In recent years, asset managers, insurance companies, fund investors, and consultants have become increasingly sensitive to the potential withholding tax disadvantages triggered by investment through a collective investment fund, as opposed to direct investment. At the same time, regulators have placed increased focus (and in some cases requirements) to optimize tax efficiency for certain investment schemes and products.   

To solve for these sensitivities, BBH works closely with sponsors to launch tax transparency initiatives to provide investors (e.g., pensions, charitable trusts, insurance companies, and other large institutions) with a collective investment vehicle that provides strategically-optimized after-tax returns. These structures can both solve for the impacts of withholding tax drag on investment returns by enabling tax relief to the extent of investors’ eligibility, and also offer the sponsor and manager significant cost efficiency and economies of scale. (For more information on beneficial ownership, including recent developments, please refer to our recently-published In Focus piece, “Beneficial Ownership for Tax Treaty Entitlement.”)

Where tax transparency is employed, fund dividend yields can more closely match those achievable by underlying investors if they invested directly in the securities held by the fund, for purposes of withholding taxes. This is sometimes referred to as “tax look-through” because when determining the tax on an income event, withholding agents “look-through” the fund entity to the investors. Though use of look-through and transparent vehicles has been quite common for some time, large-scale institutional tax transparent funds have grown rapidly over the last 5-10 years, spurred, in part, by an expanded range of tax transparent vehicles approved by regulators. Asset managers, corporations, and sponsors are finding additional ways that these funds can be used: to support the benefits of scale, efficiency, and tax transparency to portfolio holdings of insurance funds or corporate affiliates.

Chart 1: Illustrates Common Contractual Funds (CCF) total AUM growth from approximately $10 billion in 2013 to nearly $110 billion in 2019.

Benefits of Tax Transparency in a Pooled Investment Vehicle

Transparent structures allow comingling of multiple investors with a variety of tax rates in a single collective fund, thus facilitating the economy of scale advantage without causing undue tax drag for investors. A transparent structure can benefit investors because it:

  • Allows asset managers to attract pension assets by largely eliminating excess taxation as a potential negative differentiator
  • Limits the necessity of launching separately managed accounts by allowing both managers and investors to take advantage of the economies of scale and efficiencies inherent to collective investment vehicles
  • Offers the benefit of robust regulatory frameworks already in place today, e.g., the UCITS regime

Often, under a provision of double taxation agreements with the US, pension funds and other tax advantaged vehicles are eligible for a 0% rate of tax withholding on US source dividends. If a pension fund invests into a non-transparent fund, however, then the pension fund may not be able to avail itself of the 0% withholding rate. Instead, all the US dividend income will be charged at the fund’s applicable withholding tax rate, which will generally be 30%. Assuming a 2% yield on US equities, the annual tax drag on the fund would equal 60 basis points (bps). This essentially amounts to underperformance for the pension fund.

Over time, this benefit becomes even more obvious, as illustrated in the matrix below, using an Irish Common Contractual Fund (CCF) investing in US equities as an example:

Chart 2: A comparison of tax drag for 3 years, 7 years, 10 years, 15 years, and 20 years for a UCITS CCF’s. The chart illustrates that over a 20 year investment period the reduced tax costs would create additional investor returns of approximately $1 billion.

Similar benefits may be available in other markets where tax transparent treatment may provide similar benefits in reducing the statutory withholding rate for pension funds, but fund managers should be aware that each market of investment presents unique regulatory and operational/mechanical considerations for transparent funds and fund investors; financial benefit analysis is highly recommended to realize true benefits.

Transparent vehicles also offer benefits to the European insurers facing the regulatory requirements of the Solvency II directive. Insurers must hold capital to safeguard against the risk of insolvency. As we enter a period of economic uncertainty, there is a fine balance between income generation and safeguarding against risk. Shifting from a policy holder to a unit holder in a tax transparent vehicle (like a CCF) has the potential to greatly reduce the level of capital required to be held against that investment.

