How can I align the interests of the external investors and the fund’s management?
Fund managers will generally receive carried interest and be expected to participate in co-investment arrangements, which act together to align the interests of the capital-providing investors and the fund management team.
The taxation of carried interest can be complex. Some jurisdictions (such as the UK) have tax regimes that legally define carried interest and impose income tax charges on fund returns that fall outside the definition. An example of this is the disguised investment management fee (DIMF) rules, which aim to tax carried interest returns as trading income where the carried interest investors provide investment advisory services if the carried interest does not fit within the statutory definition. Other UK rules can re-characterize carried interest as income based on the holding period of the underlying investments.
If executives acquire or carry for less than market value, this can trigger employment taxes. It’s therefore prudent to consider valuation, as well as the interplay with the carry structure.
Obtaining advice on the taxation of your carry structure early on — in advance of discussions with potential investors or new team members — is critical to making sure the carry tax rate for the new team does not end up higher than anticipated or considered in initial discussions.
Similar considerations apply to co-investment arrangements.
What is my tax position?
Consider your personal tax position as an entrepreneur: are you able to claim the remittance basis of taxation (“non-dom” status, under which funds not remitted to the UK aren’t subject to UK taxation)? Where is the capital coming from to establish the fund? Do you have assets offshore that you might want to repatriate to the UK?
Do you intend to stay resident in one jurisdiction for the duration of the fund? Do you need to plan to respond to changes in underlying investment opportunity, family circumstances or politics? While seeing the future is of course impossible, to the extent that these are known unknowns, they should feature in the fund formation discussion.
Not only will the taxation of carried interest and co-investment be key, but it’s also important to consider your day-to-day remuneration arrangements and how you envision working with the rest of the team. For example, is a limited liability partnership structure appropriate, or is a corporate vehicle with an employer-employee relationship preferable? This decision may be influenced by a desire to roll up fees in the management vehicle to meet co-investment obligations, an arrangement that is often crucial for first-time managers but that is coming under increased scrutiny.
What advisors do we need?
In this new fundraising landscape, it’s more important than ever to appoint advisors early in the process. The regulatory and tax structure of the fund is derived from the first principles of who (investors, team), where (management, marketing) and what (investments). Getting these structures in place early in the fundraising process is the first step along the road to creating a successful fund business.
In today’s tax and regulatory environment, there are more questions than ever facing first-time fundraisers. Obtaining early advice is a sound and proven practice. Give yourself an advantage by having a clear plan from the start, anticipating the critical questions you’ll need to answer and having a more informed, more holistic approach.
This article was originally published in Tax Insights on 19 June 2018.