How to Run Offshore Management Companies and Funds with Substance and Corporate Governance

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1 White Paper Series: How to Run Offshore Management Companies and Funds with Substance and Corporate Governance This white paper series by Laven Financial Services discusses how hedge fund businesses should run offshore management companies and funds with substance and corporate governance. The series aims to provide best practice guidance to fund managers with offshore business structures. Laven Financial Services is the Laven group s offshore consultancy servicing fund managers and their funds in Caribbean jurisdictions. Introduction 1. The Idea of the Offshore Management Company The Cayman Islands and the British Virgin Islands (BVI), according to Q statistics published by their regulators, have in total over 13,000 mutual funds between the two jurisdictions and, more importantly, over 2,500 management companies. But how many of these management companies are really doing what they are supposed to do and truly carrying out their functions as investment manager? This white paper looks at the reasons for setting up an offshore management company and how it should be managed from an operational and tax point of view. We have also sought to provide our readers with case studies that showcase the growing efforts of tax authorities to clamp down on tax avoidance across a number of jurisdictions. Why set up an offshore management company? The choice of jurisdiction for a fund can often be straightforward; usually one with a favorable tax and regulatory regime which will also ring bells with intended investors is chosen. The natural choice for the related management companies should be where the main management activities are based. However management companies can benefit from being set up offshore, typically in a tax free jurisdiction, and then delegate some of the key functions, such as asset management, marketing or risk management to onshore service providers such as sub-investment managers, where the star traders are based. These points (and many more) would usually be considered at the outset of any new fund set up, as part of initial structuring planning. Most start up fund businesses are keen to get set up and trading as soon as possible, and few, whether because of time or cost restrictions, will consider seeking proper tax planning or structuring advice. Investing in some straightforward and practical tax and structuring advice can however massively benefit businesses in the long-

2 term and does not need to be costly or overly legalistic. What such planning does allow is to consider the best possible structure for the business from a tax as well as commercial point of view (provided the advisor has a practical enough approach). Whether or not a management company offshore is a suitable option should also be addressed as part of this initial review. This will have an important bearing on investors as well as the tax authorities. From a tax point of view, the management company, which can be in a typical fund jurisdiction such as the Cayman Islands, can benefit from 0% tax on fees made from the fund. This can provide some great financial incentive for many business owners however it must be thought through carefully, as explained later below, to ensure it does not create a new risk related to tax avoidance. Offshore management companies are not just set up for tax reasons contrary to popular and political belief. They can also provide great flexibility for business owners. It permits ownership outside the onshore jurisdiction which may be attractive to many businesses with international partners and evolving plans. It provides greater future flexibility should the business undergo any restructuring at any point and, for example, if the onshore subinvestment manager wishes to relocate to another jurisdiction due to various lifestyle and/or commercial considerations. Another reason to retain activities offshore is linked to the fund. In many countries where sub-investment managers and traders reside, there is a degree of legal ambiguity with regards to the actual taxation of the fund vehicle. The fund is indeed only truly tax exempt if it meets certain criteria. One of those criteria relates to the control exercised over the fund. Since control is deemed to occur mostly from the board and the rights to vote that pertain to the fund in question, many structures seek to appoint foreign directors (a topic we will focus on in another white paper), but also seek to place any voting shares (also known as management shares) in the hands of offshore persons. The offshore management company therefore can hold the voting shares of the fund, and, although not necessarily an arrangement without conflicts of interest, it does help ensure that the control of the fund does not come within the tax framework of the onshore jurisdiction of the sub-investment manager. This would be more difficult obviously if the voting shares of the fund were held directly by the partners onshore, as can sometimes be the case. The risks of controlling a foreign company from onshore are addressed later in this paper. Another commercial reason for management companies to be established in traditional fund jurisdictions is also related to the ease with which the companies can be set up offshore, thanks to the speediness of the set up process. There are also many established and cost effective service providers. The offshore management company therefore provides a number of benefits to fund businesses that operate in a fast evolving industry and can be a good choice if well thought through.

3 Will an offshore management company not just be another costly entity to operate? Yes and no. To really understand the potential benefits of an offshore management company, some initial planning is required and it is better to do this at the beginning stages of launching the business as it is more difficult and costlier to add another company to an existing structure at a later stage. What should be looked at are the potential savings against the costs that the company will incur to support those savings. Are the projected tax savings higher than the projected costs, in the short-term, medium-term and long-term? For most businesses the answer here will be yes. However, one should always note that this must be done in accordance with real commercial principles. Businesses will indeed need to consider transfer pricing issues which relate to the value of the services provided by the onshore sub-investment manager to the offshore manager. How much of the total work in relation to the service provided to the fund is carried out by the offshore manager and how much by the onshore sub-investment manager, and what is fair and reasonable? For some, an acceptable level of service offshore means that 80% of the fees paid by the fund to the offshore manager are then paid to the sub-investment manager for their services. Thus 20% remain offshore and this must be substantiated. In fact, this applies whatever the percentage that remains offshore. The 20% is not a strict rule and should be individually considered. Many managers push this rule to much higher levels, sometimes negligently but at times also quite legitimately. What is important is the rationale for the decisions which should be based on an assessment of the services provided and how the assessment is documented and later on put in practice as things may change over time. How should an offshore management company be operated? To ensure the proper operations of the offshore management company and so as to keep it outside of the tax framework of the onshore entity, where the delegated services are carried out and where most of the employees will be based, the offshore management company should have substance. This essentially means it should not operate as a so-called shell or a mailbox company. For example, under English law it is important that any offshore company has its central management and control in its jurisdiction of incorporation or that this is at least not carried out from the UK. This is because a company incorporated in a jurisdiction outside the UK may become liable to UK tax if the UK tax authorities consider that the central management and control of such a company is actually being undertaken in the UK. This is however not only relevant to the UK and includes many other countries, including Switzerland as well as France, as evidenced in our case studies below. The question therefore arises as to what conduct is sufficient to evidence that the central management and control of a company is in the country of incorporation and not onshore?

