Podcast: Credit Funds: The Benefits, Challenges and Applications of Treaty Fund Structures When Investing in Credit
In this podcast, Laurel FitzPatrick, Adam Greenwood and Jim Brown discuss the tax considerations applicable to non-US investors investing in funds that invest in credit and debt instruments. So-called 'treaty funds' offer one alternative to managing tax implications resulting from these investments, but their complexity requires an understanding of the various structures and mechanisms of these types of funds. In particular, the group discusses the types of treaty funds that are available, such as ‘bring your own treaty’ and Luxemburg and Irish company structures, as well as the differences in operating a treaty fund versus a traditional private equity fund.
Laurel FitzPatrick: Hi, and welcome to this Ropes & Gray podcast. I'm Laurel FitzPatrick, co-leader of the firm's hedge funds practice, and today we're having another in our series of credit funds podcasts – this one will be focused on treaty funds. I'm joined today by two of my tax partners, Jim Brown and Adam Greenwood. I assume we have people listening, some of whom are very experienced with treaty funds, and some of whom probably want to know what a treaty fund is. Let’s level set, at the beginning. For starters, let's talk about the problems for non-U.S. investors, and what they need to consider when investing in funds where there's loan origination. Adam, do you want to take that one?
Adam Greenwood: So, as a general proposition, non-U.S. investors have to consider a number of tax considerations when making investments in loans and negotiating and structuring loans directly, or through investment vehicles, that they generally have not had to consider when making investments in traditional private equity funds. Non-U.S. investors generally are able to freely invest in traditional private equity funds that buy and sell equity of portfolio companies without any taxable event. It is actually much more complicated for non-U.S. investors to be participating in credit investments. The U.S. tax code provides an exception for non-U.S. investors to be traders in stocks and securities from being subject to taxation. However, a similar exemption does not apply, generally, to general loan origination or financing activities that can give rise to a trade or business. If a non-U.S. investor is treated as engaged in a financing trade or business, it can be required to file U.S. federal income tax returns on an annual basis and pay income taxes as if it were a U.S. resident. And non-U.S. investors generally will also be subject to an additional 30% branch profits tax, resulting in, potentially, an effective federal tax rate of around 46%. This is pretty substantial consequences of being treated as engaged in a trade or business, and so non-U.S. investors are keenly focused on how credit funds are managing this risk of being treated as engaged in a trade or business, and making sure that they are not subject to additional tax returns in jurisdictions and suffering significant tax leakage on their investments.
Laurel FitzPatrick: And I guess there are concerns for tax-exempt investors, too. Jim, do you want to address those?
Jim Brown: Sure. One of the important level-set points to make, though, is that loan origination activity itself is not subject to tax in the hands of a tax-exempt investor. That's because unrelated business taxable income, which is the measure of the amount of income on which tax-exempt investors are subject to tax, does not include interest income or capital gains – and it also doesn't include other income, including fees that are earned in connection with the making of loans. However, unrelated business taxable income, or UBTI, does include so-called “debt-financed income,” which is income that is earned on assets that are acquired with indebtedness. And so, because a lot of credit funds are levered, they would otherwise generate UBTI as a result of debt financing. And so the common way that exempt investors invest in assets that are debt financed is through off-shore corporations, because normally, the off-shore corporation, when it invests in a “trading in stocks and securities fund” would itself not be subject to tax. But, for the reasons that Adam mentioned, when the off-shore corporation is engaged in a loan origination business, it is subject to tax on its effectively connected income, just like any other non-U.S. investor. Therefore, for all practical purposes, when the loan origination activity is going to be debt financed, in order to avoid any U.S. tax, the exempt investor is sort of in the same place as a non-U.S. investor, because they need to invest through an off-shore corporation, which is, itself, an entity that would be subject to trade or business tax in the way that Adam described.
Laurel FitzPatrick: Thank you. So that's the problem that investors face. What do we mean when we talk about “treaty funds”?
