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Tax legislators on both sides of the Atlantic have built up a head of steam in an effort to encourage compliance with tax return obligations. US tax authorities regularly comment on their intention to increase enforcement in the international tax reporting arena and, indeed, have recently promulgated significantly stricter rules for assessing penalties against paid tax return preparers who sign returns with unreasonable tax positions. UK tax authorities continue to closely monitor perceived tax shelter abuses and are progressing the Varney Review to implement new procedures linking HMRC with large businesses. Both regimes are vigorously scrutinizing the fund management industry, as evidenced by the hotly debated and emotive atmosphere surrounding the taxation of carried interest.

Fund management firms are realizing that they must carefully manage their tax compliance risks and execute accurate tax returns in order to avoid even closer scrutiny by revenue authorities. Indeed, given the demands of increased disclosure under a variety of legislation (for example, Sarbanes Oxley), these companies are challenged to address all facets of financial and tax reporting within their organization. There is a clear reluctance to be seen as engaged in tax avoidance or to run afoul of compliance reporting, due to fear of reputational risk and being “named and shamed”.

Managing US Tax Complexities

As mentioned, the tax enforcement environment continues to intensify around the world, and nowhere is this more evident than in the US. The Internal Revenue Service (IRS) continues to receive increased budgets for enforcement efforts, even at the expense of both administrative modernisation and taxpayer service. Recent IRS annual budgets have exceeded $11bn, with the lion’s share directed toward enforcement efforts.

After a period of relatively relaxed enforcement policies, the IRS has returned to a stricter enforcement mode, perhaps in response to the numerous high-profile accounting and tax scandals over the past few years. For example, not long ago IRS authorities floated concepts related to whether US corporate tax returns and practitioner disciplinary proceedings should be made public. Furthermore, there is evidence of increased co-operation between the IRS and the tax authorities of countries with the closest ties to the US, such as the UK. In this landscape, European-based investment funds and asset managers will want to strengthen their compliance management and control procedures.

What triggers US tax reporting?

US tax reporting will typically be driven by the quantum of US investors and/or US investments. Additionally, the nature of an investment structure (whether it is “flow-through” or “blocked”) and the proportion of US taxable and tax exempt investors will impact the specific type of reporting.

Diagram 1 shows how funds should report taxable activity to their US investors. Such activity can either be recognized on an arising basis each year or may be “blocked” from current taxation and only subject to tax when cash or property distributions are made.

In general, local country income is converted to US taxable activity via a system of tax adjustments, informally known as “Schedule M-1s”. These adjustments can be made against financial statements reported under local country GAAP (including IFRS), and conversion to US GAAP is not required.

Risks of non-compliance

There is no question that the most important criteria to an investor in an investment fund will be its track record and the likelihood of generating a high rate of return. Nevertheless, lack of compliance with fundamental US tax reporting and disclosure requirements can result in the following consequences:

• Damaged investor relations with fund management;
• Lost market competitiveness for US funding;
• IRS examination of the fund and/or its US investors;
• Increased administrative burden and inefficiencies;
• Missed tax planning opportunities;
• Lower rate of return due to excessive effective tax rate.

US TAXABLE VERSUS Tax EXEMPT INVESTORS

Within the US investor base, US taxables will have very different objectives from US tax exempts. Assuming US taxables are not expecting flow-through taxation on an arising basis each year, these investors will want to ensure that they avoid “phantom income” (that is, taxable income prior to cash distributions), ensure capital gain treatment, and maintain double tax relief.

Broadly, the most common anti-deferral regimes affecting US taxables in a “blocked” investment structure include the controlled foreign corporation (“CFC”) and the passive foreign investment company (“PFIC”) regimes. While a complete discussion of the rules related to CFCs and PFICs is beyond the scope of this article, essentially the CFC and PFIC regimes can be viewed as impacting structures with a US majority or US minority interest, respectively.

