How tax is reshaping the fund environment

The evolving tax regulations and compliance requirements drives the investment funds environment through significant transformation. This article explores how various tax frameworks, including Withholding Tax (WHT), Capital Gains Tax (CGT), Faster and Safer Tax Relief of Excess Withholding Taxes (FASTER), the Foreign Account Tax Compliance Act (FATCA), the Common Reporting Standard (CRS), and the 8th Directive on Administrative Cooperation (DAC8), are reshaping the landscape for investment funds. 

Withholding Tax (WHT) 

WHT plays a crucial role in the fund environment, particularly for cross-border investments where tax implications can significantly affect returns. WHT is levied at the source on various types of income, including dividends and interests, and can vary widely depending on the jurisdiction and the specific tax treaties in place. This variability often results in excess withholding tax being retained in the countries where the income is generated.  

Excess WHT can be reclaimed from foreign tax authorities, but the processes and types of WHT claims differ by country. Consequently, fund managers must tailor their reclaim strategies based on Double Tax Treaties (DTT), domicile rules, or European Court of Justice (ECJ) rulings. As regulatory scrutiny increases, authorities are paying closer attention to payment chains, the nature of claimants, and the number of investors involved to ensure compliance and verify that the correct tax amounts are withheld. This has led to a greater emphasis on transparency and documentation, compelling fund managers to implement rigorous processes for tracking and reporting WHT claims. This may result in foreign authorities’ inquiries to provide sufficient comfort prior to any reimbursement decision. 

Given the complexity and local representation requirements for certain WHT reclaims, fund managers often seek the support of specialized tax firms to enhance their success in reclaim activities, ultimately benefiting the performance of investment funds and their investors. In countries where WHT reclaims have historically faced challenges, there is a growing trend toward rectifying past issues and reimbursing claimants. Investment funds can only capitalize on these reimbursement opportunities if they filed the reclaimable amounts before expiration dates (i.e., statutes of limitations), which typically range between two and five years after the revenue payment depending on jurisdiction.  

As an example of evolutions in the reimbursement opportunities, Germany has recently initiated efforts to reimburse WHT claims dating back to before 2017, reflecting a broader trend among European countries to address historical tax matters. This initiative not only aims to correct past discrepancies but also underscores the importance of maintaining accurate records and compliance with WHT reclaim opportunities. Other countries, such as Italy, are expected to implement similar measures. 

In this evolving landscape, it is increasingly important for fund managers to consider protective claims. These claims act as safeguards for potential future reimbursements against over-withholding of taxes. By filing protective claims, funds can mitigate the risk of losing significant capital that could otherwise be reinvested or returned to investors. 

Fund managers must also define their reclaim strategies on a country-by-country basis. While some jurisdictions may allow for a single type of reclaim, others present varying chances of success and significantly different reclaimable amounts based on the chosen strategy. For instance, jurisdictions like Spain and Portugal have reported higher reclaimable amounts when adopting an ECJ approach, which often provides broader grounds for reclaiming excess WHT. In contrast, DTT-based claims may impose stricter limitations (e.g., 15% reclaimable under DTT vs. 35% reclaimable under ECJ). 

As the regulatory environment continues to evolve, understanding and navigating the complexities of WHT will be essential for fund managers seeking to optimize excess taxes paid and enhance overall returns for their investors. Fund managers must adeptly navigate intricate WHT regulations to recover amounts paid or withheld in excess, including understanding applicable treaties and exemptions, which can vary by jurisdiction. 

Capital Gains Tax (CGT)

CGT is a pivotal factor in investment funds accounting, as it applies to the profits realized from the sale of assets or investments. The implications of CGT extend beyond mere taxation; they significantly impact a fund's net asset value (NAV) computation. When a fund benefits from realized or unrealized capital gains, these gains must be accounted for in the NAV, affecting the overall valuation and potentially influencing investor perceptions and decisions. Consequently, fund managers must diligently provision for CGT liabilities to ensure accurate financial reporting and compliance with local tax regulations in case of material impacts on the NAV. This involves calculating the unrealized CGT and understanding the specific tax rates and rules applicable in each jurisdiction. 

For instance, in India, the taxation of capital gains is differentiated based on the holding period of the asset. Short-term capital gains (STCG) are taxed at a flat rate of 15%, while long-term capital gains (LTCG) exceeding INR 1 lakh are taxed at 20% with the benefit of indexation. This distinction necessitates careful tracking of holding periods and transaction details. Tax agents or tax service providers must extract relevant data from local sub-custodians, who maintain comprehensive records of transactions, including purchase prices, sale prices, and holding durations. These data are essential for accurately calculating the CGT owed, as it provides the necessary information to determine the cost basis and the resultant gains or losses. It's also important to note that this rate applies to listed shares and may differ for unlisted shares or other assets. Other CGT may draw attention when investing in other countries subject to CGT. 

