Research

There has been tremendous growth in the European hedge fund arena over the last decade and the majority of indicators point towards continued rapid growth in this market. European managers have demonstrated the ability to raise significant amounts of money both in Europe and elsewhere, including the U.S. Although London is, and is likely to remain, the European "capital" for hedge fund managers, fund managers are now to be found throughout the continent in France, Germany, Italy and Scandinavia amongst others. Several European domiciles now provide a framework for "onshore" hedge fund vehicles and European regulators are now looking more closely at hedge funds and the regulatory issues to which they give rise.

Fund Vehicles and Structures

Generally speaking, the same considerations arise as to the type of vehicle to be used for a European managed fund as elsewhere. The fundamental consideration is the nature of the target investors. In deciding which vehicle is appropriate for the target investors, investors can generally be broken down into three categories:

Non-U.S. investors: Non-U.S. investors will typically invest in a corporate fund and so will not pay tax until redemption or other distribution. It should be noted, however, that if the fund as a whole is controlled by shareholders resident in the U.K., a U.K. corporate investor having an interest of 25% or more in the fund may be subject to tax on a current year basis under the controlled foreign companies legislation. If this were the case, the U.K. corporate investor would be subject to U.K. tax on its share of the underlying profits of the fund, irrespective of whether those profits were distributed. This would be a similar treatment to an investor in a limited partnership.

U.S. taxable investors: Generally, U.S. taxable investors invest in a vehicle which is tax transparent, normally a U.S. limited partnership. The reason for this is that an offshore corporate fund will normally be a passive foreign investment company ("PFIC") under U.S. tax legislation. Under the PFIC rules, although the investor will not be subject to current taxation in the U.S., when it redeems its shares in the corporate fund, its total gain will be treated as ordinary income which will be taxable. In addition, the investor will be deemed to have recognised a gain rateably over its holding period, and will therefore be subject to a non-deductible interest charge on taxes-which it should have paid on gains based on this arbitrary allocation of the gains over its holding period.

The PFIC issue does not, however, arise in the case of a limited partnership as it is transparent for tax purposes. In the case of U.S. investors, this provides an additional tax advantage as it may be possible to take advantage of the lower U.S. income tax rates applicable to long-term capital gains in the underlying portfolio.

The PFIC situation can be avoided even in the context of a corporate fund if a U.S. taxable investor can make a qualified electing fund ("QEF") election, the effect of which is generally to treat the corporate fund as a partnership for U.S. tax purposes. The corporate fund will need to provide the investor each year with current tax information so that the investor can currently report its share of the income, but not all funds will be in a position to supply such information even if they choose to do so; and there are certain disadvantages of a PFIC which gives investors this information (e.g. tax losses do not pass through to the investors).

U.S. Tax-Exempt investors: Although a U.S. tax-exempt entity-pension and other retirement funds, university endowments, private foundations and tax-exempt individual retirement accounts-generally is not subject to taxation, if, directly or indirectly (including through a partnership interest in a limited partnership), it incurs indebtedness in connection with investments, it will be subject to taxation, under rules involving unrelated business taxable income ("UBTI"), on the proportion of any gains from the investment attributable to debt. As a result of the adverse UBTI rules, U.S. tax-exempt investors typically invest in offshore funds organised as corporations that are not pass-through entities (unlike partnerships) for tax purposes. Any leverage incurred inside an offshore fund organised as a corporation will not be deemed to pass-through to the tax-exempt shareholders of the corporation.

Stand-alone funds are the simplest type of fund. Where a company is used, investors in the fund will own shares in the company redeemable in accordance with the company's memorandum and articles of association or bye-laws (often monthly or quarterly). Separate classes of shares may be issued to investors. These may be used where the fund wishes to offer shares denominated in different currencies. Where the fund offers shares in multiple currencies, the investment manager may seek to manage the foreign currency exposure of those classes denominated in a currency other than the operational currency of the portfolio. The costs and fiscal results of any such currency management would be solely for the account of the relevant class(es). There may be other differences between classes, such as in the level of fees or liquidity. Often, a fund may offer a class that pays lower fees in return for reduced liquidity and higher minimum investment. Separate classes may also be required where the fund may invest in "hot issues". Sometimes, funds issue a class of share to the manager which has no economic interest in the performance of the fund, but which holds exclusive voting rights in certain matters. The intention here is to give more flexibility and to retain an element of control, provided that the interests of the other shareholders are not prejudiced.

