Jessica: Why would a fund or institutional asset manager want to insure tax risk?
Richard: The precise risk will depend on the nature of the fund – private equity (PE), real estate (RE), credit, or hedge. Ultimately, the key driver for using tax insurance will be the same – to maximise returns for investors and protect against potentially material tax leakage.
From a structural perspective, tax insurance can be a useful tool to mitigate any risk that investors will be worse off from a tax standpoint than if they had invested directly. This can allow proceeds to be returned to investors when investments are disposed of, the fund is wound-up, or otherwise. Interestingly, we have encountered references in fund documentation to managers considering tax insurance as part of a prudent tax strategy to attract investors.
At an investment level, tax insurance can be used to protect modelled returns to the fund. For PE and RE funds, this can apply to both operational activity by giving certainty of tax treatment – e.g. What is the VAT treatment of a certain supply? – and mergers and acquisitions (M&A) by preventing ‘trapped cash’ relating to an escrow, specific indemnity, etc or to otherwise deal with identified due diligence matters. Whereas a credit fund may require that a borrower considers insurance for tax matters – e.g. identified in due diligence – in order to get comfortable during their underwriting process.
Advisers to institutional investors can be confronted with the inability to offer certainty with millions of dollars of tax at risk. Insurance can provide additional comfort over and above relying on diligence alone and offer a quicker alternative to seeking a tax authority ruling or clearance.
Jessica: Regarding your point on fund documentation, I suspect using TLI to manage structural tax risks could also aid side letter negotiation with investors.
Richard: Yes, exactly. Comfort could be sought via side letter or, as some managers do not grant side letters, it can be helpful to confirm that the manager is at least aware that insurance is a possibility.
Jessica: Can you give some examples of the fund structural tax risks you referred to?
Richard: Yes – these typically relate to how cash is repatriated or how an entity is treated within a structure.
In terms of repatriation, we are regularly asked to consider insuring against withholding taxes or whether interest deductions will be denied such that they cannot be matched against income. For example, where debt is recharacterised as equity or under transfer pricing rules. Concern may arise due to developments since a structure was established which increase the risk of tax leakage. For example, the ECJ’s Danish Cases have caused several fund managers to consider the substance of their holding structures.
Alternatively, the fund may need to act in a way that was not anticipated at the time the structure was established and that may carry an element of tax risk. For example, an unregulated fund may prejudice its special tax exempt status if it is trading – does accepting an unsolicited offer to acquire its assets shortly after its own acquisition of these constitute trading activity? Insurance can provide the comfort to allow the transaction to proceed.
Jessica: I expect the increased certainty TLI offers would be a significant comfort when valuing investments for acquisition purposes, which could be of assistance when making a competitive bid.
What other tax risks do you insure that are unique to funds?
Richard: Secondaries transactions can give rise to potential tax headaches. For example, a new investor can give rise to secondary liabilities for existing investors in some jurisdictions, like transfer taxes if the fund is deemed to be a real estate rich entity. Insurance can be used to protect other investors in a scenario where it is unclear whether the rules apply and the incoming investor takes the view that it will not pay the taxes thus creating a potential secondary tax liability.
Further, a key tax concern for fund managers – other than their investors’ position – is the treatment of their incentivisation or co-investment. During 2020, we saw a huge increase in requests for cover relating to whether amounts paid to fund managers would be taxed as capital or employment income.
Jessica: Do you also insure risks from the retail investment sector?
Richard: Yes, this is also something that we have looked at. Unlike institutional risks, these typically relate to how the business itself operates and the key risk for the retail investment sector tends to be the tax treatment of the services supplied.
For example, whether VAT ought to be charged on the supply of services and/or whether a VATable supply is part of a dominant exempt supply. VAT treatment can often require a judgment call, and insurance is well-placed to offer certainty in this instance. Due to consolidation among independent financial advisers, this is often a risk identified during a purchaser’s due diligence, but we have also considered insurance on a forward-looking basis where a supply is being restructured.
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