By Anthony J. Tuths, JD, LLM, Partner, [email protected]
TAX PLANNING FOR THE ALTERNATIVE FUND MANAGER
Being an advisor to the alternative investment industry allows me to observe recurring issues
that leaders take into account, such as governmental regulation, investor preferences and
idiosyncratic asset problems. There is a constant issue which fund managers are always eager
to discuss, and that is the taxation of their own compensation.
Within the asset management arena there are several strategies
that managers employ to limit their global tax burden. In this
article I will briefly describe several accepted methods managers
can employ to legally reduce their U.S. tax costs including:
1.
2.
3.
4.
Affirmatively using the PFIC rules
Off-shore reinsurance companies
Private placement life insurance
Expatriation
AFFIRMATIVE USE OF PFIC RULES
U.S. investors, including U.S taxable fund managers, in alternative
investment funds, almost universally, invest into a U.S. master fund
or a U.S. feeder fund. If such U.S. persons were to invest through
the foreign feeder fund, they would be treated as holding an
interest in a passive foreign investment company (a “PFIC”). PFIC
investments are normally viewed as undesirable for a number
of reasons, namely that capital gains from a foreign feeder fund
do not flow through to the investor unless a special election is
made (QEF, or Qualified Electing Fund, election). Without a
QEF election, tax is deferred until distributions are received from
the fund or the fund units are disposed. Then, all appreciation /
distributions are taxed at the highest ordinary income rates and an
“underpayment” interest charge is applied to the tax amount.
Nevertheless, in the asset management realm there is the
possibility of using the PFIC rules in an affirmative posture. A U.S.
fund manager can invest through the off-shore feeder and gain
tax deferral for many years. When the manager eventually cashes
out there will be tax at ordinary rates with interest as though
the income had been earned ratably over the manager’s holding
period. Moreover, using a PFIC allows the U.S. investor to avoid
limitations on deductions (at both the federal and state level),
interest expense, capital losses, wash sales and straddles. For
funds that would otherwise produce long term capital gains on a
regular basis this strategy may not be advisable but for all others
it is worth considering.
OFF-SHORE REINSURANCE COMPANY
Many large U.S. based fund managers have created off-shore
reinsurance companies, converting ordinary income into long
term capital gain in order to gain a tax rate advantage. In order to
achieve this, the fund manager will work in tandem with a non-U.S.
partner, typically a reinsurance company. The non-U.S. party owns
a portion of the reinsurance company to ensure it is not treated as
a controlled foreign corporation (a “CFC”) for U.S. tax purposes.
The new reinsurance company then begins writing reinsurance
policies and collecting premiums. The initial share capital of the
company plus the insurance premiums collected are invested into
the manager’s fund(s). The fact that the company takes on real
insurance risk and operates a true reinsurance business means that
the company will not constitute a PFIC and unlimited tax deferral is
permitted.
U.S. investors are able to buy shares in the reinsurance company
with the ultimate goal of taking the reinsurer public and providing
investors liquidity in the market. Once publicly registered, the fund
is open to retail investor money, not just qualified purchasers. The
investors have no tax liabilities (absent any dividend distributions)
until they dispose of their shares. When they finally do exit the
investment they will have long-term capital gains (assuming a
minimum one year holding period). The fund manager may also be
an investor in the reinsurance company
PRIVATE PLACEMENT LIFE INSURANCE (“PPLI”)
If you’ve ever been introduced to a variable life insurance policy
then you can quickly understand Private Placement Life Insurance
(PPLI). With variable life policies the insured pays a premium and
part of the payment covers a standard death benefit amount while
the remainder is invested. The policy offers myriad investment
options - typically mutual funds. The invested amounts are able to
grow tax deferred inside the insurance policy. PPLI works the same
way except that the investment portion goes into selected private
investments as opposed to publicly registered mutual funds. These
investment options can range from hedge funds to real estate
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to art. Moreover, the investment option can be one the insured
creates —an insurance dedicated fund or “IDF.”
The tax benefits associated with PPLI are incomparable. The cash
investment amount grows tax deferred and invested amounts can
be borrowed at any time with proper arrangements. However,
there is a fine line between legitimate PPLI and illegal tax evasion.
Any manager investigating a PPLI policy should enlist the
assistance of tax professional knowledgeable of the issues created
by PPLI.
EXPATRIATION
Expatriation means to give up one’s citizenship. In tax terms
expatriation comes in two flavors: full or partial. In full expatriation
a fund manager would physically leave the U.S. and give up his or
her U.S. passport. The expatriation would have to be disclosed
to the U.S. government and there would be an exit tax imposed
on the individual. The individual’s assets are treated as sold for
fair market value on the day before the expatriation and taxed
accordingly. The first $600,000 of gain (adjusted for inflation)
is permitted to escape tax. Thereafter, the individual would be
treated as a non-resident for both tax and immigration purposes.
Partial expatriation is a relatively new concept and involves the
U.S. fund manager relocating to a U.S. territory like Puerto Rico.