Under the CFC rules, where a portfolio company is owned directly, indirectly or constructively greater than 50% (vote or value) by US investors each holding at least 10%, “phantom” or “dry” income may arise to the extent the CFC entity generates certain types of passive income. This passive income is informally known as “subpart F” income and it includes interest, dividends and other types of passive income. Subject to certain limitations, subpart F income will generally be treated as a deemed dividend to US 10% investors irrespective of whether cash has been distributed.

In many cases, European-based funds will more commonly see application of the PFIC rules with respect to US minority-interest investors. A non-US company (that is not treated as transparent for US purposes) will be a PFIC if either 75% or more of its gross income is passive, or 50% or more of its assets (by value) are held to produce passive income. If an entity is treated as a PFIC, draconian rules may apply to assess interest charges that reflect a deemed loan from the US government on prior-year earnings that were not currently taxed when accrued. To add insult to injury, the PFIC provisions re-characterize capital gains to trading income and subject all income to the top statutory tax rate of the US investor.

The most common ways to mitigate adverse PFIC treatment include making a “qualified electing fund” (“QEF”) election to report all earnings from the PFIC as currently taxable each year to US investors, or making a “check the box” election to treat the portfolio entity as flow-through. In both cases, the PFIC implications are essentially de-activated and US investors will be taxed currently. However, US investors will be able to recognise capital gains and benefit from graduated income-tax rates where applicable.

On the other hand, US tax exempts are, by definition, generally not subject to income tax except under certain circumstances, and investment funds will typically take measures to prevent the generation of so-called “unrelated business taxable income” (“UBTI”). The primary purpose behind enacting a tax on UBTI was to eliminate any unfair advantage that might arise from an exempt organization’s participation in activities in competition with profit-oriented ventures.

In the investment fund industry, UBTI generally surfaces when a portfolio is debt financed or where there is active participation in the portfolio business. Ultimately, as long as a US tax exempt is simply putting straight equity into a blocker holding company and only receiving dividends in return, the underlying activity of the fund and portfolio companies should not be attributable to the US exempt investor. Such an arrangement should therefore eliminate recognition of UBTI and allow all proceeds to be tax free in the US.

A further critical concern of US tax exempts only applies to certain specified US investors, mainly pension funds. The Employee Retirement Income Security Act (“ERISA”) relates to pension regulatory law and governs the operation of pension funds. In brief, ERISA requires that the assets of a qualified pension plan be held in trust and that only a named fiduciary has the authority to manage and control such assets. The primary ERISA concern relates to the risk that the underlying assets of a fund with an ERISA investor will be deemed to be “plan assets”. If this is the case, ERISA requirements may be violated and create a fiduciary responsibility for the direct or indirect managers of the fund. It should be emphasised that ERISA is a regulatory rather than a tax issue. ERISA implications should always be carefully scrutinised by appropriate US legal counsel.

MARKET “BEST PRACTICES”

There are many ways to meet a fund’s US tax compliance obligations with respect to market best practices and, fundamentally, investment fund asset managers will be best positioned if they take action on the following points:

• Specifically confirm responsibilities for US tax reporting;
• Agree on specific timing, including production of data and completion of US tax reporting deliverables;
• Conduct advance compliance preparation prior to the fiscal year end of the fund to conclude on responsibilities, timing and portfolio transactions that have taken place year to date;
• Establish a US tax reporting methodology for producing deliverables in a format that is familiar to US investors;
• Make internal fund personnel and external tax advisers available for immediate follow-up investor support during the weeks succeeding delivery of the US tax information.

Conclusion

With vigilant and established internal oversight and awareness of the technical issues, combined with use of the latest tools and observance of the best practices outlined herein, a fund’s stakeholders will meet their regulatory and tax compliance challenges effectively and efficiently. Ultimately, with proper planning, administrative complexities can be manageable, leaving time to steer most energy toward achieving fruitful portfolio returns.

For more information,
contact Peter Badenhuizen on:
Tel: +44 (0)20 7007 0607
E-mail: pbadenhuizen@deloitte.co.uk

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