If a limited partnership is used for U.S. taxable investors, one partner-the general partner-will manage the fund and have unlimited liability for the obligations of the partnership, while the investors will come into the fund as limited partners with limited liability provided they take no part in the management of the partnership. A limited partnership agreement would be entered into by all partners setting out the terms governing the partnership. Investors would receive an interest in the partnership directly related to their capital contribution.

Where it is desired to target both non-U.S. and U.S. tax-exempt investors, both a corporate fund and a limited partnership may be established and run in parallel. Each of these will be a separate fund and will have a separate portfolio. Thus, although the same investment program may be followed for each, unless it is possible to allocate all investments pro rata and rebalance the portfolio when necessary, the two funds may soon diverge.

Where it is desired to target both non-U.S. and U.S. tax-exempt investors, but not to establish parallel funds, a master-feeder might be used. The classic master-feeder structure involves the establishment of a master fund, usually as an offshore tax exempt company, which will "check the box" and therefore be treated as a partnership for U.S. tax purposes. The fund portfolio will be held and traded at the master fund level and thus there will only be one portfolio and no need for allocations or rebalancing of the portfolio.

One feeder fund would be a corporate that would be invested in by non-U.S. investors and U.S. tax-exempt investors. The other feeder would be a U.S. limited partnership that would be invested in by U.S. taxable investors. Both feeders would invest in the master fund. If a listing is required, it is the shares of the corporate feeder that are usually listed. As a consequence, it may be necessary to put in place an agreement between the master fund and the corporate fund whereby the master fund agrees to operate as if it were the fund whose shares were listed.

It would be possible to have a "one-legged" master-feeder where an offshore corporate feeder fund will invest in a limited partnership. Non-U.S. investors and U.S. tax-exempt investors would invest in the corporate feeder and U.S. taxable investors would invest directly into the limited partnership master fund. However, U.S. Investment Company Act issues may arise where there are a significant number of U.S. investors as there may be a "look through" for the purposes of determining compliance with the applicable rules. The one-legged master feeder would not normally be structured the other way round (i.e. a limited partnership for U.S. taxable investors investing into a corporate master fund into which all other investors invested directly) as the PFIC issue set out above would still arise.

If a U.S. limited partnership invests through a corporate master fund, it will not normally be able to take advantage of any reduced rates of withholding tax levied in jurisdictions which have double tax treaties with the U.S. and which might otherwise be available to it if it invested directly in the relevant assets.

The investment manager of a master-feeder fund may be subject to conflicts of interest because of different taxation considerations. U.S. taxable investors may be able to obtain beneficial tax treatment in respect of long-term capital gains from the sale of securities held for more than one year. As a result, they generally prefer investments to be held over the longer term whereas this will not be a consideration for non-U.S. investors who will simply be seeking maximum performance. U.S. taxable investors will also want the investment manager to realise tax losses at the end of each year. In addition, the offshore master will be subject to U.S. withholding taxes on U.S. sourced dividends. Whilst it may be possible to enter into synthetic transactions (e.g. equity swaps) to avoid these, the costs could be higher than in a straightforward equity investment and the investment manager must balance its fiduciary obligations to the U.S. feeder with the interests of the offshore feeder in reducing U.S. withholding tax. Accordingly, where tax planning could be a material consideration, parallel funds may again be more advantageous.

In summary, if it is not intended to take in both U.S. taxable investors and U.S. tax-exempt and non-U.S. investors, a stand-alone fund may be the most appropriate fund structure. Where the fund promoter intends to manage a number of different portfolios, it may be that the umbrella fund has certain advantages over the use of a number of separate and distinct offshore funds. If, on the other hand, both U.S. taxable investors and U.S. tax-exempt and non-U.S. investors are being targeted, then a master-feeder or parallel structure should be considered.