In this case, the individual is able to keep his or her U.S. passport
and U.S. citizenship. However, the individual will take advantage of
special U.S. tax rules for territories. In the case of Puerto Rico this
can be compelling for an asset manager. The island’s government
has special tax programs available for asset managers designed to
encourage relocation. Under current law, managers relocating to
Puerto Rico can achieve a zero percent capital gains tax rate and
a 4% tax rate on management fees. Moreover, the manager will
escape state tax.
CONCLUSION
The fact that asset management is an advisory function which is
highly mobile creates unique tax planning opportunities. These
planning options are valuable and should be used, but never
abused. Shortcuts, slipshod planning and questionable techniques
have no place in tax planning. Always consult with an experienced
and reputable tax planner before undertaking any tax reduction
strategies.
HELPING A FRIEND OR ACTING AS AN UNREGISTERED BROKER-DEALER?
By Brian Wallace, CPA, Partner, [email protected]
Recent crackdowns, by the SEC, have put one
question at the top of many fund managers’ and
investors’ minds: When are ‘finders’ required to
be registered as broker-dealers? Not an easy
question and one that must be approached with
caution and proper education.
According to the Securities Exchange Act of
1934 (“Exchange Act”), any person who effects
securities transactions in the U.S is required to register as a
broker dealer, unless that individual is an associated person of a
registered broker dealer. That’s a pretty broad definition and one
that has caused some serious headaches to friends of start-ups
and private fund managers.
CONSIDER THE FOLLOWING SCENARIO
You are a partner in a law firm who works in the areas of trust and
estate law. By nature of your practice your clients are primarily
high net worth individuals (translation - accredited investors). A
good “friend” of yours is starting a technology company based
around some social media application and he is looking to raise
some capital. He asks for your help and you agree to present this
opportunity to some of your clients.
From a regulatory perspective, you’ve acted within the law to
this point. (Ethically, the area is grey.) Where things start to get
cloudy, and where the SEC, catching on, has taken up recent
enforcement actions, is if you go beyond this point.
For example, suppose you provide your clients with some fact
sheets surrounding the potential investment and tell them a little
about the company they may be investing in —The SEC
will raise their eyebrows.
Now, let’s take it a step further and consider the same
scenario but you get compensated for your investor
referral. If you are compensated with a one-time flat fee,
regardless of the company’s success: you are probably
okay. However, taking compensation based on the
amount raised or anything contingent on the success
of the transaction without a broker-dealer license can land you in
some hot water. Recently the SEC has been quoted as saying that
even a single instance of transaction-based compensation may be
enough to find that an individual was “engaged in the business” of
a broker activity, and subject to registration or penalities for failing
to hold registration.
Finally, suppose this isn’t the only “friend” you have done this
for. In fact every year a “friend” comes to you with a similar
opportunity. Guess what? In industry terms, you are what
is commonly referred to as a “finder:” someone who assists
companies and private fund managers in raising capital. And you
are required to be registered as a broker-dealer.
The penalties associated with acting as an unregistered brokerdealer can be severe. Thus, care must be taken when “helping”
your “friends” find investors. Finder compensation agreements
need to be properly structured and the scope of services needs
to be clearly defined with activities limited to merely making
introductions. In matters even remotely breaching the realm of
federal securities regulations, it’s always best to consult with legal
and compliance professionals before crossing that line.
“Employing Finders and Solicitors: Proceed with Caution.” Morgan Lewis: Venture Capital & Private Equity Funds Deskbook Series, www.morganlewis.com. | “Finders” and the “Issuer’s Exemption:” The SEC Sheds New Light on an Old Subject. Latham&Watkins Client Alert, no. 1503 (7/24/2013):1-7
FASB ISSUES NEW GUIDANCE FOR INVESTMENT COMPANIES
By Frank R. Boutillette - CPA/ABV, CGMA, Partner [email protected]
In June 2013, the Financial Standards Accounting Standards
Board (FASB) issued Accounting Standard Update (ASU) No.
2013-08, Financial Services – Investment Companies (Topic
946) Amendments to the Scope, Measurement and Disclosure
Requirements. This amendment was the joint effort of the FASB
and the International Accounting Standards Board (IASB). The
IASB is responsible for International Financial Report Standards
(IFRS). Together the FASB and the IASB have been working to
merge their respective standards into one cohesive and uniform
standard.
Under U.S Generally Accepted Accounting Principles (GAAP),
investment companies typically measure their investments at fair
value, including controlling financial interests in investees that are
not investment companies. In contrast, IFRS did not include the
concept of an investment company.
The main provisions of this amendment are as follows: to clarify
the definition of an investment company, requirement of all
investment companies to measure non-controlling ownership
interests in other investment companies at fair value, and required
additional disclosures for investment companies.
Under this new ASU 2013-08, an entity will be required to meet
the following fundamental characteristics to be considered an
investment company:
Obtain funds from one or more investors and provide the
investor(s) with investment management services.
