There has been tremendous growth in the European hedge fund
arena over the last decade and the majority of indicators
point towards continued rapid growth in this market. European
managers have demonstrated the ability to raise significant
amounts of money both in Europe and elsewhere, including the
U.S. Although London is, and is likely to remain, the European
"capital" for hedge fund managers, fund managers
are now to be found throughout the continent in France, Germany,
Italy and Scandinavia amongst others. Several European domiciles
now provide a framework for "onshore" hedge fund
vehicles and European regulators are now looking more closely
at hedge funds and the regulatory issues to which they give
Fund Vehicles and Structures
Generally speaking, the same considerations arise as to the
type of vehicle to be used for a European managed fund as
elsewhere. The fundamental consideration is the nature of
the target investors. In deciding which vehicle is appropriate
for the target investors, investors can generally be broken
down into three categories:
Non-U.S. investors: Non-U.S. investors will typically
invest in a corporate fund and so will not pay tax until redemption
or other distribution. It should be noted, however, that if
the fund as a whole is controlled by shareholders resident
in the U.K., a U.K. corporate investor having an interest
of 25% or more in the fund may be subject to tax on a current
year basis under the controlled foreign companies legislation.
If this were the case, the U.K. corporate investor would be
subject to U.K. tax on its share of the underlying profits
of the fund, irrespective of whether those profits were distributed.
This would be a similar treatment to an investor in a limited
U.S. taxable investors: Generally, U.S. taxable investors
invest in a vehicle which is tax transparent, normally a U.S.
limited partnership. The reason for this is that an offshore
corporate fund will normally be a passive foreign investment
company ("PFIC") under U.S. tax legislation. Under
the PFIC rules, although the investor will not be subject
to current taxation in the U.S., when it redeems its shares
in the corporate fund, its total gain will be treated as ordinary
income which will be taxable. In addition, the investor will
be deemed to have recognised a gain rateably over its holding
period, and will therefore be subject to a non-deductible
interest charge on taxes-which it should have paid on gains
based on this arbitrary allocation of the gains over its holding
The PFIC issue does not, however, arise in the case of a
limited partnership as it is transparent for tax purposes.
In the case of U.S. investors, this provides an additional
tax advantage as it may be possible to take advantage of the
lower U.S. income tax rates applicable to long-term capital
gains in the underlying portfolio.
The PFIC situation can be avoided even in the context of
a corporate fund if a U.S. taxable investor can make a qualified
electing fund ("QEF") election, the effect of which
is generally to treat the corporate fund as a partnership
for U.S. tax purposes. The corporate fund will need to provide
the investor each year with current tax information so that
the investor can currently report its share of the income,
but not all funds will be in a position to supply such information
even if they choose to do so; and there are certain disadvantages
of a PFIC which gives investors this information (e.g. tax
losses do not pass through to the investors).
U.S. Tax-Exempt investors: Although a U.S. tax-exempt
entity-pension and other retirement funds, university endowments,
private foundations and tax-exempt individual retirement accounts-generally
is not subject to taxation, if, directly or indirectly (including
through a partnership interest in a limited partnership),
it incurs indebtedness in connection with investments, it
will be subject to taxation, under rules involving unrelated
business taxable income ("UBTI"), on the proportion
of any gains from the investment attributable to debt. As
a result of the adverse UBTI rules, U.S. tax-exempt investors
typically invest in offshore funds organised as corporations
that are not pass-through entities (unlike partnerships) for
tax purposes. Any leverage incurred inside an offshore fund
organised as a corporation will not be deemed to pass-through
to the tax-exempt shareholders of the corporation.
Stand-alone funds are the simplest type of fund. Where a
company is used, investors in the fund will own shares in
the company redeemable in accordance with the company's memorandum
and articles of association or bye-laws (often monthly or
quarterly). Separate classes of shares may be issued to investors.
These may be used where the fund wishes to offer shares denominated
in different currencies. Where the fund offers shares in multiple
currencies, the investment manager may seek to manage the
foreign currency exposure of those classes denominated in
a currency other than the operational currency of the portfolio.
The costs and fiscal results of any such currency management
would be solely for the account of the relevant class(es).
