Sectors: 1064

White paper - Investment funds - why substance is key

17 August 2016

Written by Kirstie Brewer

In the current climate of regulatory reforms, and the political impetus behind improving tax transparency, the need to prove that an offshore fund manager has the necessary ‘substance’ to its business dealings and functionality has never been more acute. This paper will examine the increasing importance of substance in the fund management sector, particularly in the context of the Alternative Investment Fund Managers Directive (AIFMD) and Base Erosion and Profit Shifting (BEPS) initiative.

Defining substance

This is harder than it sounds. There are no real guidelines on what constitutes substance from country to country, with a number of local regulators putting the issue under scrutiny without yet committing to a definition. However, Anglo Saxon domiciles offer some of the better direction, both in terms of the way substance is defined and how that definition is enforced.

In the UK, an offshore company could still be subject to UK tax if HMRC take the opinion that management activities and control of that company are primarily in the UK. It is up to the offshore entity, therefore, to ensure that its central management and control is not carried out from the UK, but from its offshore domicile, in order to remain subject to the latter’s regulations and tax laws of its place of domicile.

What does this look like in practice? Case-by-case analysis is required to some extent, but, broadly speaking, substance calls for sufficient personnel offshore, at least one of whom is senior, conducting risk management. According to Neil Robson, a regulatory and compliance partner with Katten Muchin Rosenman UK LLP, ideally offshore personnel would also perform some portfolio management duties.

“At a minimum, the offshore AIFM needs to be supervising and monitoring the portfolio management activities of the other management entity which is not the AIFM,” he says.

If you wanted to demonstrate that an alternative investment fund manager (AIFM) is in Guernsey, for example, you need to have sufficient staff based in your Guernsey office and be able to demonstrate that, between them, they are performing the risk management functions for the relevant fund or funds and, ideally, portfolio management.

As a result, it is possible for an offshore entity to be deemed an AIFM with minimal staff, whilst having a much larger complement of staff in the onshore office of their parent company. The core questions are:

(i) Where are senior personnel involved in the fund’s management based?

(ii) Where is the portfolio management and risk management being undertaken?

(iii) Where are the meetings being held at which the decisions for everyday operations are being made?

New technology such as video conferencing could have an impact on the interpretation of the definition of ‘substance’. In theory, it enables key personnel to be virtually present at an important meeting without physically being in the room.

However, in domiciles such as Guernsey, physical presence has always been the primary measure of substance from a board attendance perspective, and new technology has done little to confuse this, according to Christopher Jehan, Chairman of the Guernsey Investment Fund Association (GIFA) Technical Committee.

“[However], what has changed the issue slightly is a loosening of the interpretation by HMRC meaning that some companies are using a mix of physical and virtual presence,” he explains. It means that some board meetings have the whole board attending physically in Guernsey, whilst at others only part of the board is physically present.

The decision-makers

Few aspects of asset management have been more scrutinised in the past five years than fund governance. Many offshore fund managers have been criticised for employing ineffective and/or impotent directors, some with multiple board seats, which might be perceived as undermining claims about substance.

Whilst there are no set rules specifying a minimum number of local directors, the regulator would tend to look at the composition of the board to ensure that there are directors with appropriate expertise and local knowledge, explains Jehan. “In any case a good board will want to ensure that there are directors within the mix who have a solid understanding of the local regulatory environment,” he adds.

Proving that a board of directors is an effective unit, and not a proxy for an onshore decision-maker is vital: do they have the capability to operate autonomously, or do they answer to someone based onshore, in London, for example?

While there has been industry-wide improvement, some jurisdictions have made bigger strides than others, notably the UK’s Crown Dependencies.

Gavin Farrell, Partner at Mourant Ozannes in Guernsey, explains: “From a Guernsey regulatory and structural perspective we provide the substance that is required for the management and running of the Guernsey entities, both the products and their management companies. Not only because we have all the service providers in Guernsey – custodians, administrators, lawyers, banks and accountants – who provide live services to those entities but also because the individuals appointed at the board level are very credible individuals and under a regulatory burden and scrutiny to exercise their managerial and fiduciary duties.”

Farrell continues: “The substance we provide here is very much exemplified by the required oversight of all managerial functions by the board including oversight of all delegated activities. By way of example the process is to have management report back to and scrutinised by the board at the very least on a quarterly basis.

“Certain types of structures may require Guernsey boards to in addition take responsibility for investment making decisions. That would occur after consideration of a report prepared by the adviser. This would add another level of independent scrutiny and review which would strengthen the substance argument. Another key issue will be to ensure that such actions and discussions are appropriately recorded in minutes or other records of the companies, thus also relying on the expertise and oversight of administrators or company secretaries.”

Generally, fund administration work is not outsourced or offshored away from the island, adds Jehan; “particularly in areas like private equity where part of the reason for choosing Guernsey as a domicile is the specialist administration skills.”

Significantly then, the quality, work ethic and location of a fund’s directors are no longer merely subject to industry guidelines, recommendations and infrequent investor litigation. They go to the heart of how substance is interpreted in AIFMD, the EU’s defining piece of alternatives regulation.


Much of the industry’s current preoccupation with substance can be traced back to the creation of AIFMD, the EU’s attempt to regulate AIFMs and, indirectly, offshore hedge funds, private equity, infrastructure and real estate funds.

The Directive – which was written into UK law in 2013 – homes in on so-called ‘letterbox entities’.

If an AIFM is deemed to be a letterbox entity, it will no longer be recognised under AIFMD as managing an alternative investment fund (AIF) and its case for being offshore and taking advantage of that jurisdiction’s tax neutral position would be undermined.

