Sectors: 1064

Substance requirements remain under the fund microscope

14 April 2016

Written by Dominic Wheatley

Guernsey Finance Chief Executive Dominic Wheatley looks at ‘substance’ in the funds industry and how Guernsey stacks up.

Take the EU’s Alternative Investment Fund Managers Directive (“AIFMD”) as an example. If you are a European fund manager or wish to market and distribute to investors in Europe, not only will you have to consider marketing and distribution matters, including which European countries you want to target for investors, you will also need to carefully consider the structure and operation of your fund to determine the appropriate location and domiciliary characteristics you require. This needs to be done both from a strategic and a tax perspective, bearing in mind that the tax treatment will depend on real issues of substance and not simply on formal legal structures.

The Organisation for Economic Co-operation and Developments (“OECD’s”) Base Erosion and Profit Shifting (“BEPS”) project has further brought the topic of substance to the fore. BEPS aims to better align taxation with the location of economic activities and value creation. Its actions are intended to result in changes to international tax standards based on three core principles, one of which is substance.

A key component of substance is thinking about risk management and capital deployment. For example, return for risk should be attributed to the entity that controls the risk and, furthermore, has the capacity to assume the risk. Equally, an entity that only provides capital but does not manage or deploy it in any active way will only be entitled to a risk-free return.

Guernsey, along with its competitor jurisdictions, may not be obliged to adopt any of the BEPS measures but nevertheless the investment fund management sector will feel its impact. Therefore, undertaking a risk versus reward analysis to determine if appropriate substance levels existing within a particular structure is useful and should be done on a regular basis.

The crux of any new rules to be introduced in coming months and years will include a much greater focus on the substance of activities in the places where profits are being booked. For the finance industry, 'substance’ amounts to senior people making key decisions. In the context of contractual arrangements, emphasis will be on actual performance of the contract in question and the level of seniority of those undertaking the activities.

From a domicile perspective, Guernsey is well positioned to meet the required demands for substance in its fund structures – an important factor to consider at a time when there is much greater scrutiny on investment fund structuring arrangements and, in particular, on the existence of substance to justify the levels of profits being booked in certain jurisdictions. Tony Mancini the head of tax, at KPMG in Guernsey, explained to me recently that unlike some competitor jurisdictions, Guernsey has the advantage of significant substance already being present in existing structures.

“It is for this reason that Guernsey has continued to see new funds launch throughout the introduction of AIFMD in 2013 and during the BEPS consultations more recently,” he said.

Indeed, since the beginning of 2013 and the end of September 2015, 185 Guernsey funds have been launched, while 119 non-Guernsey scheme open-ended funds, that are not domiciled in Guernsey but have some aspect of their management, administration or custody carried out in the Island, have similarly been approved. Mr Mancini went on to explain that Guernsey was home to an enviable community of experienced Non-Executive Directors (NEDs) that were specialists in the areas of private equity, infrastructure, real estate and debt, amongst other things – another important factor for substance requirements.

“Take the example of private equity, which has been present in Guernsey for 20-25 years. Other international finance centres with fledgling private equity sectors simply don’t have the infrastructure, including the experienced NEDs, as that evolves over a period of time, through growing, learning and adapting. This is why Guernsey has such a compelling proposition. Substance increasingly represents brainpower, which in the case of investment funds can mean directors with significant expertise together with the other necessary supporting providers and infrastructure. This ensures Guernsey can offer the full package to service investment funds now and in the future.”

Not only is having the requisite substance important, but substance coupled with expertise is critical for fund manager. That message was relayed by Storm Boswick, the managing director of New York-based Brightwood Capital, at a London seminar in early February, when he extolled the virtues of using a Guernsey structure to raise capital in Europe for the first time. He explained that Guernsey came out best from an extensive due diligence process on different fund structures, as well as jurisdictions and their respective regimes.

“We concluded, or decided, based on their findings, that a Guernsey authorised fund, to be listed on the Main Market of the London Stock Exchange (“LSE”), was the perfect solution. The reputation of Guernsey has been extremely well received by the investors that we’ve spoken to, and our experience with the service providers in Guernsey has been exceptional. In fact, the experience we have with the UK service providers, and their relationship with Guernsey, has also been demonstrated as having been an excellent choice.”

This marriage between substance and expertise comes as no surprise to those working in Guernsey’s funds sector or those working in collaboration with it. As leading global funds lawyers, CMS Cameron McKenna LLP, has a lot of experience working on various fund structures, but also with Guernsey’s fund service providers. Cathy Pitt, a corporate partner at CMS, recently said: “I have always been impressed with the knowledge, professionalism and service levels of Guernsey’s funds community, from independent directors to administrators, trustees, law firms and accountancy firms. There is particular strength in relation to listed funds, which is my particular area of specialisation.”

She also appreciates the ability of the Guernsey Financial Services Commission (“GFSC”) to “combine pragmatism and rigour in its approach to regulation”. Something she believed was “noteworthy and had allowed managers flexibility without compromising on investor confidence”.

