This paper explains the benefits of using Guernsey to domicile funds to attract US investors and the differing tax profiles and complexity related to those US investors. The tax requirements, the structuring and the reporting needs for these investors can vary. Sophisticated investment managers need to be sensitive to these variations in order to successfully secure and service allocations of capital from US investors.
Globally recognised as a high-quality international financial centre
Guernsey’s recognition as a secure, stable jurisdiction of substance comes from a number of different accreditations and actions.
- Guernsey has been endorsed by the OECD as a whitelist member of offshore locations for implementing internationally agreed tax standards with no harmful tax regimes and was endorsed by the rating agency Standard & Poor and given an AA-/A- rating.
- In the 2015 assessment by MoneyVal, Guernsey was recognised for its substantially strengthened anti-money laundering and countering the financing of terrorism (AML/CFT) requirements on its financial institutions.
- Guernsey’s regulator for the finance sector, the Guernsey Financial Services Commission (GFSC) brought in new AML/CFT requirements in 2020. This strengthens the security that investors coming into Guernsey funds have been fully assessed against globally recognised standards of AML/CFT.
With a reputation for professionalism across the legal, administration, auditing and insurance sectors, an in-depth knowledge of the funds industry and an offering of innovative structures that attract investors and investment managers, Guernsey remains at the forefront of the funds industry globally. Particularly, Guernsey is a leader in Private Equity and London Stock Exchange listed closed-ended investment companies.
Guernsey domiciled funds contribute to the global economy which is a credential that is widely recognised by US investors. The recent report of Frontier Economics based on data from mid-2019 reviewed capital flows through Guernsey domiciled funds and determined that flows of fees, in particular fees associated with fund management, generated incomes and tax revenues globally. In addition, the tax neutrality of Guernsey helps to maximise returns, including for including for institutional investors.
Guernsey successfully attracts US based investors into Private Equity Funds
At both investor and investment manager levels, Guernsey is considered a jurisdiction of choice for capital flow into Private Equity. In 2019, US investors invested 94.9% of capital flow into Guernsey domiciled Private Equity structures, the next investment structure being debt structures at 2%. In the same period, investment managers based in the US earned around £267 million in fees from their Guernsey-domiciled funds (Frontier Economics, 2020).
Flexible fund structures to suit investor needs
Guernsey has a history of innovation, reacting to investor requirements to be first to launch Protected Cell Companies and Regulated Green Funds.
There are differing fund types and structures available to suit all needs which attracts diverse classes of investors:
Registered Collective Investment Scheme (RCIS)
Fund Vehicle-regulation: Yes, but limited
Category: Open or closed
Fast Track registration/ authorisation: 3 days
Investor restrictions: None
Prescribed investment memorandum contents: Yes – prospectus Rules 2018 apply
AIFMD – eligible for marketing through National Private Placement Regime: Yes
Reporting to GFSC: Limited
Private Investment Fund (PIF)
Fund Vehicle-regulation: Very limited regulation
Category: Open or closed
Fast Track registration/ authorisation: 1 day (fast tracking any general partner licence as well)
Investor restrictions: 50 investors max, 30 new investors per year max; only investors able to sustain loss (unlimited in number when marketing)
Prescribed investment memorandum contents: None
AIFMD – eligible for marketing through National Private Placement Regime: Yes
Reporting to GFSC: Very limited
Manager Led Product (MLP)
Fund Vehicle-regulation: Yes, only through its manager
Category: Open or closed
Fast Track registration/ authorisation: 1 day (fast tracking any general partner licence as well)
Investor restrictions: None
Prescribed investment memorandum contents: Yes (imposed on Guernsey manager)
AIFMD – eligible for marketing through National Private Placement Regime: Yes (+ compliance with Guernsey AIFMD rules)
Reporting to GFSC: Equivalent to AIFMD
Authorised Fund (all classes)
Fund Vehicle-regulation: Yes, varies between classes
Category:
The Authorised Collective Investment Schemes (Class A) Rules 2008 (Class A Fund)
The Authorised Collective Investment Schemes (Class B) Rules 2013 (Class B Fund)
The Collective Investment Schemes (Qualifying Professional Investor Funds) (Class Q) Rules 1998 (Class Q Fund)
The Authorised Closed-Ended Investment Schemes Rules 2008 (ACIS)
Fast Track registration/ authorisation: 3 days (QIF only)
Investor restrictions: No restrictions, other than Class Q and those that elect to be marketed to qualifying professional investors only (QIFs)
Prescribed investment memorandum contents: Yes
AIFMD – eligible for marketing through National Private Placement Regime: Yes
Reporting to GFSC: Limited, unless open ended fund type
Understanding US investor structuring requirements
While a full analysis of all of the complexities of structuring for US investors is beyond the scope of this article, generally, the structuring needs of US taxable investors vs. US tax-exempt investors are nearly diametrically opposed.
