At the core of every international private equity fund is achieving maximum tax efficiency among the jurisdictions where the investments are located (and income generated), the shares are held of special purpose vehicles ("SPV's) – also known as single asset companies, and the domicile of the investors. The primary factors that will determine how and where a fund is structured are (i) the investment vehicle must be transparent in that profits and gains are not taxed at the entity level, only at the investor level (no double taxation); (ii) the investment vehicle must protect the investors as well as the shares of the fund (limited liability); (iii) there should not be any laws or regulations inhibiting the investment activities of the fund; and (iv) that the vehicle can be established as a closed-end fund.
In the not too distant past, investments were structured using companies established in tax havens in the Caribbean.
The "Dutch Sandwich"
Formerly, one of the most popular international holding structures was the "Dutch Sandwich", in which the shares of a Dutch private limited liability company ("BV") were held by a Netherlands Antilles public limited liability company ("NV"). The BV could own an unlimited number of special purpose vehicles ("SPV"). The Dutch Sandwich essentially looked like this:
The Dutch Sandwich carried advantages for making investments in other companies, thus adding layers of limited liability protection for the investors. Tax treaties among the EU members known as the Parent-Subsidiary Directive generally afforded low withholding taxes for dividends paid by a SPV to a BV (between 0% and 15%, but in the case of Turkey, 10%). The dividends received by a BV from its SPV's are tax-exempt in the Netherlands pursuant to its "Dutch participation exemption". The same is true for capital gains realized from the transfer of shares of the SPV's. Under the tax laws of the Netherlands, a Dutch dividend withholding tax rate of 8.3% was applied to dividends from the BV to the NV so long as the NV holds at least 25% of the shares of the BV. On payments other than dividends, royalties, and interest, there is no withholding tax in The Netherlands.
Unfortunately for many taxpayers, especially Americans or those subject to American tax, the Obama administration appears to have targeted the Dutch Sandwich for the trash bin of tax evasion history. One alternative for non-US residents subject to worldwide income tax is to form a Guernsey or Jersey Limited Partnership or Trust to hold shares in investment companies, real estate, or funds located in foreign states. For the purposes of this article, only Jersey entities and their regulation will be examined. However, it should be noted that there is no significant distinction between the two jurisdictions. Collective investment funds can be structured through a multitude of corporate structures, including companies, protected / incorporated cell companies, limited partnerships and unit trusts.
Regardless of the structure adopted, the Jersey Financial Services Commission (the "JFSC") will approve and regulate any collective investment fund and its related advisers under a combination of the legislation discussed below.
There are a considerable variety of fund structures available, all of which are regulated by the Jersey Financial Services Commission (the "JFSC") and that fall into basically three categories; companies, unit trusts, and limited partnerships. These investment strategies are regulated under the following legislation:
- the Control of Borrowing (Jersey) Order 1958 ("COBO")
- the Collective Investment Funds (Jersey) Law 1988 ("CIF Law"); and
- the Financial Services (Jersey) Law 1998 ("FS Law").
The following provides a brief outline of the different regulatory regimes offered in Jersey under the above legislation currently in force in Jersey.
Very Private Structures
The most basic fund structure, limited to small groups of up to 15 investors, or where there is a single investment purpose and no formal offering of securities is known as a "very private" structure. Very Private Funds are regulated under COBO and can be established within a few days. The only requirement is the disclosure of the identity of the investors to the JFSC and confirmation that the structure is not considered a collective investment fund and would be marketed to less than 15 investors. This type of structure is appropriate for single investor vehicles, as well as joint ventures or entities created to act as a co-investor with other entities.