There may be other differences between classes, such as in
the level of fees or liquidity. Often, a fund may offer a
class that pays lower fees in return for reduced liquidity
and higher minimum investment. Separate classes may also be
required where the fund may invest in "hot issues".
Sometimes, funds issue a class of share to the manager which
has no economic interest in the performance of the fund, but
which holds exclusive voting rights in certain matters. The
intention here is to give more flexibility and to retain an
element of control, provided that the interests of the other
shareholders are not prejudiced.
If a limited partnership is used for U.S. taxable investors,
one partner-the general partner-will manage the fund and have
unlimited liability for the obligations of the partnership,
while the investors will come into the fund as limited partners
with limited liability provided they take no part in the management
of the partnership. A limited partnership agreement would
be entered into by all partners setting out the terms governing
the partnership. Investors would receive an interest in the
partnership directly related to their capital contribution.
Where it is desired to target both non-U.S. and U.S. tax-exempt
investors, both a corporate fund and a limited partnership
may be established and run in parallel. Each of these will
be a separate fund and will have a separate portfolio. Thus,
although the same investment program may be followed for each,
unless it is possible to allocate all investments pro rata
and rebalance the portfolio when necessary, the two funds
may soon diverge.
Where it is desired to target both non-U.S. and U.S. tax-exempt
investors, but not to establish parallel funds, a master-feeder
might be used. The classic master-feeder structure involves
the establishment of a master fund, usually as an offshore
tax exempt company, which will "check the box" and
therefore be treated as a partnership for U.S. tax purposes.
The fund portfolio will be held and traded at the master fund
level and thus there will only be one portfolio and no need
for allocations or rebalancing of the portfolio.
One feeder fund would be a corporate that would be invested
in by non-U.S. investors and U.S. tax-exempt investors. The
other feeder would be a U.S. limited partnership that would
be invested in by U.S. taxable investors. Both feeders would
invest in the master fund. If a listing is required, it is
the shares of the corporate feeder that are usually listed.
As a consequence, it may be necessary to put in place an agreement
between the master fund and the corporate fund whereby the
master fund agrees to operate as if it were the fund whose
shares were listed.
It would be possible to have a "one-legged" master-feeder
where an offshore corporate feeder fund will invest in a limited
partnership. Non-U.S. investors and U.S. tax-exempt investors
would invest in the corporate feeder and U.S. taxable investors
would invest directly into the limited partnership master
fund. However, U.S. Investment Company Act issues may arise
where there are a significant number of U.S. investors as
there may be a "look through" for the purposes of
determining compliance with the applicable rules. The one-legged
master feeder would not normally be structured the other way
round (i.e. a limited partnership for U.S. taxable investors
investing into a corporate master fund into which all other
investors invested directly) as the PFIC issue set out above
would still arise.
If a U.S. limited partnership invests through a corporate
master fund, it will not normally be able to take advantage
of any reduced rates of withholding tax levied in jurisdictions
which have double tax treaties with the U.S. and which might
otherwise be available to it if it invested directly in the
The investment manager of a master-feeder fund may be subject
to conflicts of interest because of different taxation considerations.
U.S. taxable investors may be able to obtain beneficial tax
treatment in respect of long-term capital gains from the sale
of securities held for more than one year. As a result, they
generally prefer investments to be held over the longer term
whereas this will not be a consideration for non-U.S. investors
who will simply be seeking maximum performance. U.S. taxable
investors will also want the investment manager to realise
tax losses at the end of each year. In addition, the offshore
master will be subject to U.S. withholding taxes on U.S. sourced
dividends. Whilst it may be possible to enter into synthetic
transactions (e.g. equity swaps) to avoid these, the costs
could be higher than in a straightforward equity investment
and the investment manager must balance its fiduciary obligations
to the U.S. feeder with the interests of the offshore feeder
in reducing U.S. withholding tax. Accordingly, where tax planning
could be a material consideration, parallel funds may again
be more advantageous.
In summary, if it is not intended to take in both U.S. taxable
investors and U.S. tax-exempt and non-U.S. investors, a stand-alone
fund may be the most appropriate fund structure. Where the
fund promoter intends to manage a number of different portfolios,
it may be that the umbrella fund has certain advantages over
the use of a number of separate and distinct offshore funds.
