[authors: Emily Yiolitis & Aki Corsoni-Husain]
Directive 2011/61/EU on Alternative Investment Fund Managers, known colloquially as the “Alternative Investment Fund Managers Directive” or the “AIFMD”, will overhaul the pan-European regulatory regime applicable to the managers of hedge funds, real estate funds, private equity and other collective investment schemes containing, what is loosely being described as, “alternative investments”.
On its face, the AIFMD restricts its scope to the regulation of investment managers rather than underlying funds being managed. However it is clear these regulations will have a knock on effect in shaping and influencing the forms of the investment funds under management.
For these purposes an alternative investment fund (an “AIF”) falls into the Directive, in summary, where it is a collective investment undertaking which raises capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit for the investors. It is clear that this definition will capture both open-ended and closed ended funds. Managers of these funds who are active in the European Economic Area (“EEA”), which includes all EU member states as well as Iceland, Norway and Liechtenstein, will be caught. Specifically excluded are managers of funds regulated under the UCITS framework, holding companies as well as managers of family offices. Some funds that wind down operations and limit the solicitation of new investors prior to commencement of the Directive will also fall out of scope.
At its heart the Directive will introduce a passport mechanism so that managers of AIFs can offer services across the EU. However to qualify for the passport a shopping list of requirements will need to be met. Managers that do not qualify for the passport will be restricted from offering their services, unless one of the exemptions in the AIFMD applies.
Timing as at June 2012
The first effects of the AIFMD will be felt by industry stakeholders on 22 July 2013 by which time all EU member states must have transposed the requirements of the Directive into local law. These requirements will impact:
• EU-based Alternative Investment Fund Managers (“EU-AIFMs”) of EU-based Alternative Investment Funds (“EU AIFs”); and
• EU-AIFMs of Alternative Investment Funds based outside the EU (“non-EU AIFs”)
At this time EU-AIFMs of EU AIFs will be required to be authorised under the AIFMD, they will also benefit form the passporting arrangements. EU-AIFMs of non -EU AIFs will be required to be authorised but will not permitted to benefit from the passport until 2015 at the earliest.
Alternative Investment Fund Managers based outside the EU, managing either EU or non-EU AIFs, will not be subject to the rules of the Directive until around 2018 at which point the current national private placement regimes may be phased out.
In November 2011, the European Securities and Markets Authority (“ESMA”) published its ‘Level 2’ technical advice on implementing measures of the Directive and, following this, opened a public consultation into key concepts of the Directive, which closed on 23 March 2012. ESMA’s positioning on an array of issues was, in general, warmly welcomed by industry stakeholders.
In late March 2012 the European Commission sent a first draft of its proposal Level 2 implementing text to the European Parliament and Council of Ministers for comment and review. There is industry concern that this implementing text, drafted as a regulation, seeks to re-open some of the hard-fought battles won at Level 1. There is also concern that ESMA’s consultation recommendations may not be implemented in the proposed draft.
In April 2012 ESMA confirmed that it will lead negotiation of co-operation arrangements with non-EU authorities on behalf of EU supervisors, a necessary step under the AIFMD. It is intended that a Memorandum of Understanding be established between EU and non-EU authorities to facilitate cross-border supervision of those non-EU entities subject to AIFMD.
We expect Level 3 implementation by member states themselves to begin in earnest once the Level 2 implementing text has been finalised. Cyprus, one of the three jurisdictions that Harneys advises on, has already published its draft implementing laws for AIFMD and is presently consulting with the industry.
The EU Perspective
The AIFMD aims at harmonising the EU regulatory framework and favoring EU-based AIFs. In particular the AIFMD provides that an EU AIFM authorised in its home member state may manage and market an EU AIF both in its home member state and in other member states as a result of the “passporting” rights. Therefore an AIF based in one-member state will be eligible to be marketed to European investors in other member states.