AIFMD response

For example, in response to AIFMD, the GFSC introduced a dual regulatory regime in which it is possible to continue to distribute Guernsey funds into both European and non-European countries. This consists of the existing regime for those managers not requiring an AIFMD fund, including those using National Private Placement (“NPP”) regimes and those marketing outside Europe, as well as an opt-in regime which is fully AIFMD compliant.

Guernsey’s regime enables managers and funds with no connection to Europe to continue to operate under Guernsey’s existing regulatory framework, which is completely free from the requirements and costs associated with AIFMD.

For managers wishing to market into Europe, Guernsey provides a platform to access all the benefits and opportunities of European capital markets, but crucially is not actually in the European Union (“EU”). Indeed, the NPP route should be used where possible and full AIFMD status should only be sought if there is a specific commercial reason to do so. For those managers with elements of EU and non-EU business, parallel structures can also be utilised.

In July 2015, Guernsey further reinforced its appeal, particularly to non-EU managers, when the European Securities and Markets Authority (“ESMA”) announced its recommendation to grant Guernsey a ‘third country’ passport under AIFMD. Guernsey is one of only 3 jurisdictions to receive the recommendation to date, which, if approved by the relevant European authorities later this year, would further enhance Guernsey’s position to distribute funds into Europe.

Figures released by ESMA in the same piece of advice also underlined how Guernsey was proving to be a key route into Europe for AIFs. Data showed that Guernsey was the third largest non-EU fund domicile - trailing only behind the US and Cayman Islands – when it came to the number of non-EU AIFs being marketed into Europe: in particular, core markets such as the UK, Ireland, Sweden, the Netherlands, Benelux, Finland and Denmark. Ms Pitt has described Guernsey’s response to AIFMD as laudable.

“Regulators and lawmakers worked alongside industry to develop a regulatory regime that is compatible with the Directive, while leaving market participants the flexibility to fall within or without the AIFMD regime for so long as Europe permits. The GFSC was also able to demonstrate to ESMA a culture of robust enforcement and co-operation with EU regulators that gave ESMA the confidence to recommend the extension of the AIFMD Passport to Guernsey.”

Attractive destination

Leading investment houses such as Access Capital, Apax, Apollo, BC Partners, Cinven, Coller Capital, HarbourVest, KKR, Pantheon, Permira, Starwood and Terra Firma have funds domiciled and serviced in Guernsey (with a number also including offices and staff present). In fact, some $65 billion of non-Guernsey funds, typically from the Cayman Islands or Delaware, are administered and managed in Guernsey – a testament to our quality service provision and availability of high quality financial service practitioners on the ground.

Additionally, our flexible migration rules allow certain promoters to easily re-domicile funds to Guernsey. In fact, in quarter four of last year two notable funds confirmed relocations to Guernsey. The first saw VinaCapital Vietnam Opportunity Fund migrate its domicile from the Cayman Islands. The closed-ended investment company focuses its investment strategy across the key growth sectors of the Vietnam economy with net assets of the fund well in excess of $650 million.

Explaining the reasons behind the fund's migration, the directors said it had become apparent that the fund's place of domicile was a barrier to certain potential new investors. Among the reasons for choosing Guernsey were the Island's well- established infrastructure for the administration of closed-ended funds listed on the London Stock Exchange (LSE) and a robust regulatory and compliance regime.

The second redomiciling saw SafeCharge International Group Limited announce its relocation from the British Virgin Islands. The company which was floated on AIM of the LSE in April 2014, raising $125 million, now regularly ranks in the FTSE AIM 100. SafeCharge is an international provider of payments services, technologies and risk management solutions, providing its services to a number of online and mobile businesses. At the time of migration, which was completed on 30 October, it was capitalised at around £400 million.

SafeCharge's decision to move to Guernsey was motivated by several factors, one of those being Guernsey's reputation as a base for a number of funds and companies which are listed on the LSE. The company also viewed Guernsey as well- positioned for it to make a potential move to the LSE's Main Market in the future. This is bolstered by the fact that Guernsey companies benefit from the City Code on Takeovers and Mergers, which provides greater protection to shareholders. In addition, having a Guernsey domicile enables the company to enjoy greater exposure to potential investors thereby facilitating liquidity in its shares.

OECD membership

Other positive news to close out last year included clarification over Guernsey’s status with respect to OECD membership. Confirmation that Guernsey is an OECD member is welcomed as this is a matter that can sometimes be of concern to investors, but a statement by HM Treasury and Ministry of Justice reaffirmed the Island’s role and position within the OECD, which it has held since 20 July, 1990.

This clarification is key because in some jurisdictions there are prohibitions on the marketing of funds that do not originate from an OECD country. The statement has once again emphasised our quality and standing in the international funds environment.

An original version of this article was published in Clear Path Analysis' Fund Formation, Domiciling & Distribution 2016 Report, March 2016.

Back to News
Download Find a related practitioner