Types of Tax Transparent Funds

Transparent fund structures with robust regulatory frameworks are available in a number of jurisdictions, with the most common European fund structures being Ireland’s Common Contractual Fund (CCF) and Irish Collective Asset-management Vehicle (ICAV)[1], Luxembourg’s Fonds Commun de Placement (FCP), the Netherland’s Fonds voor Gemene Rekening (FGR), and the UK’s Tax Transparent Fund (TTF).

Establishing a Tax Transparent Fund

Tax transparency is a compelling tool at the disposal of fund managers, but it is not always the right one and should be deployed where analysis indicates there will be significant uplift. When considering a tax transparent fund structure, there are three key considerations: financial benefit analysis, legal and structural decisions, and investor impact.

Financial Benefit Analysis

The costs associated with creating and maintaining a transparent fund escalate depending on how expansive a transparency strategy is, both with respect to the residence countries of investors and the number of countries of investment targeted. In many cases, the cost of achieving and maintaining tax transparency can outweigh the reduction in tax drag. These considerations have caused many asset managers to focus on transparency when the cost benefit analysis yields significant upside, e.g., for certain classes of investors and large markets of investment.

To ensure economic efficiency, standing instructions based on materiality thresholds may be provided to the custodian to ensure that tax relief and reclaims are only pursued when worthwhile. These considerations have caused asset managers to focus on transparency when the cost benefit analysis yields material upside.

In addition, consideration should be given to fund-level opportunities for tax benefits that may not require transparent servicing, e.g., benefits provided to UCITS funds in many European markets may be simpler to administer and, in some cases, more advantageous than employing a transparent model.

Legal and Structural Decisions

From a tax transparency perspective, there is little differentiation among the various EU-based tax transparent investment vehicles.

To gain tax transparent status, three different types of jurisdictional analyses are required:

  • Fund – The fund must be recognized as tax transparent in its domicile.
  • Investor – The investor’s country of residence must view the fund as transparent.
  • Investment – The fund must be recognized as tax transparent in each country where the fund seeks to gain tax transparency on investment income.

Obtaining recognition within the jurisdiction of the fund is often straightforward, as countries have created specific tax transparent fund frameworks. What can pose a challenge is obtaining verification that an investor in a tax transparent fund is entitled to treaty benefits under its own home country treaty network. Ultimately, the verification of tax transparent status is required by the withholding agent in the country of investment to assure the agent that treaty benefits are being offered appropriately, and to reduce the risk for the fund itself.

Procuring these approvals and/or opinions varies by jurisdiction and structure and can be a time consuming and costly exercise, which requires engaging local market tax experts (e.g., local tax authorities and/or tax advisors) to help navigate the process. It is critical that in certain countries these advisors are engaged early as there may be local considerations to factor in when establishing the tax transparent fund.

In some cases, the form of these opinions is evolving as the market for tax transparent vehicles grows. For instance, BBH has observed an increase in discrete, market-by-market opinions for investment in the United States. On the bright side, as advisors and tax advisors grow savvy and more accustomed to these tax-advantaged structures and investment/investor combinations, opinions and approvals may come more swiftly and easily.

Investor Impact

Tax transparency provides a financial return in the form of reduced withholding tax, however, fund managers should also consider investor level issues. The three key issues include:

Tax Documentation – Investors may be required to complete tax documentation to obtain the desired treaty rate, essentially shifting what might otherwise be the fund’s burden to investors. This process will need to be explained to investors and managed through operational processes between the fund’s transfer agent and custodian. Some of the required forms, such as the US Form W-8 and Canadian NR Forms, are complex and may require a distinct communication strategy to investors. Additionally, this documentation may need to be completed regularly (e.g., on a transactional level for certain reclaim markets) or refreshed on an annual or more frequent basis depending on the market rules. The additional documentation burden is a key consideration in evaluation whether a transparent approach is the right one for a particular vehicle or set of investors.

