Alternative Investment Management Association Representing the global hedge fund industry
Skadden, Arps, Slate, Meager and Flom (UK) LLP
Permanent Capital Vehicles are best understood when stripped to their bare essentials.
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They attract investment capital which cannot be returned to investors except in certain corporate situations, such as share buybacks or liquidation.
PCVs are not new e.g., UK Investment Trusts are typically issuers of “permanent” capital. Real estate funds have often been structured as PCVs (such as the so-called REIT-petites). However, recent interest has centred on their use by alternative asset managers, to tap the public markets.
Discussion of their commercial merits is not for this article but, notably, their key attractions differ depending on who is answering this question. Managers like permanence of capital on which to levy fees and access to a different investor base, which can raise profile should the manager consider a listing. Investors in listed PCVs like access to previously inaccessible managers, plus the perceived liquidity of an after-market and in some cases, lower risk-weighting. Underwriters for listed PCVs, like the profile of bringing a new product to market and, of course, IPO fees and table credit, although there are also benefits in offering buy-side clients different investment ideas as well as marketing to the manager for a possible manager listing.
Whether the PCV product, in the alternative asset management space, has been a success again, depends on whose point of view you are seeking. Some listed vehicles, such as Queen’s Walk and Caliber, have been marked down heavily in the market, although another (Prodesse) has shrugged off corporate attacks and recently tapped investors for further funds. Tetragon also just closed a successful Euronext float. Partners Group is trading above NAV. As the product evolves, constructers learn from previous deals and incorporate features to address issues which the markets have previously punished.
This article touches on some UK tax issues for offshore PCVs, being the structure of choice for recent permanent capital deals by alternative asset managers.
The PCV most commonly used is a new corporate entity, typically a Guernsey-incorporated company. It does not have to be listed, although if it does, it helps that the PCV is a company rather than a partnership or a unit trust.
The company needs to be “closed-ended”. That, simply, is all that is needed to make it a PCV. This means that the holders of shares in the company cannot require the company to repurchase their investment, as would be available with OEICs (open-ended investment companies).
There are degrees of “permanence”. Some PCVs write into the articles that the company can, or will, wind up if/unless (X) event happens within (Y) time. “X” event can be a variety of things; examples include whether a private PCV has listed in an agreed timeframe; or if a listed PCV is trading continuously at a specified percentage below NAV. A PCV can also be “limited-life” so that winding-up is pre-determined, sometimes combined with shareholders’ ability to extend.
To address sub-NAV trading issues, certain listed funds have developed incentive arrangements to encourage IPO investors. These include variable management fees, loyalty payments direct to investors or placement agents, if investors do not sell down and options granted alongside the shares.
An asset manager might set up a PCV either as a feeder for its existing master funds (as in MW Tops, BH Macro), or as a separate stand-alone fund (Queen’s Walk, Caliber). Alternatively, they are used simply as listed fund of funds (e.g. Altin, CMA Global Hedge).
UK Tax Issues
Several of the tax issues are common with other offshore funds, with slight modifications to reflect the nature of the vehicle.
The PCV needs to be tax efficient (paying little or no tax). Guernsey exempt status would ordinarily be sought for a Guernsey resident company.
If there is UK involvement in the transaction, the PCV needs to be centrally managed and controlled outside the UK. The safest approach is for all board meetings to physically take place outside the UK. Given greater imperative for investors’ capital in a PCV to be protected (since the fund is closed-ended), the need for board meetings (e.g. to review the performance of the asset manager, consider ongoing listing compliance, market performance) is increased. Quarterly board meetings (or more frequent) are common.
If a UK manager advises the PCV, then UK “permanent establishment” issues need to be considered. A stand-alone fund may or may not be trading – this is a question of fact based on its investment activities – but if it is trading through the medium of a UK manager, it will normally need to benefit from the terms of the “investment management exemption” to escape UK tax on its trading profits.
A feeder fund will not, strictly speaking, be trading, given that it simply holds an investment in the master. However, if the underlying master is a trading fund, the UK revenue authorities will regard the feeder as a trading fund.
The terms of the investment management exemption (IME) are detailed and cannot be covered in depth here. However, the most important conditions are that:
(i) manager and affiliates (worldwide) cannot hold >20% of the PCV on average over a five year period.
(ii) the PCV only invests in “investment transactions” as defined (there are several key exclusions here, including physically settled commodities, land and arranging lending syndicates),
(iii) the manager receives a “customary” remuneration and
(iv) that the manager is “independent” of the PCV.
“Independence” is not defined but the existing UK Revenue statement of practice on the IME (SP 1/01) gives guidance. A “safe harbour” is currently available if the fund is widely held, actively traded or if the manager has significant other clients.
The IME is currently the subject of consultation with the UK Revenue, which plans to issue a revised statement of practice in mid-summer 2007. Many aspects of the consultation have been positive, although there remain some areas still requiring discussion with the authorities. Some of the lobbying on the new SP has come specifically from the PCV area, for example in ensuring manager options are not counted within the 20% (pre-exercise) or that IPO incentivisation schemes do not deteriorate the “customary fee” analysis.
Compared with “ordinary” offshore funds, availability of the IME can be more of a negotiated matter in the context of listed PCVs, or private pre-listing PCVs with significant seed capital investors, given involvement of the underwriter or major investors. Relating to the IME, which is largely fact based, allocating risk is a very live issue, e.g. whether the manager indemnifies (or is indemnified by) the PCV. An acceptable compromise might be that the manager takes risk of the exemption failure (where caused by its own actions) and the PCV takes the balance of the risk, including change of law. Thought also needs to be given to disclosure in the PCVs’ public offering documentation.
One UK tax aspect is specifically relevant to offshore PCVs, given they are closed-ended. Normally they would benefit from falling outside the UK “offshore funds” rules, due to not allowing investors the ability to redeem their capital, except in certain situations. This allows UK resident investors to sell their shares in the market and obtain capital gains treatment, rather than income treatment (unless they are already traders). Budget 2007 and draft legislation, cast doubt over this position, although UK Revenue have since “clarified” their views in discussion with various bodies including AIC (the Association of Investment Companies). Hopefully, the position will be reinstated that an offshore closed-ended vehicle (including most limited-life vehicles) are outside the offshore funds rules.
The PCV typically would not withhold any tax on dividends paid. However, withholding tax issues at the PCV asset level may need to be addressed, normally by setting up subsidiaries in suitable jurisdictions. The PCV board would also need to be comfortable that it does not have to withhold UK tax on any loyalty or other incentivisation payments to shareholders and, equally, that those shareholders do not have any residual exposure to UK tax as a result.
Concentrated holding by UK individuals (e.g. above 10%) or corporates can give rise to certain UK tax charges on imputed profits of the PCV but these risks are normally just disclosed and unlikely to occur in most circumstances.
Finally, it is worth noting, a Guernsey vehicle allows the manager not to charge VAT on its fees and trading in the shares, should not attract UK stamp taxes.
From a UK tax perspective, offshore PCVs can be made to work very efficiently, in passing the incidence of tax to the investors, rather than imposing it at the corporate level. They can also be synchronised with existing master hedge funds without disturbing the master fund’s tax position. As well as residual thorny legal issues, such as the insider trading concerns that caused Winton Capital, which runs multiple managed accounts, to pull a recent flotation, the key to the PCVs’ success will lie with the markets.