COBO-Only Private Placements
Any fund that is offered to no more than 50 potential investors and will not seek a listing can be treated as a COBO-only, or private placement fund. Although this type of fund falls outside the scope of regulation as a "collective investment fund", the JFSC will still exercise some regulation through its authorization process and conditions contained within the COBO Consent issued on approval. The authorization includes a multi-stage process whereby the JFSC would review the "promoter" of the fund as well as reviewing the private placement memorandum prior to granting COBO consent. Provided a COBO-only fund qualifies as a professional investor regulated scheme, Jersey entities providing fund services to the scheme need not be regulated under the FS Law. Three main conditions apply to such private placements:
- The promoter must satisfy the JFSC's Promoter Policy in relation to private funds, including satisfactory track record, reputation and experience of the promoter as well as the risk allocation and financial resources of the firm;
- Investors must be the roughly equivalent to US definitions of "qualified" or "experienced" investors – either professional (institutional) investors or investors contributing at least £250,000 - and execute a legally prescribed investment warning statement; and
- Ongoing regulation of the fund will be through compliance with the conditions set forth in the COBO consent.
Unregulated funds have recently been made available in response to market demands for a fully flexible framework aimed at sophisticated and institutional investors. Unregulated funds are exempted from regulation by virtue of an enabling order made under the CIF Law, which specifies schemes or arrangements that have been established in Jersey as either an unregulated, closed end exchangetraded fund listed on a recognized stock exchange or in the process of listing; or an unregulated eligible investor fund. Investors may qualify as eligible by virtue of their total wealth, experience, or making an initial investment of over US$1 million.
On satisfactory compliance with the order, there will be no regulatory review or oversight by the JFSC of the terms or conduct of such unregulated funds and therefore, processes for their establishment depend only on being carried out in accordance with the exemption order.
Stock exchange listings for unregulated eligible investor funds are possible provided the exchange / listing allows for certain transfer restrictions. Either type of unregulated fund may take the form of a Jersey company (including cell structures); a Jersey limited partnership, or a unit trust having at least one Jersey corporate trustee or manager. Beyond the obvious requirement to comply with COBO, there is no regulatory oversight of an unregulated fund, although such a fund must appoint a Jersey functionary, itself regulated under the FS Law. The offering document of an unregulated fund must prominently display the official warning language, and completed/executed notices must be filed with the Jersey Registrar of Companies.
Should a fund be offered to more than 50 investors it would be regulated under the CIF Law, with a higher degree of regulation placed upon lower minimum investment amounts. The CIF Law allows a fund to make an unlimited number of offerings to an unlimited number of investors.
As part of its regulation of Unclassified Funds under the CIF Law, the JFSC will require the promoter to qualify and comply with its policies, as well as undertaking a review of the principal fund documentation including the offering memorandum, company formation documents, and all other agreements related to the fund. Prior to providing authorization of the fund structure, the JFSC will approve the fund's borrowing, and investment practices. The extent of compliance and regulation is largely dependent on whether the fund is open or closed ended, together with the amount of the individual investments. Closed end funds are generally less highly regulated than open ended funds. In return for satisfying certain investor criteria Jersey has, under the CIF Law, created a lighter touch regulatory environment for Expert funds and Listed Funds.
The Jersey Expert Fund Guide, created under the CIF Law, provides a lighter touch regulatory environment, in return for which the Fund must meet certain criteria and conditions. This includes all potential investors must qualify as "expert investors" and acknowledge this and the associated investment warnings in writing prior to making an investment. The qualification criteria for an expert investor include a minimum investment of at least US$100,000 (or currency equivalent).
As part of the lighter touch regulatory environment, the approval process is streamlined and provides for the authorization of a fund in as little as three days from filing of the application. Other requirements for an Expert Fund are:
- The investment manager must be regulated in an OECD member state or the state previously entered into a Memorandum of Understanding with the JFSC, whereby the JFSC considers the state to be an equivalent jurisdiction.
- The offering memorandum must comply with certain content and disclosure requirements.
- The fund company, general partner, or trustee requires a minimum of two Jersey resident directors and the fund itself must be a Jersey company or have a Jersey general partner or Jersey Trustee (as applicable); and
- An Expert Fund must appoint a Jersey "monitoring functionary" being an administrator, manger or trustee, which are regulated under the FS Law.
Modeled on the Jersey Expert Funds the Jersey Listed Fund Guide allows listed closed ended funds to be authorized within a few days through a self-certification approach. Similar qualification requirements to the Expert Fund regime, however a Listed Fund may be offered to any category of investor including retail investors.