However, the AIFMD will require EU AIFMs to be subject to capital requirements, detailed reporting and disclosure requirements, which will inevitably curtail their operational freedom and increase their operational costs. The AIFMD will introduce a raft of provisions with which AIFMs will have to comply, including:
• registration and authorisation requirements for AIFMs;
• requirement to appoint a custodian or depositary to safe-keep fund assets;
• supervision by the competent authorities of the home member state and notification requirements in respect of host member states;
• conduct of business obligations including requirements to treat investors fairly and to act in their best interests;
• employment of liquidity management techniques, except in respect of unleveraged closed-ended AIFs;
• restrictions on marketing to retail investors;
• compliance with the Directive’s detailed remuneration policy;
• minimum capital requirements of at least €125,000;
• additional obligations for leveraged investments; and
• reporting certain trade and market data on a regular basis to the home member state.
The Directive, in creating a more or less level playing field between member states as far as the regulatory framework is concerned, will allow fund sponsors to conduct jurisdiction arbitrage when establishing AIFMs or AIFs based on other local considerations such as taxation, competence of the local regulator, speed of set up and reputation of the jurisdiction.
Cyprus as a cost-effective low tax jurisdiction for AIFs and AIFMs
Cyprus-based AIFMs and AIFs established as companies will benefit from low tax burdens levied on Cyprus-based corporations. Further, non-Cypriot investors in Cyprus AIFs will, at the time of a redemption from, or distribution of, a Cyprus AIF, benefit from an extensive double-taxation treaty network in place in Cyprus.
The tax regime applicable to corporate funds in Cyprus is one of the most favourable in the EU, further the Cyprus tax regime has recently undergone several amendments in order to increase the island’s competitiveness in the fund industry. At the fund level the AIF would be subject to corporate income tax on the same basis as any other corporate structure in Cyprus, i.e. at a flat rate of 10%. Any profits realised by way of redemptions from holdings in other companies (including other AIFs) would be considered a disposal of an investment and consequently any profits from the disposal would be entirely excluded from corporate income tax or any other form of taxation in Cyprus. For this reason Cyprus AIFs may be ideal vehicles for private equity investments.
At the investor level, as mentioned above receipts from redemptions in an AIF would be considered a disposal of securities (or equivalent) so the redemption proceeds exceeding the capital contributed by the investor, i.e. any profit, would be completely exempted from taxation in Cyprus. Despite this, if capital losses arise on the disposal of assets they can be carried forward indefinitely and set-off against any other liability to tax in Cyprus.
Dividends received by the AIF from a non-Cyprus tax resident subsidiary will, in the vast majority of cases, be exempt from corporate income tax in Cyprus. Cyprus-resident non-corporate investors in an AIF would be liable to a reduced rate of deemed dividend distribution, so tax on only 3% dividend income would be payable instead of 20%.
More importantly, with respect to a non-Cyprus resident investor in a Cyprus AIF, such investor based in a country party to a double-taxation treaty with Cyprus, would be highly likely to the benefit from substantial tax relief over any profits received from a redemption or income received on a dividend. The extent of the relief will in many cases, reduce the tax payable by the investor in his/her home jurisdiction to zero.
Robust double-taxation treaty infrastructure
As mentioned, Cyprus does impose 10% tax on income earned by AIFs and AIFMs, in line with general corporate income tax rates. Under principles which are generally universal to double-taxation treaties, entities subject to zero-rated income tax regimes may be classed as being ‘non-resident’ for tax purposes (meaning that the relief envisaged by the double tax treaty does not apply). Investors in zero-rated funds in other domiciles may face this dilemma. It would be important to understand whether a zero-rated tax model is actually sustainable for an AIF’s investor base.
Longstanding AIF regulatory regime
Finally it should be mentioned that Cyprus’ regime for alternative investment funds has been in place for over a decade in the form of the International Collective Investment Scheme Law, 1999 (“ICIS”) and has inspired similar laws in other upcoming funds jurisdictions in the EU. The ICIS is the most popular form of non-UCITS collective investment scheme in Cyprus. It is expected that ICIS will become fully AIFMD-compliant by the end of 2012.