4 In this regard, while not exhaustive, the following factors are commonly considered by the tax authorities: where the actual activities of the company take place; where meetings are convened and decisions for day-to-day operations are carried out; where the directors are tax resident or located normally; whether the directors operate independently or at the request of a person onshore; and where the shareholders holding a majority stake are tax resident or located. The question is: today, how many of the 2,500 management companies in the BVI and the Cayman Islands are operated in a manner that would bear the tax authorities scrutiny? In the course of our business, we have unfortunately encountered many businesses that may be at risk and have sought to advise industry professionals of the simple steps that can be taken to limit such risks. Our future white papers will discuss in more detail how to increase substance, for example through corporate governance. Further and as outlined in more detail in the FT Guide to Investing in Funds by Jerome Lussan, managers should also be aware of potential tax risks where a manager or advisor is based in the UK. It is vital that the UK manager or advisor qualifies for certain English tax law exemptions, such as the investment manager exemption, especially where it carries out trading or execution. If the relevant conditions have not been thoroughly considered and complied with by the UK manager or advisor, this creates a risk that the offshore entities may become subject to UK taxation. Case Studies Below, we have chosen a Swiss and a UK example. Similarly to the UK, offshore companies may be subject to relevant Swiss taxes if their management is effectively carried out from Switzerland. Switzerland provides no guidance on what is deemed effective management and therefore authorities will seek to find circumstantial evidence confirming the actual location of management. Case 1 In 2003, the Swiss Supreme Court concluded that the income from a BVI parent company was subject to corporation tax in Switzerland as the place of effective management was found to be in Switzerland. In the case, an employee of the BVI firm s Swiss subsidiary was responsible for day-to-day matters relating to the operational management of the BVI firm, notably, operating bank payments and monitoring any related transaction risks. This employee was the sole signatory for the BVI firm and the Supreme Court therefore concluded that the activities by the employee established the

5 place of effective management in Switzerland. 12 The company therefore became liable to pay corporation tax in Switzerland on its income. Case 2 Meanwhile in the UK, on 11 August 2009, a first-tier tribunal ruled that Laerstate BV, a Dutch company resident in the Netherlands, had its central management and control in the UK and therefore the company would be liable to UK tax. In the case, the court accepted the HMRC's arguments and found that the central management and control of the company was exercised in the UK. On the facts of this case however, HMRC proposed and the court agreed that the company was run out of the UK although none of the board meetings were held in the UK, nor were any of the documents signed in the UK. The case shows that it is imperative for board meetings not only to be conducted outside the UK but for these meetings to be a proper forum for discussion. Simply rubber stamping pre-defined decisions will not be acceptable in the eyes of HMRC. It is also important to maintain the correct balance of non-uk directors. This decision shows HMRC's willingness to pursue cases of this nature and the courts' likeliness to find in HMRC's favor. Conclusion Due to the global structure of most hedge fund businesses and some traditional fund businesses spanning across a number of jurisdictions, management companies and subinvestment managers, should be aware of the tax risks they may expose themselves to, by operating foreign based companies out of onshore locations, whether those locations are the UK, Switzerland, France and even Hong Kong etc. This is particularly essential in the current climate of regulatory reforms, generally political angst against fund managers and pressure and crack-down on tax planning, not to mention increased powers for certain tax authorities. In the second white paper of our series on How to Run Offshore Management Companies and Funds with Substance and Corporate Governance we will look at how the actual board meetings held by offshore companies can be processed to evidence actual controls so as to help control tax risks, as well as promote the business as more operationally sound and sustainable. 1 X. Oberson, H. Hull, 2011, Switzerland in International Tax Law 2 P. Altenburger, K. Krech, 2011, Host Country Switzerland

6 This white paper series on How to Run Offshore Management Companies and Funds with Substance and Corporate Governance is produced by Laven Financial Services, a consultancy providing substance and control services in the Caribbean across traditional hedge fund structures, such as management companies in the Cayman Islands and the British Virgin Islands. Laven Financial Services offers corporate governance, international compliance and operational support services, as well as directorships to offshore management companies. The series draws on the Laven group s experience in corporate governance and fund formation but also its expertise through compliance and tax specialists and operational due diligence consultants. The white paper series is also offered as useful guidance for any investors on how they may view corporate governance of offshore fund structures when carrying out any operational due diligence or manager selection. For more information, please visit Disclaimer This material has been prepared by Laven Financial Services Limited for informational purposes only and should not be construed as legal, tax or other professional advice. You should consult with your own independent legal, tax and other professional advisors before taking any action on the basis of this information. The information provided in the material is based upon sources believed to have been reliable by Laven Financial Services, but Laven Financial Services has not taken any steps to verify the accuracy or completeness of the information. Neither Laven Financial Services nor any of its officers, employees, agents, affiliates or advisers make any representation or warranty as to the accuracy or completeness of the material or are under any obligation, express or implied, to update the information to correct any inaccuracies it may contain or to reflect any changes that may occur in the future. This material is confidential and may not be disclosed to any person other than the intended recipient without the express written approval of Laven Financial Services. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means or (ii) redistributed, without Laven Financial Services prior written consent. December 2012 Laven Financial Services Limited All rights reserved, and all moral rights are asserted and reserved.

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