Recognized funds are authorized as collective investment vehicles under the CIF Law and must comply with a different prescriptive order which includes greater levels of regulation than that of the COBO, Unclassified, Expert or Listed funds. This increased level of regulation is promoted by the ability of recognized funds to be marketed to the retail public in the UK and a number of other states including Australia, Belgium, Hong Kong, the Netherlands, and South Africa. Recognized funds are highly regulated fund structures and provide investors with access to a statutory compensation scheme.
Codes of Practice
Over recent years, Jersey has undertaken an overhaul of its regulation of collective investment funds and their functionaries. The process started in 2007 with functionaries becoming regulated under the FS Law and will be complete towards the end of 2009 with the introduction of a Codes of Practice for Funds. Codes of practice for fund services business ("FSB Codes") were introduced in November 2007 and there are proposals currently in consultation to introduce a Codes of Practice for collective investment funds authorized under the CIF Law. These codes of practice aim to make regulation more effective and consistent, while reducing the administrative burden on both the industry and the JFSC.
Jersey Investment Vehicles
Jersey Limited Partnerships
Limited partnerships are governed by the Limited Partnerships Law of 1994. This law was amended and supplemented by the Limited Liability Partnerships (Jersey) Law of 1997 and the Limited Liability Partnerships (Insolvent Partnerships Regulations) of 1998. These regulations established Jersey as one of the world's most advanced jurisdictions for use of the limited partnership.
The limited partnership is managed by a general partner. In most cases, the actual fund management company owns all the shares of the general partner. In addition to its fairly typical duties as a general partner, the manager (known as the Advisor in fund jargon) has more specialized financial reporting and communications responsibilities vis a vis the investor limited partners and must meet the requirements of the Limited Liability Partnerships (Jersey) Law.
To form a limited partnership a declaration must first be lodged with the registrar. The declaration need only provide the names of the general partners (not of the limited partners), and the partnership agreement does not need not to be filed. Limited partnerships are treated as tax transparent. Each of the partners is separately assessed on their partnership income and gains; resident partners on worldwide partnership income, and non-resident partners only on Jersey income.
In June 2006, the Jersey authorities published new proposals to amend the jurisdiction's Limited Partnership Law, in an effort to improve the competitiveness of the island's offshore financial services industry. One of the main aims of the proposals is to allow a Jersey limited partnership to have a legal 'personality', bringing the island into line with Guernsey, which amended its relevant legislation in 2001 allowing limited partnerships to elect to have legal identity.
Another method for investors is to employ a Jersey-based Trust. The powers that may be reserved by the settler (the one establishing the trust) include the power to appoint and remove trustees, to amend or revoke the terms of the trust and to appoint or remove an investment manager or investment adviser. Amendment Number 4 to the Trust Law of 2006 also permits a trustee to delegate any of his or her trusts or powers if permitted by the terms of the trust. Other amendments include conflict of law provisions which will mean that the validity of a trust governed by Jersey law will not be affected by any rights conferred on anyone under a foreign law, and a provision that removes the former automatic 'personal guarantor' provisions for directors of corporate trustees.
Jersey is a party to the Hague Convention on the Law Applicable to Trusts and Their Recognition. Jersey trust law explicitly excludes foreign inheritance laws and does not recognize foreign judgments. The creation of a trust is free from Government duty and there are no registration or audit requirements as such in Jersey, although the tax authorities of beneficiaries' jurisdictions (e.g. the UK) may require annual reports. Jersey trusts may 'migrate' to other jurisdictions by changing trustees and the applicable law of a trust; likewise, foreign trusts may migrate to Jersey.
When the beneficiaries of a Jersey trust are not residents of Jersey, income arising from sources outside Jersey is not liable to income tax in Jersey, nor is distributions to the beneficiaries. Interest on bank deposits made by the trustees of a non-resident trust is not taxed because of a government concession. The trustees of a non-resident trust are not required to make returns or provide accounts of the trust to the Comptroller of income tax. Trust accounts must be kept but do not require auditing.
