How Are AIFMD And BEPS Impacting Economic Substance Needs For Fund Structures?

The ever-increasing complexity and volume of global compliance regulations related to alternative investments is putting pressure on fund managers to ensure the right level of peripheral services are attached to their funds.

Base Erosion and Profit Shifting (BEPS), the Organisation for Economic Cooperation and Development's (OECD) project, led to the most significant changes to how international businesses are taxed in a generation.

Tax legislation not keeping up with globalisation had opened opportunities for multinationals to minimise their tax burdens. This led to the Group of 20 (G20) instructing the OECD to prepare an action plan with respective reports to counteract BEPS. This comprehensive package of measures is now being adopted widely in local legislation and within tax treaties.

We have seen economic substance play a role in various parts of the BEPS project, which even caused certain jurisdictions (such as Cayman, BVI, Jersey and Guernsey) to introduce economic substance requirements for various types of activities, including fund management and holding activities.

The recent trend has focused on having qualified local decision-makers in a local entity that is engaged in true economic activities, which means having a local board of directors with sufficient expertise and industry knowledge as well as the local entity "behaving" as a company with true operations.

The principal purpose test brings location into question

Treaty abuse and in particular, treaty shopping, has been identified as one of the most important sources of BEPS concerns. Action 6 of the BEPS project recommended jurisdictions introduce a so-called principle purpose test in tax treaties. This rule is meant to deny treaty benefits if obtaining that benefit was one of the principal purposes of the arrangement or transaction.

The principal purpose test is providing (source) countries the legal instrument to deny treaty benefits, but at the same time the subjective nature of this test is causing uncertainty amongst taxpayers.

The OECD has provided some limited guidance in relation to the application of the principal purpose test with respect to Non-Collective Investment Vehicle (CIV) funds. Based on this guidance, the principal purpose test may drive the PERE industry to consider setting up a regional investment platform in one jurisdiction. This means having holding Special Purpose Vehicles (SPVs) as well as the funds in the same jurisdiction as the fund...

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