Tax Efficient Funds for Investors

At its minimum definition, a fund is a ‘collective investment undertaking’. Each of those words is significant. The OECD calls them collective investment ‘vehicles’, which serves to distinguish a fund from a ‘managed account’ in a bank, where the investor owns the assets in the account, and there is no separate vehicle. However, in a managed account the risk lies exclusively and squarely with the individual investor. That is quite important, not least because managed accounts have been coming back into popularity in recent times.

Generally with public funds, part of the reason why you invest is that you share risk with other investors. It gives the ordinary man in the street the ability to own shares, or other investments all over the world, without having to buy and sell them himself. You also get the services of a professional investment manager.

A large part of the world revolves around the funds industry. It is the penultimate destination of money that was originally subscribed into pension schemes, insurance policies, savings plans and into banks. There are actually more funds in the United States than there are listed securities.

Somewhat surprisingly, the tax department of the OECD, which usually tends to be the bugbear of international investment, actually thinks that funds are a ‘good thing’. Having international regulatory authorities thinking what you do is a good thing is a not a bad place to start.

In the OECD’s 2010 report on the taxation of funds, they specifically mention the fact that funds:

• reduce the cost for the small investor,
• allow for diversification of risk,
• produce economies of scale and provide liquidity for the investor because, normally, he can redeem his shares at any time.

Funds tend to be prudently supervised and highly regulated by regulators; so therefore, in ‘officialdom’ funds are recognised as beneficial to society.

The global funds industry is massive, with an estimated size of around US$40 trillion, of which around 50 per cent is in the United States, 30 per cent in Europe, and the remaining 20 per cent elsewhere.

The three main domiciles for funds are:

• onshore,
• regulated cross-frontier, (i.e. Luxembourg or Ireland)
• and offshore in a traditional international financial centre.

Offshore funds, despite recent increased international regulation and OECD initiatives, are still attractive options. Most offshore funds are established in Cayman or BVI, although the majority are actually administered in Ireland.

The other option is the regulated cross-frontier fund. These funds are typically found in Ireland or Luxembourg. There is currently over US$3 trillion in fund assets in each of these two centres. Taken together, this represents between 15 and 20 per cent of the world's funds.

Luxembourg tends to be more retail. Ireland tends to be more ‘hedgy’, or alternative, and caters more for the institutional market.

Funds and Taxation

There are three separate aspects to consider when looking at the taxation of funds:

• The investor
• The fund itself
• The investments

Tax can arise on dividends, or on interest paid from the investments to the fund and on capital gains made by the fund. In most jurisdictions, funds are tax neutral, i.e. they do not actually pay any tax. Investors pay, in their own jurisdiction, income or corporation tax on their income from the fund and capital gains tax on the disposal of their interest in the fund.

In some countries, such as the United States and Germany, it is possible that fund investors might be charged on undistributed income or capital gains in the fund. But, by and large around the world funds do not pay any tax. Importantly, this tends not to be seen as a big issue for revenue authorities, because funds are deemed to be a transparent mechanism where the investors come together, and then investors get taxed in their own jurisdictions.

Withholding tax is also relevant. A lot of jurisdictions apply withholding tax to dividends or interest, and also, but less so, in the case of capital gains. Asian countries, such as Korea, India and Russia, have withholding tax on capital gains.

In many countries one can still ‘bed and breakfast’. So, if you have a dividend coming up on some shares, you can sell the shares cum-div and buy them back ex-div. In this way, you can ‘wash’ the dividend and convert the income into a capital gain, where withholding tax does not apply.

Tax Treaties for the Prevention of Double Taxation

Can funds avail themselves of double tax treaties? It is essential to appreciate that tax treaties do not impose tax charges. They just regulate the taxing rights between countries.

In the case of a fund, what matters is where the fund is tax resident. This is where we encounter problems with funds, because, whether or not a fund can be resident at all, is often in dispute.

For example, in Ireland, for about half the countries that funds invest in, they will get treaty benefits. So instead of having 30 or 15 per cent withholding tax, there could be none at all on interest and dividend payments. Under the Ireland-Korea treaty, for example, it is possible to get an exemption from Korean capital gains withholding tax, notwithstanding that the Irish funds do not pay any tax because the Irish Revenue has been prepared to write a letter to the Korean authorities, saying the fund is liable for tax, although it does not actually pay any tax.

