Alternative Investment Management Association Representing alternative asset managers globally
We are often asked to explain why a significant proportion of the world’s alternative investment funds, including hedge funds and private equity funds, are set up in offshore jurisdictions such as the Cayman Islands. Is it to evade tax or hide assets? This brief note seeks to provide the answers. For further information, contact us at email@example.com.
To download the full paper - www.aima.org/en/document-summary/index.cfm/docid/057FEF3C-EE65-43BD-9A3CAEF26A2CFCC9
Collective investment is good for investors. Investors such as pension funds, sovereign wealth funds, not-for-profit organisations, charities and other similar entities (often called “sophisticated investors”) can either make alternative investments directly or invest via a collective investment scheme - a fund that pools monies from a number of sophisticated investors and then manages those monies on their behalf. The use of such a collective investment scheme gives investors significant benefits including (i) professional management with specific industry expertise, (ii) the ability to diversify their portfolios across a broad range of alternative investment strategies, (iii) sharing of investment expenses and (iv) access to alternative investment types which are outside the scope of even sophisticated investors acting alone. However, collective investment can also bring legal, regulatory and tax complications, which sophisticated investors wish to minimise in order to maximise returns to their stakeholders.
Offshore funds are “tax neutral”. Tax neutrality essentially means that the country where the fund is formed, such as the Cayman Islands, does not impose its own duplicative layer of taxes on the fund. However, that does not mean that investors in tax neutral funds registered in offshore jurisdictions such as the Cayman Islands do not pay taxes – see the table below. Tax neutral status is not unique to offshore funds. There are tax neutral fund categories in the UK and the USA, for example. What sets offshore funds - and particularly, offshore alternative funds - apart is the combination of tax neutrality, investment flexibility and sophistication allowed by offshore alternative fund structures. This is what makes offshore alternative funds so attractive to sophisticated investors. As funds are often set up as a company or a partnership, those companies and partnerships can be subject to a separate tax charge in the place where they are formed. This means that investors could effectively (and unfairly) be taxed twice on the same income and capital gains. Such double taxation would render most funds uneconomic and defeat their purpose of assisting investors. Tax neutral funds provide an answer to this problem by removing this unfair “Layer 2” of tax (see the table below). Tax neutrality in the jurisdiction where the fund is established - whether onshore or offshore - ensures that such duplication of taxation does not occur, preserving the attributes that an investor would have if investing directly in the underlying assets rather than through an alternative fund. A fund should be seen as an aggregation of capital rather than a discrete taxable entity and such characterisation underpins many of the rules allowing exemption for funds in general.
Investment through any alternative fund or other collective investment scheme adds a potential layer of tax over and above that which would be payable were the investors to own the underlying assets themselves. Ideally, alternative funds will be established with tax neutral status to prevent “Layer 2” tax being applied to the fund in addition to the taxes incurred (i) by the investors at “Layer 1” and (ii) on the investments at “Layer 3”, as illustrated in the table.