By Anthony J. Tuths, JD, LLM, Partner, [email protected] TAX PLANNING FOR THE ALTERNATIVE FUND MANAGER Being an advisor to the alternative investment allows me to observe recurring issues that leaders take into account, such as governmental regulation, investor preferences and idiosyncratic asset problems. There is a constant issue which fund managers are always eager to discuss, and that is the taxation of their own compensation.

Within the asset management arena there are several strategies OFF-SHORE REINSURANCE COMPANY that managers employ to limit their global tax burden. In this Many large U.S. based fund managers have created off-shore article I will briefly describe several accepted methods managers reinsurance companies, converting ordinary income into long can employ to legally reduce their U.S. tax costs including: term capital gain in order to gain a tax rate advantage. In order to achieve this, the fund manager will work in tandem with a non-U.S. 1. Affirmatively using the PFIC rules partner, typically a reinsurance company. The non-U.S. party owns 2. Off-shore reinsurance companies a portion of the reinsurance company to ensure it is not treated as 3. Private placement life a controlled foreign corporation (a “CFC”) for U.S. tax purposes. 4. Expatriation The new reinsurance company then begins writing reinsurance policies and collecting premiums. The initial share capital of the AFFIRMATIVE USE OF PFIC RULES company plus the insurance premiums collected are invested into U.S. investors, including U.S taxable fund managers, in alternative the manager’s fund(s). The fact that the company takes on real investment funds, almost universally, invest into a U.S. master fund insurance risk and operates a true reinsurance business means that or a U.S. feeder fund. If such U.S. persons were to invest through the company will not constitute a PFIC and unlimited tax deferral is the foreign feeder fund, they would be treated as holding an permitted. interest in a passive foreign investment company (a “PFIC”). PFIC investments are normally viewed as undesirable for a number U.S. investors are able to buy shares in the reinsurance company of reasons, namely that capital gains from a foreign feeder fund with the ultimate goal of taking the reinsurer public and providing do not flow through to the investor unless a special election is investors liquidity in the . Once publicly registered, the fund made (QEF, or Qualified Electing Fund, election). Without a is open to investor money, not just qualified purchasers. The QEF election, tax is deferred until distributions are received from investors have no tax liabilities (absent any dividend distributions) the fund or the fund units are disposed. Then, all appreciation / until they dispose of their shares. When they finally do exit the distributions are taxed at the highest ordinary income rates and an investment they will have long-term capital gains (assuming a “underpayment” interest charge is applied to the tax amount. minimum one year holding period). The fund manager may also be an investor in the reinsurance company Nevertheless, in the asset management realm there is the possibility of using the PFIC rules in an affirmative posture. A U.S. PRIVATE PLACEMENT (“PPLI”) fund manager can invest through the off-shore feeder and gain If you’ve ever been introduced to a variable life tax deferral for many years. When the manager eventually cashes then you can quickly understand Private Placement Life Insurance out there will be tax at ordinary rates with interest as though (PPLI). With variable life policies the insured pays a premium and the income had been earned ratably over the manager’s holding part of the payment covers a standard death benefit amount while period. Moreover, using a PFIC allows the U.S. investor to avoid the remainder is invested. The policy offers myriad investment limitations on deductions (at both the federal and state level), options - typically mutual funds. The invested amounts are able to interest expense, capital losses, wash sales and straddles. For grow tax deferred inside the insurance policy. PPLI works the same funds that would otherwise produce long term capital gains on a way except that the investment portion goes into selected private regular basis this strategy may not be advisable but for all others investments as opposed to publicly registered mutual funds. These it is worth considering. investment options can range from hedge funds to

Continued on next page to art. Moreover, the investment can be one the insured Partial expatriation is a relatively new concept and involves the creates —an insurance dedicated fund or “IDF.” U.S. fund manager relocating to a U.S. territory like Puerto Rico. In this case, the individual is able to keep his or her U.S. passport The tax benefits associated with PPLI are incomparable. The cash and U.S. citizenship. However, the individual will take advantage of investment amount grows tax deferred and invested amounts can special U.S. tax rules for territories. In the case of Puerto Rico this be borrowed at any time with proper arrangements. However, can be compelling for an asset manager. The island’s government there is a fine line between legitimate PPLI and illegal tax evasion. has special tax programs available for asset managers designed to Any manager investigating a PPLI policy should enlist the encourage relocation. Under current law, managers relocating to assistance of tax professional knowledgeable of the issues created Puerto Rico can achieve a zero percent capital gains tax rate and by PPLI. a 4% tax rate on management fees. Moreover, the manager will escape state tax. EXPATRIATION Expatriation means to give up one’s citizenship. In tax terms CONCLUSION expatriation comes in two flavors: full or partial. In full expatriation The fact that asset management is an advisory function which is a fund manager would physically leave the U.S. and give up his or highly mobile creates unique tax planning opportunities. These her U.S. passport. The expatriation would have to be disclosed planning options are valuable and should be used, but never to the U.S. government and there would be an exit tax imposed abused. Shortcuts, slipshod planning and questionable techniques on the individual. The individual’s assets are treated as sold for have no place in tax planning. Always consult with an experienced fair market value on the day before the expatriation and taxed and reputable tax planner before undertaking any tax reduction accordingly. The first $600,000 of gain (adjusted for inflation) strategies. is permitted to escape tax. Thereafter, the individual would be treated as a non-resident for both tax and immigration purposes.