If, on the other hand, both U.S. taxable investors and U.S.
tax-exempt and non-U.S. investors are being targeted, then
a master-feeder or parallel structure should be considered.
The basic criteria for determining the appropriate domicile
for a European managed fund are the same as elsewhere. These
include flexibility, reputation, speed and service levels,
cost, investor perception and the status of the domicile.
The majority of European managed funds targeted at investors
other than U.S. taxable investors continue to be established
in jurisdictions such as the Cayman Islands, British Virgin
Islands and Bermuda, perhaps in a master-feeder structure
with a Delaware limited partnership feeder as well to accommodate
U.S. taxable investors. However, funds are also now being
established in the more traditional jurisdictions such as
Ireland, Jersey and Luxembourg and jurisdictions such as Italy
and Germany have enacted legislation, or are in the process
of introducing legislation, to permit domestic hedge funds.
These developments, combined with a diversification in the
nature of hedge fund investors and a certain level of investor
resistance to jurisdictions such as the Cayman Islands, perhaps
signal a move towards more regulated funds. However, investors
outside of Europe and more traditional hedge fund investors
are probably less influenced by the domicile of the fund and
entrepreneurial managers will probably continue to favour
the speed and flexibility of the Caribbean jurisdictions.
With the possible exception of Irish and Luxembourg funds,
which will be sold on a pan-European basis, European domestic
hedge funds are likely to be targeted primarily at investors
in the relevant country rather than more widely.
Ireland is currently the leading jurisdiction for European
domiciled hedge funds. Hedge funds can be established under
the Non-UCITS series of notices as either Professional Investor
Funds (PIFs) or Qualifying Investor Funds (QIFs), but normally
as QIFs. The Irish regulator, the Irish Financial Services
Regulatory Authority (IFSRA), may impose leverage and concentration
limitations on a PIF but will not do so on a QIF.
To qualify as a QIF, a fund must:
Qualifying investors must certify in the application form
for shares that they meet the criteria listed at (b) above,
that they are aware of the risks involved in the proposed investment
and of the fact that inherent in such investment is the potential
to lose all of the sum invested.
- have a minimum initial subscription requirement of €250,000
(or its foreign currency equivalent); and
- sell its shares or units to "qualifying investors".
Qualifying investors are defined to include (1) any natural
person with a minimum net worth (excluding main residence
and household goods) in excess of €1,250,000 (or its
foreign currency equivalent), or (2) any institution which
owns or invests on a discretionary basis at least €25
million (or its foreign currency equivalent) or the beneficial
owners of which are qualifying investors in their own right.
IFSRA requires that the assets of an Irish fund be held by
its custodian or a duly appointed sub-custodian. However,
where a hedge fund uses a prime broker, the assets of the
hedge fund which the prime broker is entitled to use as if
they were its own will not be held by the custodian as required.
IFSRA allows PIFs and QIFs to use a prime broker, provided:
It is understood that IFSRA is currently reviewing the above
guidelines and it is possible that there will be a relaxation
in the extent to which a prime broker can re-hypothecate.
- the assets passed to the prime broker which may be pledged,
lent, hypothecated or otherwise utilised by the prime broker
for its own purposes must not exceed 100% of the hedge fund's
indebtedness to the prime broker;
- in order to monitor this 100% restriction, arrangements
must be put in place to mark positions to market daily;
- the prime broker must agree to return the same or equivalent
securities to the hedge fund;
- the prime broker agreement must incorporate a legally
enforceable right of set-off for the hedge fund;
- where the prime broker holds assets of the hedge fund
in excess of 100% of the hedge fund's indebtedness to the
prime broker, that excess must either (1) be transferred at
the end of each day to the custodian or (2) be held in a separate
account of the prime broker, as sub-custodian. The prime broker
may take a charge over the assets held in the sub-custodial
account, provided that they remain in a segregated account
in the name of the custodian. Typically therefore, the prime
broker will be appointed as sub-custodian.
- the prime broker or its parent company must have a minimum
credit rating of A1/P1; and
- the prime broker must be regulated as a broker by a recognised
regulatory authority and it, or its parent company, must have
shareholders' funds in excess of €200 million.