How then can a manager ensure they are not operating as a letterbox entity under the AIFMD? The Directive states that the AIFM ‘must not delegate its functions to the extent that, in essence, it can no longer be considered to be the AIFM of the AIF and to the extent that it becomes a letterbox entity’.

As discussed earlier, this means that in order to operate under AIFMD an offshore manager must perform its own investment management services and do so with the necessary expertise, resources and oversight from senior decision-makers.

What is a letterbox entity?

But let’s turn it on its head. How does AIFMD define a ‘letterbox entity’, i.e. how does it define

a lack of substance? Article 82 lists four possible pitfalls:

(i) An AIFM that no longer has the necessary expertise and resources to undertake its delegated tasks and manage the risks associated;

(ii) An AIFM that loses the power to take the decisions of senior staff;

(iii) An AIFM that loses the rights to interact with its delegates; and

(iv) An AIFM that delegates the performance of investment management functions to the extent that the delegated activities exceed ‘by a substantial margin’ those performed by the AIFM itself.

A fund manager that falls foul of any of the above and becomes a designated letterbox entity faces a problem on two fronts: not only is it failing to meet the required regulatory standards, but, more significantly for the reputation of the individuals involved, also the standards of an increasingly diligent investor community.

What constitutes substance for tax purposes?

Historically, UK tax law underpinned substance requirements for offshore hubs, but now the OECD’s Base Erosion and Profit Shifting (BEPS) initiative – a framework to help countries manage tax avoidance issues – is becoming a new focal point.

BEPS is primarily focused on countering what the OECD perceives as abusive tax avoidance by ecommerce and multinational companies: it seeks to combat practices that artificially separate taxable profits from the activities that generate those profits. But BEPS also has the potential to make it problematic for ‘collective investment vehicles’ to obtain the benefit of double tax treaties.

“BEPS is concerned with where the substance of a transaction takes place and whether the tax being paid by the company is aligned with that,” explains Tony Mancini, Head of Tax at KPMG in Guernsey. “Scrutiny will be placed less on contractual arrangements and more on the level of oversight and seniority those people driving the activities of these arrangements have. In particular, attention will focus on the individuals responsible for the management of capital and risk.”

As previously mentioned, for AIFMs this means the board of directors. And where these directors are located, as well as their credentials, will be increasingly integral to proving that there is real offshore substance, according to Mancini.

“Where our challenge comes in is making sure the directors really are managing the risk and capital – not just following the advice of managers onshore but providing their own oversight,” he explains. AIFMs that use intermediate holding companies in other jurisdictions should also be mindful of BEPS. These are typically structured to receive dividends and income from a fund’s underlying investments and assets and are located in a jurisdiction which can offer reduced withholding taxes, usually by virtue of double tax arrangements.

A different definition

One of the BEPS action points seeks to deny such treaty benefits for companies with insufficient substance in the territory whose treaties they seek to utilise. In this instance, ‘substance’ has a different meaning. Here the requirement is for the company to have a genuine business establishment or significant shareholder connection to that jurisdiction. However, there is an appreciation that this model does not accommodate investment funds, which are important for international capital flows. The OECD is currently consulting on a different treatment for investment funds in the context of treaties.

Furthermore, the EU has given the OECD’s work on BEPS political impetus. The European Commission, together with the current Dutch presidency has produced a draft anti-tax avoidance directive.

“One aspect of the [draft directive] looks at transactions European companies have with entities in non-EU jurisdictions,” Mancini explains. “They plan to agree criteria for assessing jurisdictions’ tax governance and international cooperation, which will be used to determine how transactions with entities in those jurisdictions are treated for tax purposes.”

Why Guernsey?

Industry commentators are confident Guernsey will meet OECD criteria. The jurisdiction was commended by the IMF in 2011 for the quality of its supervision as a funds domicile.

More recently, in July 2016 it became one of only five non-EU jurisdictions to be given an ‘unqualified and positive assessment’ by ESMA, the EU regulator, to be extended the benefits of the AIFMD marketing passport. ESMA has assessed Guernsey alongside 11 other non- EU jurisdictions as part of its non-EU AIFMD passport review.

Guernsey also has a high level of anti-money laundering regulation, as proven in the latest Moneyval report on the jurisdiction. Moneyval, a monitoring body of the Council of Europe, reported in January 2016 that Guernsey has made major progress against anti-money laundering and had surpassed the equivalent IMF report that assessed the jurisdiction four years previously.

Its high level of tax transparency is a strong selling-point too, says Jehan. He also highlights reporting on matters such as FATCA, CRS and EUSD, the high number of tax information exchange agreements signed and a rating in the OECD peer review process that puts Guernsey on par with onshore jurisdictions such as the UK, Germany and the US.

Meanwhile, the fact that the island has a securities exchange is another indicator of a well-established financial services industry, says Fiona Le Poidevin, CEO of the Channel Islands Securities Exchange (CISE).

"Groups with vehicles listed on the CISE are demonstrating additional substance in the island by utilising another element of the local infrastructure," she explains. Furthermore, greater substance is provided through the activity undertaken locally to ensure adherence to the Listing Rules and the corporate governance codes which are requirements of a listing.

There are currently more than 500 investment securities listed on the CISE, including open-ended and closed-ended funds and non-fund investment vehicles including real estate investment trusts (REITs) and unregulated investment companies.

Ultimately, Guernsey’s established and well-regarded offering of back office service providers, strong corporate governance and robust regulatory regime stands it in good stead as the regulatory spotlight turns to issues of substance; however it is defined.


This white paper was produced in conjunction with freelance journalist Kirstie Brewer. As the former Investment Editor at hedge fund trade publication HFMWeek, Kirstie has expertise in the alternative investment fund management sector and corporate governance.

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