Managed entities are fund vehicles that are managed or administered by licensed third party service providers in Jersey. Managed funds can contract with these third party service providers for the provision of fund services related to compliance with the relevant Codes. The provision of such services is a unique class of fund services business that requires separate registration. In Jersey legal parlance, this class is called a "Manager of a Managed Entity or "MoMe" and is typically performed by existing regulated fund services businesses.
A currently popular and tax efficient structure for institutional investors that invest in funds which invest in Turkish real estate is to use a Jersey or Guernsey Trust that owns all the shares of a Luxembourg holding company that in turn holds shares in individual Luxembourg SPVs which own the shares of Turkish joint stock (holding) companies that in turn each own a single or multiple assets domiciled in Turkey. Maximum tax efficiency is achieved through tax treaties between Turkey and Luxembourg. It should be noted that Jersey does not have a double taxation prevention treaty with Luxembourg.
A management company ("Manager") is formed in Jersey which enters into a Management Agreement with the Jersey investment fund and under such Management Agreement Manager assumes the responsibility of making investment and divestment decisions for the Jersey investment fund's members. The Manager, often known as the Advisor in local jargon, may be formed as a Jersey limited partnership (however other jurisdictions are possible depending on tax planning of shareholders of Manager) and earns fees from the Trust for its services. The Manager works with a professional trust company with a physical presence in Jersey that handles local filings, registrations, Jersey resident Directors, distribution and deposit of income, or proceeds from asset sales, and tax filings. The Manager is typically owned by the promoters of the fund, and the fees (management fee, development fees, etc.) and income earned are in line with standard industry practices. Fees are generally based on a percentage of the NAV of the underlying assets, or the amount of funds under management.
Recent developments with international tax treaties and increased enforcement of tax collection efforts by many countries have begun to cast a shadow over the Jersey/Guernsey – Luxembourg Holding Company – Luxembourg SPV – Turkish OpCo/PropCo structure. In response to the fact that some American and European institutional investors prefer or regulations and/or bylaws prohibit them from investing in offshore fund vehicles (such as Jersey), a new formula is emerging. The most recent trend in fund structuring for Turkish private equity real estate funds involves foregoing the Jersey or Guernsey Trust and only using Luxembourg entities.
Luxembourg domiciled private equity real estate funds that invest across multiple property and asset classes typically utilize one of the two structures outlined below. Income yielding assets (usually commercial properties) are treated differently from residential properties that are developed or invested in and sold to individual owners (institutional investors prefer seperate allocations to the each asset class), this neccessetates different structures for each of the asset classes within the fund.
A SIF is a Specialized Investment Vehicle that is regulated under a relatively new law enacted in Luxembourg known as the Law of 13 February 2007 on Specialized Investment Funds ("New SIF Law"). Although perhaps a gross oversimplification, the New SIF Law consolidated prior laws on collective investment structures that originated in 1988, amended in 1991, updated in 1998, and again in 2002. As a result of confusing links between some of these prior laws, the entire regulatory regime had to be reenacted no later than February of 2007. This gave the legislators a unique opportunity to make Luxembourg more attractive than the other countries allowing SIFs for fund managers and promoters to launch new funds, in particular complex structures like hedge funds, private equity or real estate funds. A new and independent vehicle for institutional, professional, and "well-informed investors" is now available. The SIF Law broadens the notion of institutional investors by introducing this concept of "well-informed investors", which includes high net worth individuals and professional investors.
The SIF Law offers high flexibility in terms of establishing the structure and relevant investment rules. SIF vehicles are regulated by the Commission de Surveillance du Secteur Financier (CSSF) but enjoy a very flexible supervisory regime. A SIF may start its activities without CSSF prior approval provided that an application file is submitted to the authorities within one month of its creation. This combination gives Luxembourg a very competitive edge when compared to the other fund centers.
No minimum content or details are required by the law for the offering documents. This preserves flexibility and allows for the evolution of investment activities and parameters. Frequency of the net asset value ("NAV") calculation should be defined in the offering documents and must be at least once a year. Other terms may include restrictions such as lock-up periods. No investment or borrowing restrictions are defined in the Law, with the exception of the principle of risk-spreading which is found virtually everywhere fiduciaries are active. This is maintained - but at a lower degree – as defined in the CSSF circular 07/309.