One further relatively recent development in Ireland is the
introduction of retail funds of hedge funds. Although these
funds are established under the Non-UCITS series of notices,
these new funds should be distinguished from PIFs and QIFs.
In the case of a fund of funds which is a PIF, it can invest
in unregulated funds, such as Cayman Islands funds, (subject
to a maximum of 20% of net assets in any one underlying fund).
In the case of a fund of funds which is a QIF, the maximum
amount of the fund which can be invested into any one underlying
fund is raised to 40%.
Hitherto, Irish funds of funds, which are not PIFs or QIFs,
have not been permitted to invest more than 10% of their net
asset value in the aggregate in unregulated funds. However,
the new rules now permit the investment of more than 10% in
the aggregate into unregulated schemes. To the extent that
the fund invests in regulated funds, then it is subject to
the provisions of the existing rules.
Under the new rules, the fund can invest up to 5% of its
net assets in any one unregulated fund. This limit is relaxed
to 10% where the fund is managed by the same investment manager.
Where the investment manager of the underlying fund is authorised
to provide investment management services in an OECD jurisdiction,
then the respective limits are 10% and 20%. For all these
purposes, related companies/institutions are to be regarded
as a single investment manager. The funds into which the new
retail fund of hedge funds can invest must be subject to independent
audit in accordance with generally accepted international
accounting standards and must have a custodian which is independent
of the investment manager. The minimum subscription for the
new retail funds of hedge funds can be as low as €12,500
(or foreign currency equivalent and where there is capital
protection, then even this minimum may be disapplied).
There must normally be at least one redemption day per month
and the maximum interval between submission of a redemption
request and payment of settlement proceeds must not exceed
95 calendar days, although provision is made for the retention
of up to 10% of redemption proceeds where this reflects the
redemption policy of the underlying funds, as is often the
case with U.S. funds.
In addition to the normal information provided, the prospectus
must include specific information on the underlying funds
including the investment policies and related risks and the
levels of leverage. The prospectus must also set out the fees
which are charged both at the level of the retail fund of
hedge funds and the underlying funds and the expected impact
of these fees on overall performance (including the cumulative
effect of performance fees). The prospectus must set out any
potential liquidity problems and also potential valuation
difficulties and must also explain in plain English the strategies
employed by the underlying funds. The prospectus must set
out a prescribed risk warning to the effect that the unregulated
underlying funds are not or may not be subject to the same
legal and regulatory protection as funds regulated in the
EU or equivalent jurisdictions. Finally, the prospectus will
need to set out the policy which the retail fund of hedge
funds will adopt regarding diversification among different
strategies and the extent to which it will diversify the strategies
and must also set out the extent in which it will invest in
underlying funds which have historically shown a high volatility
in their rates of returns.
As with all Irish funds, the manager must show that it has
appropriate experience and expertise and, in the case of a
retail hedge fund of hedge funds, this must include appropriate
experience and expertise in relation to alternative investment
schemes. As is the case with funds of funds which are listed
on the Irish Stock Exchange, there must be appropriate controls
and systems in place to monitor the activities of underlying
funds. The IFSRA also requires monitoring of managers and
risk assessment. The investment manager will be required to
provide the IFSRA, on request, with a report on the risk profile
and performance of the underlying investments. Where the funds
in which the retail fund of hedge funds may invest are managed
by the same investment manager or an affiliated company, the
investment manager of the retail fund of hedge funds must
waive all initial charges and redemption charges and any commission
received in respect of an investment into an underlying fund
must be paid into the fund itself.
Whilst it has been possible to establish hedge funds in Luxembourg
for some time, the approval of the regulator was granted on
a case-by-case basis which was a laborious and time consuming
project. The reason for this is that whilst the relevant rules
set out guidelines relating to futures funds, leveraged funds,
venture capital funds and funds of funds, including funds
of hedge funds, they were silent on the use by a fund of a
prime broker and also on short selling.
The Luxembourg regulator, the CSSF, has set out specific
rules for funds pursuing alternative investment strategies.
The intention is to permit Luxembourg to compete with other
jurisdictions whilst retaining the advantage of regulation.
