Tax-transparent funds (TTFs), or common contractual funds (CCFs) as they are known in Ireland, have become increasingly popular with investors in recent years. They offer investors all the advantages of pooling while still preserving the benefits of their taxation status.
"Tax-transparent pooling schemes allow for the combining of assets within a fund while the income generated is taxed as if the underlying investors had held the assets directly," says Paul Heffernan, head of cross-border sales, Europe, with HSBC Securities Services.
“In other words, they provide all the advantages of pooling but with none of the potential tax downsides – that is, where non-TTF structures are corporates, corporate structures have their own tax entity status so may have worse withholding tax positions than non-taxable investors such as pension funds.”
Gareth Bryan, partner and head of investment management tax with KPMG in Ireland, uses the example of a pension fund which intends to invest in a portfolio of assets via a collective investment fund.
“Institutional investors such as pension funds are entitled to reduced withholding tax rates on investment return earned from certain jurisdictions,” he says. “However, in the event that a pension fund held its investment through a non-transparent fund, it could potentially increase the overall level of tax suffered on the return it earns on behalf of its investors. This is on the basis that the withholding tax treatment would depend on the status of the non-transparent fund – which may not be entitled to the same exemptions as a pension fund, rather than the underlying pension fund. A pension fund would, therefore, usually prefer to be treated as investing directly in the underlying portfolio of the fund. This is achievable using a tax-transparent fund vehicle.”
Co-owners
Investors are actually co-owners of the underlying assets in a CCF, says Gayle Bowen, investment funds partner and head of office with Pinsent Masons Dublin. “Investors in the CCF are treated as if they directly own a proportionate share of the underlying investments in the CCF and therefore profits are treated as accruing or arising to the investors as if they had not passed through the CCF,” she explains. “This is different to how non-transparent funds work, where investors simply hold units or shares in the fund and are not co-owners of the underlying assets, which are held by the fund.”
In addition to the potential advantage to institutional investors, tax-transparent funds have also become the vehicle of choice for private-equity fund structures, Bryan adds. “This is primarily due to the potential legal and commercial flexibility associated with using a partnership as a fund vehicle,” he says. “Another reason tax-transparent funds are commonly used as private-equity funds is the fact that investing in assets via non-transparent funds can give rise to potentially adverse tax consequences for certain categories of US investors. Such investors provide a significant source of investment in private-equity funds.”
Diversification is another advantage, according to Carmel Jordan, European chief operating officer in delegated solutions with Mercer Investments Ireland. “Tax transparency is attractive to many investors, for example, Irish pension funds, as they can retain the benefits that are afforded to them by many tax treaties and tax regimes throughout the world,”she says.
“Tax-transparent funds offer investors the opportunity to diversify their portfolio and spread portfolio risk along with cost savings from economies of scale without being adversely affected by tax status. As the leading provider of investment solutions to the Irish market we have developed significant expertise and capabilities in developing tax-transparent investment solutions for pension clients. Mercer has been at a forefront of these offerings since 2010 and we now have in excess of $25 billion in assets invested in CCF structures across both UCITS and QAIFs regulatory regimes.”
Efficiency is an added benefit. “Using a TTF, asset managers can pool assets including different funds, investment types, and separately managed accounts into a single fund to generate economies of scale and achieve a reduced cost-income ratio,” says Heffernan. “This allows investors to benefit from a more efficient and cost-effective fund structure.”
Windfall for Ireland
The global appeal of the TTF structure may generate a windfall for Ireland following the withdrawal of the UK from the European Union, whenever that may happen.
“It is quite probable that while UK fund managers will continue to offer authorised contractual scheme [the UK regulated TTF vehicle equivalent to a CCF] products to UK investors, they will use Irish CCFs, or other similar European products, for cross-border investors,” Heffernan says. “This will make Irish CCFs a natural choice for undertakings for the collective investment in transferable securities [UCITS] master feeder arrangements in the post-Brexit environment. It also strengthens their position as a tax-transparent fund domicile of choice for cross-border distribution.”
This will naturally depend on the Brexit outcome, says Bryan. “But if the UK loses the ability to passport and sell UK domiciled funds to European investors, we expect to see some additional interest in CCFs as fund promoters that are considering establishing an authorised contractual scheme may see the CCF as an alternative. In this context, we are aware of some fund promotors which currently have a UK-authorised contractual scheme considering transferring the existing fund assets into a CCF as part of their Brexit contingency planning.”
In a post-Brexit environment, multiple tax agreements, tax opinions and tax rulings will need to be reassessed, according to Jordan. “This naturally has created uncertainty around the status of UK TTFs and how the status will look once the UK has left the EU. This could lead to Irish transparent vehicles being a more attractive and stable location within the EU for these investors. While the terms of Brexit and its associated results continue to be uncertain, we are optimistic that this may create opportunities for Ireland and Irish vehicles post Brexit.”
Bowen sees this as something of a mixed blessing, however. “In my view, long term it would be better for the Irish funds industry if the UK were to remain in the EU, to ensure that we have continued access to the UK market,” she says. “That being said, given that UK funds will lose the ability to passport their funds for sale across the EU, it is likely that a number of fund managers will consider using Irish funds to retain the ability to access European capital.”