The SIF is exempt from corporate income tax, municipal business tax and net wealth tax. In addition, no Luxembourg withholding tax is levied on income distributed by the SIF to its investors. There is only an annual subscription tax of 0.01% based on the NAV of the SIF (with some exemptions, including money market, Pension Pooling Funds, other Undertakings for Collective Investment - UCIs). A local custodian duly approved by the CSSF is to be appointed for the safekeeping and supervision of the SIF's assets. However, the scope of its responsibilities does not include additional monitoring duties as was the case for funds established under earlier laws. Luxembourg Fund Structure A
Structure A: two separate investment funds each in the form of a SIF.
- In this structure there would be two separate funds each in the form of a SIF each of which either adopts the regime of a tax transparent FCP (a collective investment fund with a pool of assets) or the regime of a taxable but exempt SICAV (investment company with variable capital).
- An FCP does not have a legal personality and each SIF-FCP must therefore appoint a Luxembourg regulated management company. Such a management company can be one and the same for both SIF-FCPs.
- A SIF-SICAV must adopt the legal form of an S.A., S. à R.L., S.C.A. or any other Luxembourg corporate entity with legal personality. Because of the separate legal personality the SIF-SICAV can be self-managed and does not have to appoint a separate management company.
Structure B: an umbrella structure where one SIF will be established for both asset classes. Insolvency of one asset class will not affect the other asset classes through a separation of assets and liabilities of each asset class. There is an advantage to have this structure if the conditions for outside investors are similar for each asset class.
- In this structure the SIF also either adopts the regime of a FCP or the regime of a SICAV.
- As mentioned previously, a SIF-FCP does not have legal personality and the SIF-FCP must therefore appoint a Luxembourg regulated management company. Such a management company can be one and the same for both asset classes.
- As mentioned previously, a SIF-SICAV must adopt the legal form of an S.A., S. à R.L., S.C.A. or any other Luxembourg corporate entity with legal personality. Because of its distinct legal personality the SIF-SICAV can be self-managed and does not have to appoint a separate management company.
Exit Strategies and REICs
A potential exit strategy for a Turkish real estate private equity fund structured like the one described above would be to create a holding company at the Turkish level below the Luxembourg SPV, and for the Turkish holding company to own the direct interests in the individual Turkish properties and to convert its shares in the Turkish holding company to REIC shares. This non-taxable transfer gives the investors in the fund (usually a limited number of individuals or legal persons) access to a much larger market of potential purchasers of their shares at theoretically a multiple of their original investment. As the REIC shares are traded and sold, the proceeds flow up to the SPV and from there upstream to either the SIF (if a Luxembourg fund) or the Jersey trust (if a Jersey fund). The beneficiaries of the fund (typically the institutional investors) have a variety of options at that point, including simply cashing out and paying taxes, reinvesting with the SIF or Jersey trust into other fund opportunities, or employing other vehicles for estate planning.
For the most part, changes to Turkey's Land Registration Law have enabled foreigners to acquire real estate in Turkey with reasonable sanctity of title. This in turn has created more interest in Real Estate Investment Companies in Turkey (referred to as REICs or REITs). REIC's are special purpose management corporations with shares that trade like stocks on the exchanges and directly invest in equity market tools and real estate based rights. Investments can be made either through actual properties or mortgages on real properties. The purpose of a REIC is to invest in real estate with the potential of earning income yield, investing in real estate development projects, receiving rent from real estate in a portfolio, and achieving capital gains by trading real estate. In return, REIC's distribute equity shares. Consequently, shareholders receive profits indirectly from income-producing real estate that is held in the REIC's portfolio. The low ratio of liquidity in the REIC system is not considered as a negative feature because shareholders are also investing in companies that in turn are investing in and owning real estate. The REIC market in Turkey is currently enjoying good health and maintaining its attractiveness for investors. For this reason, perhaps some of the fund institutional investors may simply choose to enjoy the benefits of REIC share ownership over the long-term.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.