Funds, Tax Residency and ‘Gross Roll-up’

The OECD ‘Model Tax Treaty’ definition of a ‘Resident’ is a person who is liable to tax because of their domicile, residence, place of management or other criterion. The question arises as to whether ‘liable to tax’ means that you actually have to pay tax.

Interestingly, the OECD conceded this point in their 2010 Report. In paragraph 8.5 of the Commentary to Article 4 of the Model Treaty, they say:

“A collective investment vehicle may be liable to tax and so resident, even if that State does not impose any tax on it.”

It is, therefore, necessary to look at the treaty to see whether the collective investment vehicle is a person, whether it is resident and whether it is the beneficial owner of the income it receives.

Can you say that the investors receive the income? Part of the reason the investors typically cannot have income precisely attributed to them is because it is often very difficult to split it out. If you have thousands of investors, how do you work out who gets what?

The other issue is timing. Say, for example, a fund is entitled to a refund of withholding tax, but the cash refund comes in after the person has redeemed his interest in the fund. Does it belong to the persons who owned the interests in the fund at the time the refund was due or, the persons that own the fund shares today? This can become messy. Also, custodians tend to not like dealing with withholding tax, as reclaiming it is very time consuming and labour intensive.

The OECD have picked this up in their Report in considering ‘treaty shopping’, and they have identified what they call ‘good income’, which they say is income that is not derived from treaty shopping, or abusing limitation on benefits clauses. The words ‘good income’ and ‘bad income’ are of course subjective, and usually not a relevant consideration for professional advisers.

Another relevant issue in relation to funds is the concept of ‘gross roll-up’. In a fund, because it does not pay any tax, its income rolls up gross. So if you do not have attributed taxation at the investor level, such as in Germany or the US, you can actually roll up your income in the fund itself gross rather than net. It therefore grows more quickly before you sell your units, or shares, which can be very advantageous, especially if the investors have a medium or long-term investment horizon.

The main point with investing via a fund is that you should not be worse off than you would have been if you had invested directly. You can, however, unfortunately, end up worse off than you would have been, especially if you have attributed undistributed taxable income, and you have no cash, i.e. having to pay tax on the fund’s profits but not receiving any distribution.

OECD Discussion Draft and BEPS

In April 2016 the OECD published a new discussion draft in relation to what they call ‘non-CIV funds’. The discussion draft says that in the general fund universe funds are a ‘good thing’, but only some funds are a good thing.

‘Good funds’ are those that are widely held, are subject to prudential investor protection and hold a diversified portfolio. Anything that is not one of those is a ‘non-CIV fund’. One might think that that is a problem, in that they are only going to allow benefits to big retail funds and not to the hedge funds which are the non-CIV funds, but in actual fact, it turns out to not be as negative as that.

But this is where we encounter the G20 and OECD’s Base Erosion and Profit Shifting (BEPS), initiative. Article 6 forbids the use of treaties in, what they call, ‘inappropriate circumstances’. There is also a principal purpose test of the entity and limitation on benefits, similar to those found in US tax treaties.

This is relevant in the context of funds, i.e. as to whether the funds are deemed to be using treaty relief in inappropriate circumstances, at a time when the OECD is trying to get general agreement that funds can avail themselves of treaties. The new Irish Collective Asset Vehicle (ICAV) has been specifically designed to be compliant with these new rules, while facilitating investment by and into the important US market.

Summary

In conclusion, funds are highly flexible vehicles for investment which enjoy a good reputation. In contrast, entities or arrangements, such as trusts, offshore companies, or special purpose vehicles seem to be generally out of favour with tax and regulatory authorities worldwide.

Fortunately, at the moment, those same regulatory and revenue authorities are generally well disposed towards funds, because they are seen to permit the ordinary man or woman in the street the opportunity to invest his or her savings and to earn a better return than just holding cash in a historically very low interest rate environment.

There is a lot of change going on at the moment, but I would advise people to be brave. Do not be shy. Influence the direction of change. Lobby your local financial regulator. I strongly believe that it's an area that will provide plenty of opportunity in the next five to ten years.

Peter O'Dwyer
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.