Adam Greenwood: Well, many non-U.S. investors will try to avoid all origination activities and perhaps try to become extremely passive debt investors. And, for example, many CLO issuers are organized as non-U.S. vehicles that are able to earn U.S.-source interest income, and not be subject to tax on that income, because of the limited nature of their permitted investment activity. And that interest income qualifies for something commonly referred to as the “portfolio interest exemption,” providing a zero percent rate of taxation to non-U.S. investors who realize U.S.-sourced interest income and are not engaged in a U.S. trade or business. A treaty structure accepts that once there are material loan origination activities being undertaken in a fund vehicle or directly by a non-U.S. investor, that they may be treated as engaged in a U.S. trade or business, and thus ineligible for that portfolio interest exemption. And, instead, they try to rely on provisions in the U.S.'s network of tax treaties with other jurisdictions that also provide relief from taxation. And, in this area, in particular, various treaty structures rely on specific rules stating to the effect that a non-U.S. investor eligible for benefits under a treaty will not be subject to tax in the United States when treated as engaged in a U.S. trade or business, as a result of activities carried out on behalf of that non-U.S. investor through a so-called “independent agent.” And, for those investors, if they realize, say, interest income, as a result of activities of an independent agent, that interest income is then taxed at the rates applicable under the terms of that U.S. tax treaty, in many tax treaties that rate can be down to zero. At a more granular level, what it means to have a treaty structure can typically mean one of two things. One structure is commonly referred to as a “bring your own treaty” structure, which seeks to secure capital commitments from investors who are eligible for the benefits of a tax treaty between their home jurisdiction and the United States. And those investors will typically be investing in a Cayman Islands or a Delaware Limited Partnership, and they will have general partners that are unaffiliated with the investment manager. And, alternatively, you will sometimes see funds that try to utilize a treaty structure for investors who are not residents of jurisdictions that have treaties with the United States. And, in those situations, the funds will organize pooled vehicles, typically either in Luxembourg or in Ireland, that themselves are capable of being eligible for benefits under the tax treaties that the United States have with Luxembourg and Ireland.
Laurel FitzPatrick: So let's look at them one at a time. Jim, what are the core features of a “bring your own treaty” fund structure?
Jim Brown: So the “bring your own treaty” fund structure is, as Adam noted, premised on the reliance on the investors' status under its home jurisdiction treaty. And so the treaty structure itself is designed so as to ensure that those benefits can be relied on by the fund. And the principal feature is that the fund itself needs to be treated as transparent in the investors' jurisdiction, because only entities that are treated transparent in those jurisdictions would allow the fund itself to look to the investors' treaty to determine whether the benefits of that treaty are available to the income of the fund – and so that's the most critical feature. The other features are actually similar to those that relate to the other treaty, the Lux Co and the Irish Co treaty structures, and those principally are that there needs to be an investment management agreement and the manager needs to qualify as an independent agent. The rules for qualifying as an independent agent, generally speaking, are the same for all the jurisdictions, so that part of it should be relatively straightforward. So one of the issues that arises is that the types of funds that are transparent in the home jurisdictions would default to be treated as transparent in the U.S. One of the concerns of these investors is return filing in the United States, and also state and local tax in the U.S. And so, to avoid those requirements and liabilities, these structures often involve the investor investing through a separate entity, which is transparent in their home jurisdiction, but that checks the box to be treated as a corporation in the U.S. Some funds actually organize themselves such that the fund itself checks the box to be a corporation in the U.S., even though it's transparent in the home jurisdiction. But there's a little bit less certainty about the ability to claim treaty benefits in that circumstance, although I think that, probably, the predominant view is that you can.
Laurel FitzPatrick: So, Adam, I'm sure that means we can tell investors that they've eliminated all U.S. taxes, and that this is just the silver bullet, right?
Adam Greenwood: Alas, the treaty structures are not magical elixirs. As noted earlier, the benefit of being able to qualify to have a manager be treated as an independent agent of a non-U.S. investor or a non-U.S. pooling vehicle is simply that that investor is not treated as having a permanent establishment in the United States, solely as a result of that agent's activities. And there are still several ways in which the structure does not completely eliminate taxes. First, tax treaties have separate articles stating the tax rate that applies to non-U.S. investors on interest income earned by those investors that are from U.S. sources, and certain of those treaties do not provide for a zero percent rate of taxation on interest income. And there are several treaties that will provide a 10% rate, or even a higher tax rate on that interest income, which can be highly problematic. In addition, treaty structures do not solve the issues for taxation around equity investments. So, for example, dividend income that may be realized from a corporation is generally subject to a tax rate of 30%, as reduced by treaty. And treaties generally provide that dividend income will be subject to a 15% rate, or sometimes, five percent rate. Certain non-U.S. investors, often certain pension funds, will be eligible for zero percent rate on that income as well. Another situation where this can arise in the equity area is equity investments in U.S. real estate, or equity investments in operating partnerships, or operating LLCs. The so-called “FIRPTA tax rules” on real estate investments, and the tax rules on investments in U.S. operating businesses or operating partnerships, are not trumped by the provisions of a tax treaty, so it's not going to solve those problems. In addition, the tax treaty addresses federal tax issues, but does not clearly provide for a corollary exemption at the state level, which can result in certain complexities there.
Laurel FitzPatrick: So that was the high-level look at the “bring your own” treaty structure. What about for Lux or Irish Co structures, in particular, for folks that don't have a treaty to rely upon? What are some of the features, for example, of the Irish Co structure?
