General Tax Treatment of Fund Structures
Limited Partnerships & Limited Liability Companies
- Typically classified as partnerships for US income tax purposes
- Not subject to income or corporate tax at entity level
- Pass-through taxation with profits/losses flowing directly to partners
- Distributions may be taxed as ordinary income, capital gains, or potentially untaxed return of capital
Non-publicly Traded Corporations
- Fully subject to corporate taxation
- Double taxation may apply at both corporate and personal levels
Non-US Funds
- Can elect to be treated as either partnerships or corporations for US tax purposes
- Most choose corporate classification
- Generally not subject to US income tax on US investments due to securities and commodities trading safe harbor
- Certain US-source income subject to 30% US withholding tax (potentially lower with applicable tax treaty)
Tax Treatment by Investor Type
US Resident Investors
- Subject to US income tax on their allocable shares of income and gains from partnership funds
- For non-US corporate funds, subject to "passive foreign investment company" (PFIC) tax regime:
- Can elect to be taxed annually on allocable fund income/gain (whether distributed or not)
- Without election, subject to interest charges on taxes paid when income/gain is distributed
Non-US Resident Investors
- Subject to US income tax only on income "effectively connected with a US trade or business" (with exceptions for trading safe harbor)
- Subject to US income tax on gains from US real property interests
- Generally not subject to US income tax on capital gains from investments
- Certain US-source income (like corporate dividends) subject to withholding tax
Tax-Exempt Entities (including Pension Funds)
- Generally not subject to US income tax on fund investments
- Exception for unrelated business taxable income (UBTI) from:
- Income from trade or business unrelated to exempt purpose
- Income from debt-financed investments
- Non-US corporate funds generally do not produce UBTI for US tax-exempt investors
Investment and Exit Tax Considerations
- Cash investments into alternative investment funds generally tax-free
- Partial withdrawals from Delaware-domiciled funds may be tax-free
- Complete withdrawals generally taxable to US investors
- Complete withdrawals by non-US investors generally free of US tax (with certain exceptions)
- Tax rulings generally not required as entity classification and treatment are well-established
Foreign Account Tax Compliance Act (FATCA)
- US alternative investment funds must determine FATCA status of investors
- Based on Forms W-9 (US investors) and Forms W-8 (non-US investors)
- US is not a participant in the OECD Common Reporting Standard
Disclosure and Regulatory Requirements
Disclosure to Investors
- Alternative investment funds must disclose all material information regarding:
- Investment strategy
- Associated risks
- Fee structures
- Potential conflicts of interest
Regulatory Filings
- Registered Investment Advisers (RIAs) and "exempt reporting advisers" must file Form ADV with SEC
- Form ADV disclosure includes:
- Fees and costs associated with advisory services
- Third-party compensation arrangements
- Personnel information
- Outside activities
- Potential conflicts of interest
- Alternative investment funds generally make Form D filings, disclosing:
- Total amount of securities sold
- Number of participating investors
- RIAs with Assets Under Management exceeding $150 million must file Form PF with SEC
Side Letters
- No restrictions on the use of side letters
- Previously proposed SEC regulations on side letters have been vacated by US Court of Appeals
Beneficial Ownership Disclosure
- No requirements to provide details of fund participants (owners, controllers, or investors) to local regulators or record-keeping agencies for public or non-public registers of beneficial owners
Operational Considerations
Setup Requirements
- Streamlined incorporation processes, particularly in Delaware
- Documentation requirements vary by structure but generally include:
- Limited Partnership Agreement (for LPs)
- LLC Agreement (for LLCs)
- Articles of Incorporation (for corporations)
- Registration with appropriate state authorities
Governance Expectations
- Fiduciary duties for general partners and managers
- Compliance with federal and state securities laws
- Adherence to anti-money laundering regulations
- Regular reporting to investors
Timeframes and Costs
- Formation typically completed within days to weeks
- Costs vary based on structure complexity and service provider selection
- Annual maintenance fees including state filing fees and registered agent fees
Market Trends and Outlook
Emerging Developments
- Increasing regulatory focus on private funds, including enhanced reporting requirements
- Growing interest in specialized fund structures for specific alternative asset classes
- Evolution of fund governance practices with emphasis on transparency
Investor Preferences
- Rising demand for customized investment solutions and separate accounts
- Heightened focus on ESG integration within alternative investments
- Continued interest in co-investment opportunities alongside traditional fund structures
European Market Access Strategies for US Managers
US fund managers seeking to raise capital from European investors have three primary options, each with distinct advantages and limitations:
1. Use Existing US Fund Structure
Advantages:
- Administrative simplicity and reduced cost
- Leverages established Delaware or Cayman structures
Limitations:
- Many European investors require regulated fund structures due to regulatory and tax implications
- Some European investors are limited to EU-regulated funds only
- Restricted marketing activities within Europe
- Significant non-US investment into Delaware structures may complicate tax situation
2. Establish Offshore Feeder Structure
Advantages:
- Familiar route for US managers raising non-US capital
- Avoids subjecting non-US investors to US tax obligations
- Jurisdictions like Cayman Islands, British Virgin Islands, Jersey, and Guernsey offer expertise in European capital raising
Limitations:
- Still faces regulatory hurdles when marketing to European investors
- Some European investors are statutorily barred from non-EU funds
3. Set up an EU Alternative Investment Fund (AIF)
Advantages:
- Most advantageous for marketing purposes
- Access to EU marketing passport for seamless cross-border distribution
- Ability to target the deepest pool of European investors
Limitations:
- Most costly and administratively complex approach
- Requires appointment of an Alternative Investment Fund Manager (AIFM)
- Cannot be used as a feeder for US or Cayman-based master structures
- Must be established as a separate entity
Competitive Positioning
- The US maintains its dominant position for alternative investment fund domiciliation
- Delaware's specialized business courts and legal certainty continue to provide competitive advantages
- Evolving regulatory landscape creating both challenges and opportunities for fund managers
- Growing need for international distribution strategies to access global capital