For instance, US taxable investors generally prefer to invest in “tax transparent” vehicles that allow for the investor to preserve the tax treatment of the item of income earned by the fund. This is achieved through the use of investment vehicles (such as partnerships) or by making various US tax only elections that treat certain entities as tax transparent (so called “entity classification elections” or “check-the-box elections”). This also potentially helps the US taxpayer free up credits that may be used by the taxpayer in order to credit against a US tax liability generated by the investment.
US tax-exempt investors generally prefer to invest in a “tax opaque” structure such that one or more entities in the structure act as “blockers” in order to absorb any bad income for US tax purposes. Common techniques are to use an entity within a portfolio company structure, create a feeder that acts as a blocker or enable the fund itself to be treated as a blocker for US tax purposes.
For some fund structures where US taxable and tax-exempt investors bear equal weight in consideration, this may lead to complex fund or investment structures to meet the needs of all parties. Alternatively, the fund manager may take a balanced view on what is best for the majority of investors or capital under management and seek to manage their affairs as a priority over smaller investors.
Understanding US investors tax requirements
Tax Profiles of US Investors.
While the tax profiles of US investors can generally be categorized as “taxable” or “tax- exempt”, these classifications can be overly simplistic in terms of designing an attractive fund structure for US investors. While acknowledging this simplified categorization, this can still be a convenient way to think about the populations of US investors-in particular due to the fact that the structuring needs for these two classifications are nearly diametrically opposed with respect to certain aspects of US taxation.
Taxable Investor Profiles.
From a US tax perspective taxable investors can broadly be broken down into two categories- corporates and individuals. As we will explore, certain investors included in this profile will have a mixture of these two profiles- as well as tax- exempt investors even.
a. Corporate Taxpayers
Of the US taxable investor profiles, corporate taxpayers tend to offer larger allocations of capital. This profile would generally include insurance companies or special purpose entities that are required to invest part of the corporation’s individual balance sheet as opposed to pension funds sponsored by the corporation. Corporate taxpayers are currently subject to a flat 21% federal rate of taxation while state and local taxes would apply based on the facts and circumstances of the corporation.
b. Individual Taxpayers
While individual taxpayers generally cannot allocate the largest sums under management to most professional fund managers, the US tax rules applying to this investor profile tend to be the most complicated. Currently, taxable income recognized by US high-rate taxpayers are subject to 37% federal income tax and applicable state and local taxes. However, preferential rates exist for income classified as “long-term” capital gains (i.e. capital gains generated from a holding period of more than twelve months) and “qualified dividend income”. These types of income are currently taxed at 20%. Net investment income from all sources is subject to an additional 3.8% tax for certain individual taxpayers. Additional rules may apply to US individual taxpayers that received allocations attributable to a “carried interest” in the fund.
c. Family Offices
Of the taxable investor profiles, family offices tend to be the most difficult to predict needs for due to the fact that the offices are normally structured in a variety of different ways depending on the family and the family’s needs. While some take on a pure corporate form, others can represent a variety of legal entities and therefore may require a blended approach.
d. Fund-of-Funds
Fund-of-Funds (“FOFs”) are generally structured as tax transparent entities, however due to the fact specific requirements for the FOFs own investor base, this means that there could be a mix of different US taxable investor profiles, US tax-exempt profiles and even non-US investor profiles. As with family offices, it can be hard to predict the specific needs of the FOF without entering into a dialogue with them individually to understand their concerns and requirements.
Tax-Exempt Investor Profiles
While US taxable investor profiles have a number of complex concerns around ensuring the timing and rate of taxation aligns with liquidity events in the fund, tax-exempt investors are generally more straight forward to deal with once you have allowed for some basic planning provisions to meet their needs. However, tax-exempt investors also have a range of profiles requiring slight nuances a fund manager will generally need to be aware of. It is also worth noting that the size of capital under management for this population of investors tends to be much larger than the taxable investor base and so it may be reasonable to assume that this will be the larger population of tax-exempt US investors in a fund’s investor base.
