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Establishing a first-time fund raises complexities

Before establishing a new fund, you should consider the issues around commercial proposition, tax position and the importance of selecting advisors early in the process.

by Paul McCartney, Transaction Tax partner at Ernst & Young LLP and Alex Pope, Director within the Transaction Tax and Funds Advisory team at Ernst & Young LLP

The global tax and regulatory landscape is rapidly changing — complex tax anti-avoidance rules, new regulations and political uncertainties mean that establishing a first-time fund raises more complexities than ever before.

“Give yourself an advantage by having a clear plan from the start, anticipating the critical questions you’ll need to answer and having a more informed, more holistic approach."

We have drawn on our experience in private funds tax and regulation to identify the key questions we ask every fund founder to consider before setting up their first fund and have provided some insights that may help to answer those questions.

What is the commercial proposition?

In general terms, most of the recent UK and international tax changes applicable to a fund formation project are intended to align the tax consequences with the commercial reality of a fund structure. The majority of key fund structuring decisions will be made on the basis of two critical commercial considerations, each of which directly affects the tax position that would apply to the fund, its investors and the fund management team: the track record of the fund management team and the type and geographic location of the prospective investors.

First, the fund management team’s track record and experience are the basis on which investors will accept the proposed type and location of the new fund’s target investments and its investment strategy. The track record is thus central to setting up a successful fund and will directly affect all other major variables its structure. This includes the geographic location of the fund and its management entity, and accordingly, the regulatory regime applicable to operating the fund.

Second, the type and location of the fund’s target investors will also be a factor in driving the structure, as the various tax positions of investors may result in the establishment of multiple, parallel investment vehicles. Similarly, the target investor base affects the level of regulation that needs to be complied with, particularly in the marketing phase. Restricting the type of target investor — for example, marketing only to sophisticated investors who can meet a minimum investment requirement — can mean that a lower regulatory burden is imposed.

The marketing process is rarely simple, even if the plan is to remain within the European Union (EU). Navigating differing regimes, with or without an Alternative Investment Fund Managers (AIFM) marketing passport, can be time-consuming and costly. Each jurisdiction has a different definition of when it considers marketing to have taken place; some go so far as to include “teaser” materials and early, high-level meetings to discuss the fund. It’s wise to seek advice prior to entering a given market to help confirm that the fund does not run afoul of the country’s local marketing prohibitions.

How can I align the interests of the external investors and the fund’s management?

Fund managers will generally receive carried interest and be expected to participate in co-investment arrangements, which act together to align the interests of the capital-providing investors and the fund management team.

The taxation of carried interest can be complex. Some jurisdictions (such as the UK) have tax regimes that legally define carried interest and impose income tax charges on fund returns that fall outside the definition. An example of this is the disguised investment management fee (DIMF) rules, which aim to tax carried interest returns as trading income where the carried interest investors provide investment advisory services if the carried interest does not fit within the statutory definition. Other UK rules can re-characterize carried interest as income based on the holding period of the underlying investments.

If executives acquire or carry for less than market value, this can trigger employment taxes. It’s therefore prudent to consider valuation, as well as the interplay with the carry structure.

Obtaining advice on the taxation of your carry structure early on — in advance of discussions with potential investors or new team members — is critical to making sure the carry tax rate for the new team does not end up higher than anticipated or considered in initial discussions.

Similar considerations apply to co-investment arrangements.

What is my tax position?

Consider your personal tax position as an entrepreneur: are you in a position to claim the remittance basis of taxation (“non-dom” status, under which funds not remitted to the UK aren’t subject to UK taxation)? Where is the capital coming from to establish the fund? Do you have assets offshore that you might want to repatriate to the UK?

Do you intend to stay resident in one jurisdiction for the duration of the fund? Do you need to plan to respond to changes in underlying investment opportunity, family circumstances or politics? While seeing the future is of course impossible, to the extent that these are known unknowns, they should feature in the fund formation discussion.

Not only will the taxation of carried interest and co-investment be key, but it’s also important to consider your day-to-day remuneration arrangements and how you envision working with the rest of the team. For example, is a limited liability partnership structure appropriate, or is a corporate vehicle with an employer-employee relationship preferable? This decision may be influenced by a desire to roll up fees in the management vehicle to meet co-investment obligations, an arrangement that is often crucial for first-time managers but that is coming under increased scrutiny.

What advisors do we need?

In this new fundraising landscape it’s more important than ever to appoint advisors early on in the process. The regulatory and tax structure of the fund is derived from the first principles of who (investors, team), where (management, marketing) and what (investments). Getting these structures in place early in the fundraising process is the first step along the road to creating a successful fund business.

In today’s tax and regulatory environment, there are more questions than ever facing first-time fundraisers. Obtaining early advice is a sound and proven practice. Give yourself an advantage by having a clear plan from the start, anticipating the critical questions you’ll need to answer and having a more informed, more holistic approach.

How we can help: Transaction Tax Services

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