Jim Brown: Well, the critical feature of the Irish Co structure is that the fund itself needs to be a good treaty resident, a so-called “qualified resident,” and that would mean that it needs to satisfy one of a list of provisions, most of which, you know, an investment fund would be unable to satisfy. For example, being publicly traded itself or being fully subject to tax in Ireland itself. Minimizing taxes is one of the objectives of that structure, so those don't really apply. Instead, the fund itself qualifies as a resident by reason of its U.S. and Irish ownership, which as a practical matter, means mostly just U.S. ownership, and so the vehicle needs to be owned more than 50% by U.S. or Irish people. And so that may limit the number of investors or the amount of capital that the fund can raise depending on how attractive the investment can be to U.S. investors. And some of the other typical features that are important would be that the advisor needs to be independent of the fund – the fund needs to be treated as a principal, in and of itself. And so some of the features that the fund usually includes to support that position would be that the fund is managed by an independent board, that the individuals on the board are qualified in this investment space to make decisions on behalf of the fund, including the decision to hire and possibly terminate the investment advisor. Usually, depending on the risk appetite of the sponsor, there would be a mechanic whereby either the investors in the fund, or the board, or maybe both, can terminate the sponsor. There are various additional costs involved in setting up the structure. And then there are a bunch of peculiarities about the structure that are relevant to the local jurisdiction, in Ireland, in particular. So, for example, there's a vehicle referred to as an “ICAV” in Ireland that, itself, is not subject to tax, but is more heavily regulated and limits the amount of leverage that can be used in the fund. Alternative types of funds are so-called “Section 110” companies in Ireland – those provide greater flexibility, but there are also limitations on the activities that the fund can engage in under the regular Irish rules, in order to avoid Irish tax. And there's specific mechanics, whereby, if you use, for example, a 110 company for avoiding tax in Ireland, and so those mechanics can present limitations on the operations of the funds.
Laurel FitzPatrick: So the ability to remove the GP is obviously something that managers have to struggle with. Treaty funds are still pretty new to a lot of investors. What are some of the other features of these structures that may seem unusual to investors?
Jim Brown: Another feature that is often present is that there's a concern when the manager has an equity interest in a fund, the extent to which, the fund can be independent, or rather, the manager independent of the fund, as opposed to some sort of alter-ego arrangement. And then, specifically, of greater concern, frankly, is when the manager is compensated through the receipt of the equity interest, in the form of a carry. And so one of the common features of these funds is that the GP compensation is structured as a fee, including a performance fee – and that can present various challenges under the deferred compensation rules to ensure that the way that the fee is paid, its measure, and the timing of the payment, does not trigger any penalty taxes under those rules. Other challenges, depending on the jurisdiction of the fund being used, is that there can be limitations on side letters, the fee deals. There are also issues with how the fund finances itself, because, depending on whether the interest deductions are needed by the fund in order to avoid local tax, those interest deductions can jeopardize the resident or “good treaty” status of the fund itself under the so-called “base erosion” rules. So there are a bunch of features that are unusual to treaty funds that the investors would not normally see in a normal credit fund.
Laurel FitzPatrick: And Adam, how about once you're up and running the fund? What kind of unusual operational challenges present themselves with the treaty fund?
Adam Greenwood: Well, I think there are always some surprises in terms of operational hang-ups to a manager as a result of utilizing the treaty structure. For instance, you are being engaged by a fund with an unaffiliated GP and so there is some level of coordination with that general partner. And there is also, as Jim was mentioning, some of the unavoidable tensions and issues around the risks where your management contract may have termination provisions in it or where your incentive payments are not structured as a traditional carried interest in a partnership, but are instead structured as a more classical fee arrangement. The treaty structure arrangements will also potentially impact how you structure your financing and whether you are ever trying to be, say, securitizing investments, or otherwise engaging in repo, or other asset-based leverage facilities. For example, one of the pieces that Jim noted earlier is that it is important throughout the structure for the activities to be carried on through entities that are transparent, under the laws of the investor's home jurisdiction. And, whereas you might traditionally be using Delaware LLCs as your SPV vehicle for financing purposes, that is problematic from a treaty perspective. And so you would instead, say, be utilizing Delaware or Cayman limited partnerships, assuming that those entities are treated as transparent under the relevant investors' jurisdiction. The other piece in connection with financing that can come up is that in terms of providing more support for our notions of the investor being independent of the manager, or really the manager being independent of the investor, the credit agreements need to also be carefully considered that you're entering into with the fund, particularly around provisions around when you have an event of default and whether the termination of the manager might constitute an event of default under credit agreements. In those situations, there may be some enhanced risk that the manager has insulated itself from potentially being replaced, and thereby creating another factor that would be considered in assessing the manager's independence from the investor or the relevant investment vehicles. But, as can be seen by the growing interest in the marketplace of executing on treaty structures, there are many benefits that can be obtained as a result of using treaty structures, and many managers have decided some of these wrinkles are worth accepting.
Laurel FitzPatrick: Thank you so much Jim and Adam. We really appreciate your time. And thank you so much to our listeners. For more information, please visit our website at www.ropesgray.com. And stay tuned in the coming months for more in our series of credit funds podcasts. Of course, if we can be of any help to you in navigating any of these challenges, please do not hesitate to get in touch.