Tax Reporting – Investors may receive tax reporting as if they were holding assets in segregated mandates. For example, non-US investors in a fund that is transparent for US tax purposes will receive Form 1042-S, which details the annual amount of US source income the fund allocated to the investor. Like the Form W-8 requirements, a specific communication strategy may be necessary for investors.  Non-US markets may have similar reporting regimes and investors will need to be aware of these regimes and whether they might trigger other responsibilities, e.g., the requirement to file a local return. 

It’s also important for investors in transparent structures to realize that documentation and other requests may continue after initial onboarding due to changes in tax rates, expiration, and the operational processes and maintenance associated with these types of structures.

Approaches to Optimize Tax Efficiency

Tax transparency presents unique considerations, opportunities, and implementation challenges to funds. Fund managers typically follow one of three operating models:

  1. Opaque approach – Under certain conditions, target investor population, investment focus, or financial analysis do not give rise to significant differences in taxation between the fund and its investors. Additionally, business drivers such as how the fund will be distributed or managed can complicate or preclude the achievement of tax transparency. In these cases, asset managers operate the fund as opaque.
    • Example: a fund with a large volume of smaller investors might find that the costs of administering a transparent approach would be prohibitive, even if the underlying investors might be eligible for some level of benefit. In these cases, fund managers often look to fund-level opportunities available to opaque funds in order to balance tax efficiency with administrative costs and investor burdens.
  2. Comprehensive approach – In a fully transparent model, look-through benefits are sought wherever possible. In these cases, comprehensive tax diligence is performed prior to fund launch, and a complete operating infrastructure is required. This option may be employed when the investment focus is narrowed to match target investors, investment markets or strategies that facilitate the approach.
    • Example: a fund with large, institutional pension plans as investors might choose to employ a fully-transparent approach.In these situations, “like investors” are typically pooled in defined share classes or sub-funds.This approach might also suit a multi-national insurance company that would otherwise establish separately managed accounts for its subsidiaries can move into a single, pooled, unitized structure.

  3. Selective approach – Under this model, comparative market and financial analyses of the target investor population are taken into consideration and result in the creation of an operating model that mitigates threshold issues. Business or operating decisions can be made to pursue tax transparency where it makes financial sense and does not overly burden fund investors.
    • Example: a fund with a combination of large and small investors, or with a subset of investors not eligible for beneficial treaty relief may choose to pool large, treaty-eligible investors in transparent share classes/sub-funds, while keeping the smaller or ineligible investors in classes without transparent servicing and costs, in order to optimize overall efficiency.

Once the overall strategy around tax transparency is chosen, service providers can be selected and the fund can be formed.

Bottom Line

Brown Brothers Harriman (BBH) has been at the forefront of tax transparency and has a longstanding history of working with our clients on launching, maintaining, and servicing tax transparent fund structures. The BBH tax transparency platform supports varying degrees of complexity— from the simplest form of tax transparency, in which all the fund investors are entitled to the same withholding tax treatment, to the more complex forms that include comingling and virtual pooling with non-transparent funds and share classes. To date, BBH’s primary experience with tax transparency has been supporting EU-based funds seeking tax relief for institutional investors. If you would like to learn more about challenges and the potential opportunity of tax transparency, please contact your relationship manager.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. Pursuant to information regarding the provision of applicable services or products by BBH, please note the following: Brown Brothers Harriman Fund Administration Services (Ireland) Limited and Brown Brothers Harriman Trustee Services (Ireland) Limited are regulated by the Central Bank of Ireland, Brown Brothers Harriman Investor Services Limited is authorised and regulated by the Financial Conduct Authority, Brown Brothers Harriman (Luxembourg) S.C.A. is regulated by the Commission de Surveillance du Secteur Financier. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. IS-06124-2020-04-28

1Transparent for US purposes, typically opaque in other jurisdictions.