Moreover, the provision for CGT must be meticulously managed within the fund's financial statements, as it directly affects the distributable income available to investors. Inadequate provisioning for CGT can lead to unexpected tax liabilities, which may diminish returns for investors and impact the fund's reputation. Therefore, implementing robust tax planning strategies that consider CGT implications is crucial for fund managers. By proactively addressing unrealized CGT, funds can avoid material NAV variation and maintain investor confidence in a complex and evolving tax environment. 

FASTER 

The FASTER Directive, introduced by the European Union, represents a significant shift in the approach to taxation within Member States. Aimed at enhancing efficiency, transparency, and fairness in tax systems, the Directive seeks to address the challenges posed by globalization and digitalization in the modern economy.  

FASTER stands for "Facilitating Accelerated and Simplified Taxation for Earnings and Returns." The directive is designed to streamline tax compliance processes, reduce administrative burdens, and ensure that tax systems are adaptable to the rapidly changing economic landscape. It focuses on harmonizing tax rules across member states to create a more cohesive and efficient tax environment. Harmonization will be supported by further digitalization and standardization of part of the documentation. However, at start, countries will still be able to keep their specific requirements and processes. 

As the Directive comes into effect by 2030, stakeholders across the EU will need to adapt to the new landscape, ensuring that they are well-prepared to navigate the changes and seize the opportunities that lie ahead.  

Automatic exchange of Information : FATCA and CRS 

FATCA and CRS are significant regulatory frameworks aimed at enhancing tax transparency and combating tax evasion on a global scale. FATCA, enacted by the United States, requires foreign financial institutions to report information about financial accounts held by U.S. persons, imposing strict compliance obligations that can lead to substantial penalties for non-compliance. This has created a complex landscape for investment funds, as they must implement robust due diligence processes to identify U.S. investors and ensure accurate reporting to the Tax Authorities and/or Internal Revenue Service (IRS).  

Similarly, the CRS, developed by the Organisation for Economic Co-operation and Development (OECD), establishes a global standard for the automatic exchange of financial account information between participating jurisdictions. Under the CRS, funds are required to collect and report information on account holders who are tax residents in other countries, further complicating compliance efforts.  

The interplay between FATCA and CRS necessitates that fund managers invest in advanced data management systems and processes to streamline the collection, analysis, and reporting of relevant information. Failure to comply with these regulations not only exposes funds to financial penalties but can also damage their reputation and investor trust. As such, navigating the complexities of FATCA and CRS is essential for fund managers aiming to maintain compliance while optimizing their operational efficiency in an increasingly interconnected financial landscape. 

The consequences of non-compliance with tax regulations such as FATCA and CRS can be severe. Tax authorities focus on country and industry compliance with increasing scrutiny. In Luxembourg, financial institutions that fail to comply with reporting obligations may face significant fines of minimum €10,000, which can reach up to €250,000 for serious violations. Moreover, offenders that wrongly report may incur even higher penalties, with additional fines of 0.5% of the total amount of the non-reported or wrongly reported figures. The Luxembourg tax authorities have increasingly ramped up their enforcement efforts, resulting in a marked rise in the number of penalties issued year over year. For instance, in recent years, the number of penalties related to FATCA and CRS non-compliance has surged by over 100% for two years in a row, reflecting the authorities' commitment to enhancing tax transparency and accountability. This trend underscores the importance for fund managers to prioritize compliance. 

It should also be noted that in Luxembourg, financial institutions are subject to specific obligations concerning the upfront notification of CRS reportable investors prior to the submission of CRS declarations. This requirement mandates that institutions inform account holders who are identified as reportable under the CRS framework about the data that will be reported, their status and the implications of being reported to tax authorities. This proactive approach not only enhances transparency but also fosters a culture of compliance among investors. Furthermore, the obligation to notify reportable investors is part of Luxembourg's broader commitment to ensuring that financial institutions maintain accurate records and adhere to international tax standards.  

DAC8

The Directive on Administrative Cooperation (DAC8) includes an evolution of CRS requirements and a revolutionary approach to the regulation of crypto assets. As part of this evolution, funds will now be required to report how investor classification was performed, including whether it was based on valid self-certifications or other sources of information. Additionally, DAC8 emphasizes the importance of reporting the role of the controlling persons in passive Non-Financial Entities (NFEs) that invest in the funds, thereby increasing the transparency of ownership structures and ensuring that tax obligations are met at all levels. 

On the revolutionary front, Crypto Assets Service Providers (CASPs) will be subject to comply with the Crypto Assets Reporting Framework (CARF) that extends CRS with a new reporting specific to crypto asset transactions.

Conclusion 

In an increasingly complex regulatory environment, the fund industry faces significant challenges and opportunities stemming from evolving tax frameworks such as WHT, CGT, FASTER, FATCA, CRS and DAC8. As funds adapt to these changes, they must also recognize the operational impacts, including the need for robust data management systems and the potential for increased operational costs associated with compliance. By adopting a forward-thinking approach, fund managers can mitigate risks, enhance operational efficiency, and position themselves as leaders in a rapidly changing financial environment. Ultimately, embracing these regulatory changes with agility and foresight will be crucial for funds aiming to thrive in an increasingly scrutinized and competitive market.