Offshore hedge-funds, such as those based in the Caribbean and North Atlantic offshore centres, are simply too market dominant to be ignored by the AIFMD regime. Nevertheless the message conveyed by offshore commentators is that the real impact of the AIFMD on the offshore world is far off. Admittedly, much of the impact on offshore managers will be delayed until approximately 2018 at the earliest.
However EU-AIFMs managing offshore AIFs will be caught as of 2013. In this way a UK-domiciled manager of a Cayman hedge fund will be subject to the Directive very soon. Depending on the final implementation of the Directive at Level 3 this could have implications for offshore hedge funds, especially as regards the way they may be marketed, and EU-AIFMs would do well to think about these issues and plan accordingly.
It should also be stressed that many of these considerations will be equally relevant to EU AIFs, especially where these AIFs are not presently subject to regulation or licensing in the EU, such as in the private equity industry.
A particular concern of the industry regarding the draft Level 2 implementing regulation relates to its characterisation of so-called “letter box” entities. The AIFMD requires that each AIF should have a single AIFM other than a letter-box entity. Under the draft regulation an entity is deemed to be a letterbox entity where most of its functions have been outsourced to, or are provided by, third parties. Should this interpretation remain, offshore managers will need to consider whether a business model providing for substantial divestment of functionality from an offshore AIFM to onshore advisers and service providers will continue to be sustainable.
Private placement regimes
AIFMs operating outside of the scope of the AIFMD will need to rely a member state’s pre-AIFMD private placement regime. It is intended that these regimes be phased out in 2018 (at the earliest). However AIFMD does entitle member states to restrict or opt out of these domestic regimes earlier should they choose to do so. If member states do restrict access to the domestic regimes then this may spell considerable trouble for managers operating outside of AIFMD.
Professional investors only?
The most common mutual fund in the Cayman Islands is the “registered fund”. In the British Virgin Islands, the most popular fund is the “professional fund”. In general terms, both funds require a minimum initial investment of at least US$100,000 however, as the name suggests, the BVI vehicle additionally requires an investor to be “professional”, a requirement which pretty much any high net worth individual would be capable of meeting. The AIFMD has its own definition of “professional investor” which is relatively strict and cross refers to the definition of “professional client” under the Markets and Financial Instruments Directive. It will be important for AIFMs, both EU and non-EU, to carefully consider whether the investors they are permitting continue to meet the AIFMD definition of a professional investor – though it is appreciated that many or most investors in offshore AIFs will likely qualify for the AIFMD definition of “professional investor” in any event. Fortunately, the AIFMD does entitle member states to disapply the requirement to restrict the investor base solely to professionals.
Offshore Perspective: Beyond 2013
It will be important for both EU and offshore perspectives that jurisdictions such as the Cayman Islands and the British Virgin Islands enter into as many OECD-compliant tax information exchange agreements as there are EU member states in order to gain full access once the AIFMD applies in full force to offshore AIFMs, as this is a requirement to gain access to European markets. It is also important that more general information exchange agreements are put in place between relevant jurisdictions.
The Directive, whilst perhaps not being the revolutionary instrument that the draftsmen of the original version may have hoped, nevertheless will cause, and is causing, a restructuring of the alternative investments market in Europe. Understandably this restructuring cannot be fully completed until the Level 2 and 3 rules have been finalised. In the meantime stakeholders should carefully consider their liabilities under the proposed framework:
• for those market players seeking an EU platform to market funds predominantly to an EU audience, pursuing establishment in one of the Union’s cost-effective jurisdictions, in particular Cyprus with its robust double tax treaty framework, would seem sensible; and
• for those undecided on whether they need to pursue an EU platform in the long term there may well be a case for migrating the AIF’s management vehicle to an offshore centre such as the Cayman Islands or the British Virgin Islands and relying on pre-AIFMD private placement rules until at least 2018.
Above all it is clear that managers of alternative investments will need to take appropriate professional advice on the steps right for their business leading up to July 2013 and beyond.