The new rules clarify issues relating to the use of a prime
broker, limits on borrowings, the use of leverage both through
borrowings and short sales and the use of derivatives, amongst
other things. There is now more flexibility and it is no longer
necessary to detail the investment strategy and restrictions
in advance to the regulator, although there may be advantages
in doing so.
The new rules set out requirements relating to risk diversification
as well as the taking of collateral by prime brokers. In respect
of short sales, there is a requirement for liquidity and the
equity sold short must normally be freely traded on a recognised
market, although up to 10% may be off-exchange provided that
the equity remains highly liquid. Aggregate commitments from
short sales must not exceed 50% of the assets of the fund
and the fund must always hold sufficient assets to enable
it to close out open short positions.
Under the new rules, funds can borrow up to 200% of net assets
or up to 400% where there is a high degree of correlation
between long and short positions. The fund can transfer assets
to the lender up to 120% of the debt. The fund can also guarantee
exposures without the transfer of assets.
Generally speaking, the fund cannot invest more than 10%
of its assets in securities which are not freely traded on
a recognised market, acquire more than 10% of the securities
of one issuer or invest more than 20% of net assets in any
one issuer unless the securities are issued or guaranteed
by, amongst others, a member state of the OECD or a supranational
Where the fund uses derivatives, the prospectus must clearly
indicate the maximum amount of leverage and also describe
the risks associated with the transactions. Margin deposits
may not exceed 50% of net assets and the fund's liquid assets
must at least equal the margin deposits. The fund may not
borrow to finance margin deposits or enter into contracts
that may involve physical delivery, other than, potentially,
precious metals. The fund must pursue a policy of risk diversification
and no more than 5% of assets may be exposed to any open position.
The original UCITS Directive was passed on 20 December 1985
and set out a common framework for the operation and European
marketing of funds established in Member States. Ever since
that date, it has been clear that there were significant issues
with the Directive and that there was no effective single
market. Some of the difficulties related to the types of funds
contemplated (funds of funds, money market funds, etc. were
not permissible) and others reflected the inherent difficulty
in much European legislation which is that Member States are
left to determine the actual implementation of the legislation.
Further, there was no unified marketing regime. Whilst the
qualifying fund could be promoted into other Member States,
local securities laws had to be complied with. Accordingly,
whilst many funds have qualified for a UCITS certificate,
relatively few have in practice taken real advantage of the
There have, for some time, been proposals to amend the UCITS
Directive to broaden the range of funds which can qualify
as UCITS and to simplify the various requirements. Such proposals
have often faltered during detailed negotiations. However,
in January 2002, the European Council finally approved two
amending Directives. The first of these Directives (the "Product
Directive") extends the range of UCITS funds that can
be sold cross-border and the second (the "Management
Directive") establishes simplified prospectus rules and
a unified passport regime for managers of UCITS similar to
that in place for investment firms under the Investment Services
Directive. Member States should have implemented the changes
at a national level by 31 August 2003 and the changes are
to take effect, across Europe, on 13 February 2004.
The Product Directive has significantly widened the range
of investments in which UCITS can invest and hence the funds
which can qualify for a UCITS certificate. In particular,
UCITS are no longer restricted to investing principally in
"transferable securities" and it has been made clear
that transferable securities includes both equities, debt
and other negotiable securities carrying the right to acquire
any such transferable securities. The Product Directive also
now permits money market funds and, perhaps most relevantly
to the current discussion, funds of funds.
Until now, UCITS have only been able to invest in other open-ended
funds in limited circumstances. UCITS can now invest into
other authorised UCITS and in other funds meeting qualifying
criteria such that they provide a similar level of protection.
UCITS funds of funds cannot invest into other funds of funds.
Derivative funds are also now permitted. Hitherto, UCITS have
only been permitted to invest into derivatives for the purposes
of efficient portfolio management or to hedge foreign currency
exposure. UCITS funds may now invest in derivatives dealt
in on regulated markets and/or OTC derivatives provided that
certain conditions are satisfied, including the creditworthiness
of counterparties. In the case of OTC derivatives, there must
be a ready valuation and the UCITS must be able to liquidate
the derivative as and when it so desires. Where a UCITS is
authorised to invest in derivatives, it must include a prominent
statement in its prospectus as to whether the activity is
for hedging or is integral to the investment strategy.