The entity commits to its investors that its business purpose and
only substantive activities are investing for returns solely from
capital appreciation, investment income or both.
The entity and its affiliates do not obtain, or have the objective of
obtaining, returns or benefits from an investee or its affiliates that
are not attributable to ownership interests or that are other than
capital appreciation or investment income.
After consideration of the fundamental characteristics, the
following typical characteristics may be considered:
• Multiple investments
• Multiple investors
• Investors that are not related to the parent entity or the
investment manager
• Ownership interests in the form of equity or partnership
interests
• Fair value management of investments
The absence of one or more of the above typical characteristics
does not necessarily preclude an entity from being an investment
company.
Under this amendment, an entity that is regulated as an
investment company under the Investment Company Act of 1940
does not need to undergo an assessment. An entity should make
an initial determination of its status under this guidance. It will
only need to reassess whether it meets or does not meet the
guidance if there is a subsequent change in the purpose of the
entity or if the entity is no longer regulated under the Investment
Company Act of 1940.
This new update contains three examples to illustrate the
assessment to determine whether an entity is an investment
company. The first illustration shows that an entity was formed
with multiple investors but due to its start-up nature, only held
one investment during the first three years of its existence. It was
determined that this entity was in fact an investment company,
even though not all of the typical characteristics were present.
The second illustration emphasized that a technology fund that
was formed with various investors making multiple investments
was determined not to be an investment company because one
of the investors held options to acquire investees of the fund and
assets of the investees if the technology developed would benefit
the investors business.
The third illustration was that of a master-feeder structure. This
example showed that the master feeder and other feeder funds
were determined to be investment companies.
Entities reading this guidance would benefit greatly from
reviewing these examples.
The FASB decided not to address issues related to the applicability
of Investment Company Accounting for real estate entities and the
measurement of real estate investments at the current time.
“Financial Services-Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements.”
FASB Accounting Standards Codification, no. 2013-08 (2013): 1-72.
FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDS
By Matt Pribila, CPA, Partner, [email protected]
In May 2011, the Financial Accounting Standards Board issued Accounting Standards Update 2011-04, outlining
amendments to fair value measurement standards, as part of the ongoing convergence efforts between generally
accepted accounting principles in the United States (U.S.GAAP) and International Financial Reporting Standards (IFRS).
The update (effective for annual periods beginning after December 15, 2011), among other things, addresses:
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information contained in this publication is for informational
purposes and should not be acted upon without professional
advice. To ensure compliance with U.S. Treasury rules, unless
expressly stated otherwise, any U.S. tax advice contained in
this communication is not intended or written to be used, and
cannot be used, by the recipient for the purpose of avoiding
penalties that may be imposed under the Internal Revenue
Code. Please contact a member of the Financial Services
Group with your inquiries.
FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDS (CONTINUED)
• More detailed quantitative disclosure of the use of valuation
techniques and their unobservable inputs
• Qualitative disclosure of the process the reporting entity uses
to generate its valuations
DISCLOSURE OF UNOBSERVABLE INPUTS:
Prior to the Update, reporting entities were required to list the
techniques and inputs used in their valuations, but not specific
quantitative information. The Update now requires quantitative input in
an effort to bring standardization across all reporting entities.
Under the new standards, for each valuation technique used for Level
3 assets, the reporting entity is required to disclose in tabular format
quantitative information for significant unobservable inputs, including
the following:
• Type of security, including any meaningful classes of fair value
measurements, for which the valuation technique is used
• Cumulative fair value estimate for the type of security
• Significant unobservable inputs that are developed by the
reporting entity
• High and low end, as well as the weighted average values
used for the unobservable inputs
The fund is not required to include quantitative unobservable inputs
that are not developed internally when measuring fair value. The fund
should include all significant inputs that are reasonably available.
Examples of unobservable, quantitative inputs that are typically
developed by the reporting entity, and are now required to be
disclosed include, but are not limited to:
• Adjusted valuation multiples (e.g., revenue or EBITDA)
• Adjustments to historical third-party transactions and
quotations
• Discounts for lack of marketability
• Loss severities Control premiums Time to expiry (value)
• Non-controlling interest discounts
• Cost of capital
• Growth rates
• Volatility
WHEN IMPLEMENTING THIS DISCLOSURE, THERE ARE SEVERAL
THINGS TO CONSIDER:
Unobservable inputs that are used in the valuation technique which
are developed by others do not have to be disclosed to the extent
that they are unadjusted. Observable inputs do not have to be
disclosed. Meaning, certain level 3 valuations may not exclusively rely
on unobservable inputs developed by the reporting entity, and the fair
value balances in the disclosure may differ from those included in the
schedule of investments.
Insignificant unobservable inputs to valuation do not need to be
included. The determination of significance is the responsibility of the
fund.
The list of unobservable inputs listed for each valuation technique
may not be equally applicable to all of the investments in a respective
category. For instance a market comparable model technique might
use an EBITDA multiple for certain companies and use a revenue
multiple for other companies, but may not necessarily use both inputs
for all market comparable companies.