the 1988 UN Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances; endorse and implement the FATF Forty Recommendations and the CFATF Nineteen Recommendations; fulfil the obligations expressed in the Kingston Declaration as well as, where applicable, in the Plan of Action of the Summit of the Americas; and to adopt and implement any other measures for the prevention and control of the laundering of the proceeds of all serious crimes as defined by the laws of each Member.”
The Cayman Islands therefore, have appropriate and internationally endorsed standards and frameworks in place in order to tackle financial crime, such as money laundering. AIMA has developed a Guidance Note for its membership, setting out applicable Anti-Money Laundering measures, which are in place in a number of the more important hedge fund jurisdictions. Cayman Islands have been represented in this work since the outset in 2007 and the BVI was added in 2008 - this Guidance Note is available to regulatory contacts through AIMA’s website (www.aima.org).
Transparency - Access by Revenue Authorities
The initial focus of OFCs will be to appear on the OECD White list. Statements made by the OECD indicate that no counter-measures will be suggested or deployed for twelve months. There is little doubt that both BVI and Cayman will move to the White list within that time period. There is also no doubt that the criteria for appearing on the White list will be updated over time. The OECD’s stated aim is a system of automatic multi-lateral exchange of information.
Beyond considering a system for the automatic multi-lateral exchange of information OFCs will also need to consider amendments to the qualified intermediary programme with the IRS and changes to the European Union Savings Directive. Once the new tax transparency architecture (i.e., the tax exchange agreements) are in place, there will be ongoing international pressure to ensure that the exchange of information is actually taking place.
Transparency - Regulator to Regulator
Once the new regulatory regimes become clearer, amendments to the relevant laws and regulations may be needed to permit the regulator in the OFC to share information with other regulators on an expedited basis, where that information is relevant to assessing systemic risk.
Looking at Cayman by way of illustration, the Cayman Islands Monetary Authority (CIMA) has a statutory obligation and wide associated powers to co-operate with international counterparts. The Monetary Authority Law of the Cayman Islands lists the provision of assistance to overseas regulatory authorities as one of CIMA’s principal functions. CIMA has a network of co-operation and sharing of information agreements with onshore regulators, such as the FSA in the UK, the SEC and CFTC in the US and the CVM in Brazil. We would expect to see the regulators of each leading OFC enter into such agreements with their onshore counterparts.
Further, CIMA’s website sets out publicly (http://www.cimoney.com.ky/section/regulatoryframework) the list of the various Memoranda of Understanding and Undertakings for Sharing of Information into which the Authority has entered - including with the UK FSA, the US CFTC and the SEC.
This criterion is the most difficult to gauge. We expect to see the leading OFCs attract more substantial activity to their shores. A number of OFCs require some activity (beyond the simple provision of the registered office of the fund) to take place in the OFC. For example, Cayman funds registered with CIMA require a locally licensed auditor and many utilise Cayman resident directors and administrators. The ongoing accretion of skilled human capital to service the funds in their domiciles is likely to be a key business aim for a successful OFC.
A Brave New World?
The international financial system and the onshore economies and OFCs that participate in cross-border capital flows will all be more tightly regulated in the near future. We are living in a time of fast environmental change; it is interesting to compare the lexicon of the age as it applies to the ecological as well as the financial environment. Terms such as “global warming” and “financial meltdown” abound.
Despite the initial (and still ongoing) conflicts between competing tax and regulatory initiatives, a broad consensus seems to be emerging. States, whether they are islands in the sun or mountainous and land locked, cannot pursue a business model based on opacity. Transparency is the new paradigm and a key distinction is being made between structuring OFCs (such as BVI, Cayman, Guernsey and Jersey) and “tax havens” whose principal attractions are discreet personal bankers and strict secrecy laws. The reports and reviews being conducted by national and international agencies (such as the Foot Report) are contributing to a better understanding of the role of well-regulated OFCs in areas of international finance, such as hedge funds and private equity. This learning process will help inform legislators and should assist in ensuring that legislation is proportionate and specific. We are encouraged that, for example, in the US the Baucus Bill seems to be favoured over the Levin Bill and we are hopeful that an informed debate will improve the proposed EU Directive on Alternative Investment Funds. As the discussions continue, the conflation of tax issues and regulatory issues is receding and more tailored and workable proposals are (slowly) evolving.
The likely result of the current international initiatives is that the number of OFCs, but not the level of transactional flow, will shrink over the next five years as the worldwide crackdown on tax havens gathers pace. This will be the result of smaller OFCs being unable to afford implementation of the increasingly tougher regulatory and disclosure rules to meet global standards.
We suspect that whilst the G-20, through the new FSB, may produce a report outlining a global standard of regulatory principles (which OFCs will need to adhere to), detailed harmonisation is not close as, for example, the US and the EU, will end up with regulatory regimes that differ.
Structuring of operations to gain access to markets and investors will be even more important in the new world. It may be that it will be beneficial to split operations such that US investors are collected and managed in the US, EU investors are collected and managed in the EU and that other international investors are collected and managed in an OFC.
The world is changing and the leading OFCs and offshore funds and managers that use them can and will successfully adapt.