HELPING A FRIEND OR ACTING AS AN UNREGISTERED BROKER-DEALER? By Brian Wallace, CPA, Partner, [email protected]

Recent crackdowns, by the SEC, have put one about the company they may be investing in —The SEC question at the top of many fund managers’ and will raise their eyebrows. investors’ minds: When are ‘finders’ required to be registered as broker-dealers? Not an easy Now, let’s take it a step further and consider the same question and one that must be approached with scenario but you get compensated for your investor caution and proper . referral. If you are compensated with a one-time flat fee, regardless of the company’s success: you are probably According to the Securities Exchange Act of okay. However, taking compensation based on the 1934 (“Exchange Act”), any person who effects amount raised or anything contingent on the success securities transactions in the U.S is required to register as a of the transaction without a broker-dealer license can land you in broker dealer, unless that individual is an associated person of a some hot water. Recently the SEC has been quoted as saying that registered broker dealer. That’s a pretty broad definition and one even a single instance of transaction-based compensation may be that has caused some serious headaches to friends of start-ups enough to find that an individual was “engaged in the business” of and private fund managers. a broker activity, and subject to registration or penalities for failing to hold registration. CONSIDER THE FOLLOWING SCENARIO You are a partner in a law firm who works in the areas of trust and Finally, suppose this isn’t the only “friend” you have done this estate law. By nature of your practice your clients are primarily for. In fact every year a “friend” comes to you with a similar high net worth individuals (translation - accredited investors). A opportunity. Guess what? In industry terms, you are what good “friend” of yours is starting a technology company based is commonly referred to as a “finder:” someone who assists around some social media application and he is looking to raise companies and private fund managers in raising capital. And you some capital. He asks for your help and you agree to present this are required to be registered as a broker-dealer. opportunity to some of your clients. The penalties associated with acting as an unregistered broker- From a regulatory perspective, you’ve acted within the law to dealer can be severe. Thus, care must be taken when “helping” this point. (Ethically, the area is grey.) Where things start to get your “friends” find investors. Finder compensation agreements cloudy, and where the SEC, catching on, has taken up recent need to be properly structured and the scope of services needs enforcement actions, is if you go beyond this point. to be clearly defined with activities limited to merely making introductions. In matters even remotely breaching the realm of For example, suppose you provide your clients with some fact federal securities regulations, it’s always best to consult with legal sheets surrounding the potential investment and tell them a little and compliance professionals before crossing that line.

“Employing Finders and Solicitors: Proceed with Caution.” Morgan Lewis: Venture Capital & Private Equity Funds Deskbook Series, www.morganlewis.com. | “Finders” and the “Issuer’s Exemption:” The SEC Sheds New Light on an Old Subject. Latham&Watkins Client Alert, no. 1503 (7/24/2013):1-7 FASB ISSUES NEW GUIDANCE FOR INVESTMENT COMPANIES By Frank R. Boutillette - CPA/ABV, CGMA, Partner [email protected]

In June 2013, the Financial Standards Accounting Standards • Ownership interests in the form of equity or partnership Board (FASB) issued Accounting Standard Update (ASU) No. interests 2013-08, – Investment Companies (Topic • Fair value management of investments 946) Amendments to the Scope, Measurement and Disclosure Requirements. This amendment was the joint effort of the FASB The absence of one or more of the above typical characteristics and the International Accounting Standards Board (IASB). The does not necessarily preclude an entity from being an investment IASB is responsible for International Financial Report Standards company. (IFRS). Together the FASB and the IASB have been working to merge their respective standards into one cohesive and uniform Under this amendment, an entity that is regulated as an standard. investment company under the Investment Company Act of 1940 does not need to undergo an assessment. An entity should make Under U.S Generally Accepted Accounting Principles (GAAP), an initial determination of its status under this guidance. It will investment companies typically measure their investments at fair only need to reassess whether it meets or does not meet the value, including controlling financial interests in investees that are guidance if there is a subsequent change in the purpose of the not investment companies. In contrast, IFRS did not include the entity or if the entity is no longer regulated under the Investment concept of an investment company. Company Act of 1940.