The original UCITS Directive applied only to the product,
i.e. the fund, and not to the management company. The second
Directive, the Management Directive is intended to bring management
companies of UCITS into line with other investment firms which
have had the benefit of the single passport under the Investment
Services Directive. The Management Directive also provides
a simplified marketing regime for UCITS which includes the
introduction of a short form prospectus.
Future European Developments
Whilst both the Product Directive and the Management Directive
are welcome advances, they still do not extend to funds such
as hedge funds, feeder funds and private equity funds and
some of the proposals may be difficult to implement in practice.
Further, whilst the simplified prospectus is a good advance,
local marketing requirements will still apply.
Nevertheless, it is conceivable that the UCITS Directive
may be amended even further, especially following developments
in the same Member States, to permit other types of funds
and to clarify further the existing rules. Certainly, it seems
likely that the appetite for alternative products will continue
to increase among European investors and if the intention
of the regulations is to create a fair and stable market place,
then further developments will be required.
To this end, in August 2003 the Committee on Economic and
Monetary Affairs of the European Parliament produced a working
document on hedge funds and derivatives. This was essentially
a brief statement of the current market place, but also, and
more significantly, it raised the possibility of a directive,
along the lines of the UCITS Directive, to provide a single
well-regulated European market for hedge funds and questioned
whether there was a need for some harmonised guidelines or
rules across the EU or even globally. In particular, it raised
the issue as to whether harmonised rules and tax treatment
was an "essential pre-requisite for the EU providing
a favourable environment" for hedge funds.
Regulation of Investment Managers
European investment managers are typically required to be
authorised in their home jurisdiction. Under the provisions
of the Investment Services Directive, a firm which is authorised
in one Member State may be able to provide services or establish
a branch in another Member State without being separately
authorised. For those managers in the U.K., the provision
of investment management services to a fund from the U.K.
constitutes a regulated activity for the purposes of the U.K.
Financial Services and Markets Act 2000 and regulated legislation
and, accordingly, any firm providing such services would need
to apply for authorisation to do so from the U.K. Financial
Significantly, it usually takes between three and four months
after submission of the application pack for the FSA to approve
an application and, it is, therefore, important when planning
the establishment of a fund to factor into the timetable that
the U.K. investment manager will not be authorised to conduct
investment management activities until such time as the FSA
has authorised it to do so. There is no "interim"
or "conditional authorisation". Undertaking unauthorised
investment business is a criminal offence.
Together with the completed application pack, the FSA will,
on submission, also wish to see the draft fund offering documentation
and the draft investment management agreement under which
the firm will provide its investment management services.
These documents need only be in draft on submission of the
application which, from a practical perspective, leaves time
for their completion while the FSA processes the firm's application
Another key consideration for those applying to the FSA for
authorisation is the requirement to provide information about
the firm's controllers and those persons within the firm undertaking
controlled functions. Due to the detailed information required,
these items can delay submission of the application if not
dealt with at an early stage. Applicants should also note
that depending on the particular circumstances of the individuals
concerned, it may be necessary for them to take FSA approved
examinations to demonstrate their competence to perform the
relevant controlled function.
It should also be noted that an authorised firm will be subjected
to a financial resources requirement so as to ensure that
it has sufficient capital. For an investment manager this
is basically €50,000 together with one quarter of annual
expenditure (the intention being that the firm has sufficient
capital to carry on its business in the absence of income).
There are strict rules as to the nature of this capital.
In order to avoid delays to the application process, it is
vital to ensure that the application is complete and of good
quality prior to submission.
There is no unified European regime governing the marketing
of hedge funds in Member States. Rather, the rules in each
jurisdiction need to be examined and complied with. These
vary widely between each jurisdiction and in certain cases,
such as in the U.K., there may be differing rules for managers
who are authorised in the jurisdiction and managers who are
not authorised in the jurisdiction.
