We are seeing an increased interest in offshore investment funds as managers look for ways to increase their investor base. Below will touch on why a fund manager would look to set up an offshore investment fund, the various organizational structures of an offshore investment vehicle and the most popular offshore jurisdictions and their similarities and differences.
For fund managers looking to increase their investor base, an offshore entity is an attractive offering. Non-U.S. investors prefer to invest in offshore entities to avoid potential U.S. tax exposure associated with direct investment in a U.S. entity. Additionally, U.S. tax-exempt investors looking to avoid Unrelated Business Taxable Income (UBTI) will look to invest directly into an offshore blocker corporation that prevents UBTI from being passed on to U.S. tax-exempt investors.
There are several ways to structure offshore investment funds: side-by-side, stand-alone, master-feeder and mini-master.
Side-by-side involves having an onshore vehicle based in the U.S. and an offshore vehicle that both trade on an identical strategy, but with completely distinct and separate brokerage accounts. There is increased complexity with managing the same strategy in separate accounts and for that reason, side-by-side is one of the less popular structures chosen by U.S. fund managers.
An offshore standalone consists of one fund vehicle located offshore. This structure is most typically utilized by non-U.S. fund managers, or U.S. fund managers mainly serving U.S. tax-exempt investors (particularly endowment funds, pension funds and charitable organizations) and non-U.S. investors.
Master-feeder and mini-master
The master-feeder and mini-master structures solve for the issue of having to book identical trades in multiple accounts by having all trading contained in one master entity, while providing a solution for investors with different tax requirements to participate in the same fund. The master-feeder is typically structured with an offshore master fund, and two feeder funds that invest 100% of their assets into the master: an offshore feeder fund and a U.S. domestic limited partnership feeder fund. The U.S. taxable investors would invest in the Domestic Feeder, which in turn would invest in the Offshore Master Fund. The fund gains and losses applicable to the U.S. taxable investors would be passed through to them via the limited partnership they are invested in and would be taxed at the investor level.
Non-U.S. investors and U.S. tax-exempt investors would invest directly into the Offshore Feeder. As discussed earlier, this entity would server as blocker corporation and prevent any U.S. tax liability from being passed onto non-U.S. or U.S. tax-exempt investors.
A mini-master structure consists of just two entities: a U.S. domestic limited partnership master fund and an offshore feeder. The offshore feeder invests 100% of its assets into the domestic master fund. Similar to the master-feeder structure, the non-U.S. and U.S. tax-exempt investors would invest in the offshore feeder, which would serve as a blocker corporation, while the U.S. taxable investors would invest directly into the domestic master fund. There are obvious cost savings associated with two vehicles as opposed to three. Additionally, many U.S. fund managers start out with a U.S. domestic limited partnership, which enables them to continue running that fund per normal, whereas, with a master-feeder, the fund would need to transfer both the assets and investors invested in the U.S. domestic limited partnership to the new offshore vehicles.
British Virgin Islands vs. Cayman Islands
The British Virgin Islands (BVI) and Cayman Islands are the two most common offshore jurisdictions used by U.S. based fund managers. They are both highly regarded and well-established offshore fund jurisdictions. Below is a brief summary of the similarities and differences between the two offshore fund jurisdictions.
- Tax benefits:– No local tax is charged in either jurisdiction. Tax-exempt investors can be sheltered from UBTI via a blocker corporation in both jurisdictions.
- Sophisticated registration systems: Both jurisdictions have quick, sophisticated registration systems allowing for incorporation of a new entity in a matter of days.
- Privacy: Both offer a high degree of privacy with no publicly available shareholder or director information.
- Flexibility in entity type: Both allow for partnerships and corporations to fit any need an offshore fund could have.
- Local auditor requirement: Both require an annual audit, however only the Cayman Islands requires that the audit be signed off by a local auditor that is approved by the Cayman Islands Monetary Authority. BVI does not require an auditor with a BVI office sign off on the audit.
- Cost: The Caymans charges an annual fee of $4,268, while BVI charges a fee of $1,000. Additionally, the local auditor requirement in the Caymans can lead to increased fees over a similar audit in BVI.
- Clear most popular jurisdiction: Per the Cayman Islands Monetary Authority, there were 10,505 registered investment funds as of March 31, 2020. Per the British Virgin Islands Financial Services Commission, there were 1,479 registered investments funds as of March 31, 2020. As you can see, Cayman is far more popular. Due to this, investors typically have more familiarity with Cayman. Familiarity requires investors to do less due diligence. This becomes more important if a fund is working with institutional investors.
It is vital that U.S. fund managers consider the impact the structuring of an offshore entity could have on the tax implications of the incentive allocation they received as compensation for their trading on behalf of the fund. For most U.S. fund managers, it is most tax efficient to recognize the incentive allocation as a reallocation of capital, as opposed to a fee, either in a domestic master fund in the case of a mini-master structure, or in an Offshore Master Fund in the case of a master-feeder structure.
An offshore investment fund is an attractive vehicle to potential investors and should be a consideration when U.S. fund manager are looking for ways to increase their investor base. Hopefully, this article can serve as a launching point for U.S. fund managers to begin discussions with their U.S. and offshore attorneys.