The main provisions of this amendment are as follows: to clarify This new update contains three examples to illustrate the the definition of an investment company, requirement of all assessment to determine whether an entity is an investment investment companies to measure non-controlling ownership company. The first illustration shows that an entity was formed interests in other investment companies at fair value, and required with multiple investors but due to its start-up nature, only held additional disclosures for investment companies. one investment during the first three years of its existence. It was determined that this entity was in fact an investment company, Under this new ASU 2013-08, an entity will be required to meet even though not all of the typical characteristics were present. the following fundamental characteristics to be considered an investment company: The second illustration emphasized that a technology fund that was formed with various investors making multiple investments Obtain funds from one or more investors and provide the was determined not to be an investment company because one investor(s) with investment management services. of the investors held options to acquire investees of the fund and assets of the investees if the technology developed would benefit The entity commits to its investors that its business purpose and the investors business. only substantive activities are investing for returns solely from capital appreciation, investment income or both. The third illustration was that of a master-feeder structure. This The entity and its affiliates do not obtain, or have the objective of example showed that the master feeder and other feeder funds obtaining, returns or benefits from an investee or its affiliates that were determined to be investment companies. are not attributable to ownership interests or that are other than capital appreciation or investment income. Entities reading this guidance would benefit greatly from reviewing these examples. After consideration of the fundamental characteristics, the following typical characteristics may be considered: The FASB decided not to address issues related to the applicability of Investment Company Accounting for real estate entities and the • Multiple investments measurement of real estate investments at the current time. • Multiple investors • Investors that are not related to the parent entity or the “Financial Services-Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements.” investment manager FASB Accounting Standards Codification, no. 2013-08 (2013): 1-72.

FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDS By Matt Pribila, CPA, Partner, [email protected] In May 2011, the Financial Accounting Standards Board issued Accounting Standards Update 2011-04, outlining amendments to fair value measurement standards, as part of the ongoing convergence efforts between generally accepted accounting principles in the United States (U.S.GAAP) and International Financial Reporting Standards (IFRS). The update (effective for annual periods beginning after December 15, 2011), among other things, addresses:

Continued on next page WithumSmith+Brown, PC Certified Public Accountants and Consultants

withum.com

1411 Broadway, 9th Floor New York, NY 10018

Return Service Requested

Finance That Matters is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Financial Services Group with your inquiries.

FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDS (CONTINUED)

• More detailed quantitative disclosure of the use of valuation • Adjusted valuation multiples (e.g., revenue or EBITDA) techniques and their unobservable inputs • Adjustments to historical third-party transactions and • Qualitative disclosure of the process the reporting entity uses quotations to generate its valuations • Discounts for lack of marketability • Loss severities Control premiums Time to expiry (value) DISCLOSURE OF UNOBSERVABLE INPUTS: • Non-controlling interest discounts Prior to the Update, reporting entities were required to list the • Cost of capital techniques and inputs used in their valuations, but not specific • Growth rates quantitative information. The Update now requires quantitative input in • Volatility an effort to bring standardization across all reporting entities. WHEN IMPLEMENTING THIS DISCLOSURE, THERE ARE SEVERAL Under the new standards, for each valuation technique used for Level THINGS TO CONSIDER: 3 assets, the reporting entity is required to disclose in tabular format Unobservable inputs that are used in the valuation technique which quantitative information for significant unobservable inputs, including are developed by others do not have to be disclosed to the extent the following: that they are unadjusted. Observable inputs do not have to be disclosed. Meaning, certain level 3 valuations may not exclusively rely • Type of , including any meaningful classes of fair value on unobservable inputs developed by the reporting entity, and the fair measurements, for which the valuation technique is used value balances in the disclosure may differ from those included in the • Cumulative fair value estimate for the type of security schedule of investments. • Significant unobservable inputs that are developed by the reporting entity Insignificant unobservable inputs to valuation do not need to be • High and low end, as well as the weighted average values included. The determination of significance is the responsibility of the used for the unobservable inputs fund.

The fund is not required to include quantitative unobservable inputs The list of unobservable inputs listed for each valuation technique that are not developed internally when measuring fair value. The fund may not be equally applicable to all of the investments in a respective should include all significant inputs that are reasonably available. category. For instance a market comparable model technique might Examples of unobservable, quantitative inputs that are typically use an EBITDA multiple for certain companies and use a revenue developed by the reporting entity, and are now required to be multiple for other companies, but may not necessarily use both inputs disclosed include, but are not limited to: for all market comparable companies.