Tax Real estate fund managers are being forced to adapt to new investor demands. Matt Probert considers the implications for tax management
It is perhaps hard to believe, but we are now five years into the most turbulent market environment that anyone can remember (except those very few readers who are old enough to have lived through the Great Depression) and, hopefully, will ever experience.
The heady days of 2007, with free-flowing debt, plenty of equity, booming asset prices and more generous fee structures seem not that long ago. But enough time has passed for investors and investment managers to get to the point where there is a genuine acceptance that the real estate investment world has changed fundamentally and perhaps permanently.
What does this mean in practice? Except for a small select group of managers, private equity-style blind-pool funds can no longer be their raison d’etre. These vehicles will continue to exist and be raised, but managers have found themselves needing to respond to a desire from investors for a wider suite of offerings – everything from club deals, segregated accounts and single asset mandates, as well as the more familiar blind-pool funds. Whilst the impact of this on managers is far-reaching, this article is concerned with what this means for the management of tax. How should a real estate investment manager adapt to the new environment?
Most readers will be familiar with many of the more common real estate fund structures. For a typical pan-European fund, some of the entity types may change. The fund vehicle might be an English LP or a Luxembourg FCP, or, for listed funds, a Guernsey or Isle of Man company; the sub-holding structure may be in Luxembourg or the Netherlands. But fundamentally most sit within a well-established framework.
It is probably worth taking a step back at this point to understand why fund structures tended to follow this framework. When establishing a fund, tax efficiency will typically be high on the investment manager’s list of priorities. The challenge for the investment manager at that point arises from not knowing who the investors will be. However, the manager may have a good idea that they will comprise, say, a mixture of US and European institutions and high net worth investors.
While the best fund structure for any individual investor class may differ from the next, the well-established approach is one of compromise: If the fund is structured to minimise tax leakage within the fund and on repatriation of cash, then it is likely to work well for most investors, and unlikely to be compromising for any single investor. Those typical structures, which have been commonly used over the years, meet these criteria.
When it came to managing these structures, it was also always clear who had responsibility for doing what. Any tax obligations for any fund entity are the responsibility of the investment manager, whilst an investor would be responsible for their own filing obligations. Anything crossing the dividing line between investor and fund would be clearly understood by everyone concerned – for example, US K-1 reporting.
So, how does this change in this new post-crash world? One of the main attributes of investor clubs, segregated accounts and single-asset mandates is that the investors will typically be identified before there is a need to decide upon the legal structure. This means the one-size-fits-all approach of widely held funds is no longer appropriate. A single investor or small group will expect to invest in something designed for their particular circumstances. Furthermore, the clear dividing line between fund and investor may be blurred or non-existent. Both of these points have a significant impact on how the investment manager carries on its business. There are two key considerations:
First, in a world where bespoke structures are to become the norm, a good investment manager needs to have the infrastructure, expertise and resource to design and manage them properly. An investor will expect their own circumstances to be considered fully and to be presented with a structure that ‘works’ for them without compromise. Whilst most of the structures used might not be innovative or groundbreaking, they might deviate from the core knowledge base of the manager or, indeed, the investor. For example:
• Sovereign wealth funds might, when investing in some jurisdictions, be able to benefit from sovereign immunity from tax;
• EU directives mean that pension funds might now be able to claim tax exemptions outside their home jurisdictions;
• Some investors may be subject to punitive tax charges when investing through companies located in perceived tax havens, or ‘black listed’ jurisdictions;
• Close company and controlled foreign company regimes can create tax liabilities for investors even when no distributions have been received.
None of these issues are terribly challenging to address in themselves, but can have a fundamental impact on the investment structure, and it would be easy for consideration of these to fall down the crack between the parties. The investment manager needs to have the capabilities to conduct a clear, open dialogue with its clients to ensure the tax considerations are adequately addressed, and that both investor and manager identify and agree what actions are required. This is more than simply appointing an adviser; it involves taking an holistic approach to the investment itself, the structure, the tax needs of the investor, and an appreciation of where the tax risks lie and how they will be managed.
Second, absolute clarity is required over where responsibilities lie. The more structures that exist, the greater the variety of measures that need to be taken to run them effectively, be it tax residence issues, tax filings or investor reporting. Managers need to grasp this and ensure their business processes adapt in real time to the new challenges presented by each new structure.
As noted above, when an investment manager establishes a blind-pool fund, it is entering a familiar world where the boundaries are well known. However, a separate account may simply involve the establishment of entities which are wholly owned by the investor, and where the investments are managed by the investment manager. The question arises of who looks after the management of ongoing tax matters. Basic tax filings such as VAT returns may be entirely obvious to many, but many investors will have requirements that are specific to them. Investment managers will in future need to be capable of identifying and managing these issues to avoid erosion of value through tax related problems but also to ensure a harmonious relationship with their client.
In summary, just as the new environment has created challenges for investment managers in sourcing and investing equity, it has also created additional demands regarding tax management. While no one expects investment managers to reinvent themselves as tax advisers, new demands are being placed on the in-house expertise and how it interacts with investment and client relationship teams. If they haven’t done so already, these pressures are likely to require managers to recruit additional, specialist tax resource and for the prominence of tax within the organisation to increase. Not every investment manager has addressed this and investors will increasingly demand these capabilities. Although there are numerous examples to the contrary, tax has often been viewed as a commoditised, back-office function. This can be the case no longer.
Matt Probert is head of tax at Cordea Savills