In the U.K., under the Financial Services and Markets Act
2000, hedge funds are treated as unrecognised collective investment
schemes and, consequently, may not be marketed to the public
in the U.K. However, the regulations permit the marketing
of hedge funds, within certain limitations, by firms authorised
and regulated by the U.K. Financial Services Authority. Hedge
funds may be marketed by FSA-authorised firms to certain classes
of person, including investment professionals, institutional
investors, existing investors in other similar schemes and,
potentially, to individual investors, subject to suitability
requirements. It should be noted that although there is a
limited exemption for promoting to high net worth individuals,
this will not normally be available in the context of a hedge
In many jurisdictions, unsolicited sales are permitted, including
in France and Italy. In Germany, new rules are to be introduced
in 2004 which do permit the distribution of certain types
of funds, especially funds of hedge funds. Non-EU domiciled
funds cannot, however, be publicly sold, although limited
private placement is allowed. In Switzerland, a foreign fund
must be authorised by the Swiss Federal Banking Commission
before being offered, unless the offering is made to a restricted
circle, usually thought to be less than twenty investors.
There must be no general solicitation and it must be emphasised
that it is the number of potential investors to whom the offer
is made, rather than how many actually invest, which is relevant.
There are some additional carve-outs, including offers to
certain institutional investors, such as investment managers
and banks in Switzerland purchasing shares for discretionary
Many funds seek a listing on the Irish Stock Exchange. This
does not in itself facilitate marketing, but may give access
to a wider range of investors, including those who are unable
to invest in anything other than a listed vehicle. It should
be noted, however, that there is no secondary market and thus
investors who can only invest in shares which are "listed
and traded" on a recognised exchange will not be able
to invest in a listed fund.
It should be noted that the EU E-Commerce Directive, when
fully implemented in Member States, may impact cross-border
marketing of hedge funds via the internet. The Directive imposes
a "country of origin" approach to regulation, which
means that, for example, U.K. managers marketing funds into
other EU Member States will be subject to the applicable U.K.
marketing rules rather than having to comply with the rules
of the other states. It should be noted, however, that it
will only apply to promotion on the Internet; other laws,
such as tax and data protection laws and laws against unsolicited
email, will still need to be complied with.
Where the investment management of a fund is carried on from
the U.K., investors will be concerned to see that the fund
is not associated with the U.K. in such a way that the profits
and gains of the fund are subject to U.K. tax.
A company will be treated as resident in the U.K. (and hence
subject to U.K. tax on its worldwide profits and gains) if
the "central management and control" of the company
is exercised in the U.K. This concept is generally understood
to denote the strategic control and direction of the company's
affairs, as opposed to the day-to-day running of its operations,
and is generally exercised by the board of directors.
There are a number of guidelines that a fund should observe
in order to ensure that it does not become U.K. resident.
Key indicators are as follows:
Liability to U.K. Tax of a non-U.K. Resident Fund
- The board of directors should meet regularly (at least
quarterly) in a jurisdiction outside the U.K., and preferably
in the jurisdiction in which the fund is incorporated, to
make strategic decisions in relation to the company. Of course,
wherever the meeting is held, local advice should be taken
so as to ensure that there are no adverse tax or other consequences.
- The board should have a majority of non-U.K. resident
directors. All the directors should have appropriate expertise
and experience and be able to contribute fully to the meeting
and any decisions.
- All meetings of the board of directors should involve
genuine discussion and strategic decision-taking. It should
be clear that the board of directors is not merely approving
decisions taken by one of the directors or the fund promoter.
Full minutes for all board meetings should be taken and the
minutes of the meetings should be prepared outside the U.K..
Even if the necessary steps are taken to ensure that the fund
is not resident in the U.K. for tax purposes, the profits
of the fund can still, in some circumstances, be subject to
U.K. tax. Where a non-U.K. resident company is carrying on
a trade in the U.K. through a U.K. permanent establishment,
the profits and gains of the non-resident company which arise
as a consequence of the activities of the U.K. permanent establishment
are subject to U.K. tax. A U.K. permanent establishment for
these purposes is a fixed place of business in the U.K. or
a U.K. agent through which the business of the non-U.K. company
is carried out.