While various tax law provisions exist that grant an exemption to tax for the differing tax-exempt profiles, each profile sources their exemption from a specific set of laws, therefore some differences can arise in comparing the exemptions. As a base, the exemptions available for particular tax-exempt investors generally provide that the investor is exempt from passive types of income such as interest, dividends and capital gains. None of the exemptions allow for trade or business income to be tax-exempt if the trade or business is not directly related to their specific function or purpose of the tax-exempt investor. Therefore most tax-exempt profiles would still be subject to tax on this “Unrelated Business Taxable Income” (“UBTI”).
e. Pension Funds
Of the tax-exempt investor profiles, pension funds are one of the larger asset allocators. This category covers corporate as well as public pensions, however some public pensions claim to be “super” tax-exempt as discussed below. These entities are generally exempt on income subject to the income not being of a trade or business nature, i.e. the income needs to be passive such as interest, dividends or capital gains. However, these investors are subject to tax on UBTI and certain types of debt-financed income.
f. Charities
In addition to pension funds, charities also tend to invest to produce returns for their charitable endeavours. As a result, these institutions are also exempt from US tax subject to the returns being of a passive nature rather than from a trade or business. For organizations granted certain charitable status, a de minimus amount of bad income may jeopardise their entire tax-exempt status and, as a result, this tends to be a “non-negotiable” requirement for their investment. Charities are also generally subject to tax on UBTI.
g. “Super” Tax-Exempt
While corporate and public pension funds generally face the same US tax issues, some public pension funds identify themselves as “super” tax-exempt. These funds are able to claim tax-exempt status via a different set of tax legal provisions and generally maintain that they are not subject to tax on certain types of income that non-public pension funds are, in particular UBTI. They are also generally exempt from the reporting requirements that non-public pension funds are subject to.
Understanding US investor reporting requirements
US taxable investors will likely require a full service when it comes to US tax reporting on their investment. It is typical for an investor to either rely on provisions in the fund’s organizational documents or to separately agree expectations in the side letters related to their investment in the fund. Typical requests include specific types of reporting to be issued by the fund and the timing of any draft or final reporting to be made in order to fit the investor’s timeframe to pay in tax and file returns.
US tax-exempt investors are not completely immune to reporting requirements however it would be generally expected that the requirements are not as severe when compared to US taxable investors. As mentioned above, a number of US tax-exempt investors have a reduced amount of reporting and therefore may need even less than others.
Based on the sensitivity that tax-exempt investors have to UBTI, it is common for these investors to ask for either a full restriction on the production of UBTI or maintain a “reasonable endeavours” or “best efforts” basis to limiting this type of income in the investor’s returns. It is worthwhile noting that this often means that a fund manager will consent to restricting some forms of acquisition financing for portfolio investments. A further topic that generally arises is around the use of bridging financing for investor capital calls as this needs to be strictly monitored when dealing with tax-exempt investors.
Conclusion
The use of Guernsey for structuring solutions which are flexible and accommodating and its appeal to US investors with differing tax profiles are features often acknowledged by investment managers globally and their US investors. BDO assists with understanding in-depth structuring and tax requirements while Carey offers comprehensive administrative solutions and fund launch services.
Produced in partnership with BDO
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References
Carey Olsen. (2019). Table of Guernsey fund structures. careyolsen.com.
Carey Olsen. (2020). Guernsey Authorised Funds. careyolsen.com.
Carey Olsen. (2020). Guernsey Funds: an overview. careyolsen.com.
Committee of Experts on the evaluation of anti-money laundering measures and the financing of terrorism (MoneyVal). (2015). Report on Fourth Assessment Visit - Guernsey. Council of Europe.
Frontier Economics. (2020). Capital Flows: Analysis of Guernsey's Investment Funds Sector. States of Guernsey: Committee for Economic Development.
Organisation for Economic Co-operation and Development. (2021). Country Monitoring - Guernsey. OECD.
The States of Guernsey. (2021). The States of Guernsey welcomes S&P AA-/A- 1+ Ratings affirmation. Gov.gg.