Managing investor expectations is a key part of any fund-raising process for an Alternative Investment Fund (AIF), understanding the tax needs of investors, collecting and checking the tax information is a central piece of any investor onboarding process.
The tax treatment of the AIF and the income received by investors on this investment as well as the quality of the tax reporting made to them, are significant factors that enter into the decision-making process that precedes an investment in an AIF.
Moreover, the AIFs and their managers are also subject to several tax compliance rules with respect to their investors and notably from an AML and FATCA/CRS perspectives.
Investors have expectations in terms of tax information received
Investors in AIFs may have specific tax expectations based on the legal form of the AIF, the investment strategy, the asset class, and the jurisdictions involved.
Many AIFs are structured as (tax) transparent entities, such as limited partnerships to ensure tax neutrality for investors. In such structures, income, gains, losses, and deductions, pass through to investors' own tax returns. For this reason, one of the first pieces of information that investors would typically expect is how investment made by the fund will impact their personal tax situations. This is usually covered in the offering documents of the AIF.
Based on the nature of the income received, investors would also expect detailed information on the types of income and how they will be subject to tax. As such, AIFs are generally required to provide investors with detailed tax reporting statements (i.e. Schedule K-1 in the U.S.A.) to outline investor's share of income, gains, losses, and deductions, which are essential for accurate tax filing. While this is not a legal requirement, being provided with investor tax reporting is a condition sine qua non for any commitment decisions.
Additionally, if the AIF invests internationally, investors may have specific expectations regarding foreign tax considerations, including any potential foreign tax credits.
In general, investors will expect the AIF and its managers will comply with all relevant tax regulations. This includes timely filing of tax returns, adherence to tax reporting requirements, and compliance with any tax laws applicable to the fund's structure. As ESG (Environmental, Social and Governance) considerations become more important, many investors also expect that the fund will avoid any aggressive tax planning scheme and pay its fair share of tax.
Investor onboarding is not only an AML-KYC matter
The collection of tax information from investors and their Ultimate Beneficial Owners (“UBOs”) is not only required for marketing purposes but also for compliance purposes.
In particular, the AIF managers also need to collect tax information from their investors to comply with certain tax reporting (notably FATCA and CRS, partnership tax returns), withholding tax and compliance obligations, mainly from an AML perspective.
For the latter, it is crucial to determine if the funds contributed by the investor are not derived from a tax fraud (applying source of funds and origin of wealth criteria) and whether the income distributed to investors will be duly subject to tax where and when required (through an analysis of the complexity of the structure and tax residency of the UBO).
Understanding how investment income will be taxed within the hands of the investors may also be needed to determine the own taxable base of the fund in particular in the context of ATAD 2. Indeed, under this directive, distribution made to investors that would not be subject to tax on their respective share of investment income in their country of tax residence due to hybrid mismatch may not be tax deductible.
In any case, the starting point for all those processes is to determine where investor and/or UBO(s) are tax residents since this is the cornerstone for all tax related processes. For instance, in the context of its AML/KYC obligation, an AIF should identify the tax residency of its investors and UBOs to determine if the latter present higher risk of frauds, this would be the case for instance for EU blacklisted or other offshore jurisdictions or any other jurisdiction where the investor would pretend to be residing. The same information is also required for issuance of investor tax reporting, to apply tax treaty preferred withholding tax rate on certain U.S. source income, to determine whether they should be reported under FATCA or CRS as well as to assess if ATAD 2 adjustment will be applicable.
Similarly, it is also central to obtain tax identification numbers of those people to ensure that tax reporting made by the AIF is reconciled by the tax authorities with investor tax returns. We are seeing increased challenges from tax authorities when this information is not included in the FATCA and CRS reports and the upcoming eighth version of the DAC (Directive on Administrative Cooperation) will allow them to automate their controls in that respect.
It is thus important to ensure that governance around those different processes is built in a holistic manner to enhance investor onboarding experience and reduce risk of incoherent information.
New era of investor onboarding in a digital era
For an alternative asset manager, the starting point of the tax onboarding process is the definition of the investor needs and of the tax and regulatory requirements of the AIF. Based on such preparatory work, it is important to identify the synergies and interactions between the different objectives to simplify the level of information required from the investor and detect the interactions and incoherencies between the different certifications provided by the investor.
We often see in the market, investors or their representatives completing several questionnaires and certifications requesting each time the same information. Often, tax residence and TIN (Taxpayer Identification Number) details are collected through several documents during the onboarding process such as the FATCA/CRS self-certification, the AML package (which may also ask for a proof of residence), the U.S. Withholding Certificates (the W-8 Forms) or the ATAD 2 questionnaire increasingly present in the subscription package. A good practice could then consist in leveraging in the subscription form on the FATCA/CRS self-certification for all questions linked to the tax residence of the investor and their UBOs.
Those different aspects including audit trail of the actions taken to ensure compliance should be covered by the tax function to have the operational team equipped to understand how tax can affect their investors and investments on the most frequent cases they will face. This also means ensuring that relevant employees are regularly trained considering that tax landscape is subject to constant evolution.
Besides, it is also frequent for investors to request, through side letters, to be provided with certain tax information or confirmation. For instance, to comply with their own ESG policies, institutional investors often request the asset manager to confirm that the AIF is not engaged in any aggressive tax planning and is not subject to any DAC 6 reporting.
To meet all those expectations from different stakeholders, technology will play an important role. Those investors’ tax attributes could be recorded in the CRM system of the asset manager and be the mirror of its service providers in order to avoid inconsistent treatment and missing required reporting to investors. More broadly, a best practice is to interact with investors through a dedicated investor portal which could be used to communicate, collect information, provide investor tax reporting and dashboards. This allows to exchange all this sensitive information in a streamlined, controlled and secured manner.
The collaboration between tax and compliance functions and the oversight of the asset manager on their transfer agent and tax advisors is key so that no tax process is overlooked especially considering that tax function is more and more outsourced. The tax aspects should also be on the AIF Board agenda and their asset managers, to ensure respect of the commitments given to investors as well as compliance of tax obligations of the whole fund structure. Establishing such a sound tax governance is paramount to avoid any remediation plan or financial sanctions from the tax authorities and regulators as well as complaints from the investors.
As we have seen, investor tax onboarding is not only an AML matter but also a complex subject with several distribution, tax, and compliance ramifications. It is thus important for asset managers to review the way they comply with those requirements, interact with their investors, and clearly determine roles and responsibilities between transfer agent, tax, compliance and investor relationship teams.