Feeder funds are not likely to be regarded as trading. In
most cases, feeder funds will simply invest in the master
fund and hold that interest in the master fund as a long-term
investment. The strategies of most hedge funds will mean,
however, that a fund which is actively managed (whether it
is a stand-alone fund or a master fund) will be regarded as
trading through the agency of the U.K. investment manager
which will accordingly be a permanent establishment of the
There should be no charge to U.K. tax, however, if the investment
manager exemption is available. The exemption has a number
of conditions, including:
- the U.K. investment manager must carry on a business
of providing investment management services and carry out
transactions on behalf of the fund in the ordinary course
of that business;
- the investment manager must receive the "customary
rate of remuneration" for the kind of business that it
is carrying on. What counts as the "customary rate"
is a question of fact in each case;
- the investment manager must be acting in an "independent
capacity". The Inland Revenue has set out a number
of "safe harbours" where it will regard the "independent
capacity" test as met including where the investment
manager is providing services to a "widely held collective
- the "20% test" must be met. This requires
that the investment manager and persons connected with it
for tax purposes must not be entitled, over the course of
a qualifying period of up to five years, to more than 20%
of the net income of the fund. Fees paid to the investment
manager and connected persons are generally disregarded in
determining whether the 20% test is met.
U.K. resident or ordinarily resident investors also need
to consider the U.K. tax treatment of their investment. Unless
the fund is certified by the Inland Revenue as a "distributing
fund" throughout the time they hold their interest in
the fund, any gain they realise on the disposal of their investment
will be subject to U.K. tax as income rather than capital
gains (the "offshore funds regime"). Income treatment
is generally less advantageous than capital investment, in
particular individual investors are not able to take advantage
of capital gains tax taper relief to reduce the effective
rate of tax on their gain.
Despite this, hedge funds will generally not seek certification
as a distributing fund. This is because it is a requirement
of distributing fund status that the fund must distribute
at least 85% of its net taxable income in each account period
to investors. Since hedge funds are generally regarded as
trading, the requirement to distribute at least 85% of their
income would require hedge finds to distribute at least 85%
of their profits from the realisation of assets. This is clearly
contrary to the aim of most hedge funds to accumulate profits
and reinvest for long-term gains.
The Inland Revenue has recently concluded a consultation
on possible changes to the offshore funds regime and has announced
that charges will be introduced in the Finance Act 2004. It
is, however, unclear what changes (if any) will be introduced
to the regime for non-distributing funds.
EU resident individual investors may also be affected by
the EU Savings Tax Directive, which is intended to be introduced
from 01 January 2005. In broad terms, the Directive requires
that where a fund is invested as to more than 40% in debt
instruments or other interest-bearing assets, a paying agent
located in a Member State of the EU (or one of the dependent
or associated territories, such as the Channel Islands or
the Cayman Islands) who makes a payment of share redemption
proceeds to an individual investor resident in another Member
State of the EU (or one of the dependent or associated territories)
will be required either to levy a withholding tax or to provide
information about the payment to its tax authorities, which
will pass that information on to the tax authorities of the
investor's state of residence.
Where the fund is itself established in a Member State of
the EU or one of the dependent and associated territories,
the fund will itself be regarded as a paying agent and may
be required to operate a withholding tax or information reporting
regime. The entry into force of the Directive is, however,
currently dependent upon agreement being reached with the
dependent and associated territories that they will adopt
"equivalent measures" to those intended to take
effect throughout the EU and so, for the present, it is impossible
to predict precisely in what form the Directive will take
Offshore Management Company
In many cases, especially where non U.K. domiciliaries are
promoters of the fund, an offshore company will be incorporated
in a low or no tax jurisdiction such as the Cayman Islands
which will enter into the main investment management and marketing
agreements with the fund and thus be entitled to be remunerated
for its services. The offshore manager will then enter into
sub-agreements with the U.K. investment manager under which
it will delegate the performance of some or all of these functions
to the U.K. investment manager.
Generally speaking, the remuneration received by the offshore
manager would need to be paid on to the U.K. investment manager
to ensure that the "customary rate of remuneration"
is received. However, where activity such as marketing or
promotion is being performed outside the U.K. by the offshore
manager it may be possible to retain some of the remuneration
For so long as the effective investment management takes place
in the U.K., the scope for retaining remuneration offshore
may be limited. However, where the investment manager may
set up additional offices and/or move offshore, then the use
of an offshore manager will provide much greater flexibility
and potentially prove tax-efficient.
Copyright © 2003
Schulte Roth & Zabel International LLP, all rights reserved