Domicile

The basic criteria for determining the appropriate domicile for a European managed fund are the same as elsewhere. These include flexibility, reputation, speed and service levels, cost, investor perception and the status of the domicile. The majority of European managed funds targeted at investors other than U.S. taxable investors continue to be established in jurisdictions such as the Cayman Islands, British Virgin Islands and Bermuda, perhaps in a master-feeder structure with a Delaware limited partnership feeder as well to accommodate U.S. taxable investors. However, funds are also now being established in the more traditional jurisdictions such as Ireland, Jersey and Luxembourg and jurisdictions such as Italy and Germany have enacted legislation, or are in the process of introducing legislation, to permit domestic hedge funds. These developments, combined with a diversification in the nature of hedge fund investors and a certain level of investor resistance to jurisdictions such as the Cayman Islands, perhaps signal a move towards more regulated funds. However, investors outside of Europe and more traditional hedge fund investors are probably less influenced by the domicile of the fund and entrepreneurial managers will probably continue to favour the speed and flexibility of the Caribbean jurisdictions. With the possible exception of Irish and Luxembourg funds, which will be sold on a pan-European basis, European domestic hedge funds are likely to be targeted primarily at investors in the relevant country rather than more widely.

Ireland is currently the leading jurisdiction for European domiciled hedge funds. Hedge funds can be established under the Non-UCITS series of notices as either Professional Investor Funds (PIFs) or Qualifying Investor Funds (QIFs), but normally as QIFs. The Irish regulator, the Irish Financial Services Regulatory Authority (IFSRA), may impose leverage and concentration limitations on a PIF but will not do so on a QIF.

To qualify as a QIF, a fund must:

1. have a minimum initial subscription requirement of €250,000 (or its foreign currency equivalent); and
   


2. sell its shares or units to "qualifying investors". Qualifying investors are defined to include (1) any natural person with a minimum net worth (excluding main residence and household goods) in excess of €1,250,000 (or its foreign currency equivalent), or (2) any institution which owns or invests on a discretionary basis at least €25 million (or its foreign currency equivalent) or the beneficial owners of which are qualifying investors in their own right.

Qualifying investors must certify in the application form for shares that they meet the criteria listed at (b) above, that they are aware of the risks involved in the proposed investment and of the fact that inherent in such investment is the potential to lose all of the sum invested.

IFSRA requires that the assets of an Irish fund be held by its custodian or a duly appointed sub-custodian. However, where a hedge fund uses a prime broker, the assets of the hedge fund which the prime broker is entitled to use as if they were its own will not be held by the custodian as required. IFSRA allows PIFs and QIFs to use a prime broker, provided:

1. the assets passed to the prime broker which may be pledged, lent, hypothecated or otherwise utilised by the prime broker for its own purposes must not exceed 100% of the hedge fund's indebtedness to the prime broker;
   


2. in order to monitor this 100% restriction, arrangements must be put in place to mark positions to market daily;
   


3. the prime broker must agree to return the same or equivalent securities to the hedge fund;
   


4. the prime broker agreement must incorporate a legally enforceable right of set-off for the hedge fund;
   


5. where the prime broker holds assets of the hedge fund in excess of 100% of the hedge fund's indebtedness to the prime broker, that excess must either (1) be transferred at the end of each day to the custodian or (2) be held in a separate account of the prime broker, as sub-custodian. The prime broker may take a charge over the assets held in the sub-custodial account, provided that they remain in a segregated account in the name of the custodian. Typically therefore, the prime broker will be appointed as sub-custodian.
   


6. the prime broker or its parent company must have a minimum credit rating of A1/P1; and
   


7. the prime broker must be regulated as a broker by a recognised regulatory authority and it, or its parent company, must have shareholders' funds in excess of €200 million.

It is understood that IFSRA is currently reviewing the above guidelines and it is possible that there will be a relaxation in the extent to which a prime broker can re-hypothecate.

One further relatively recent development in Ireland is the introduction of retail funds of hedge funds. Although these funds are established under the Non-UCITS series of notices, these new funds should be distinguished from PIFs and QIFs. In the case of a fund of funds which is a PIF, it can invest in unregulated funds, such as Cayman Islands funds, (subject to a maximum of 20% of net assets in any one underlying fund). In the case of a fund of funds which is a QIF, the maximum amount of the fund which can be invested into any one underlying fund is raised to 40%.

Hitherto, Irish funds of funds, which are not PIFs or QIFs, have not been permitted to invest more than 10% of their net asset value in the aggregate in unregulated funds. However, the new rules now permit the investment of more than 10% in the aggregate into unregulated schemes. To the extent that the fund invests in regulated funds, then it is subject to the provisions of the existing rules.

Under the new rules, the fund can invest up to 5% of its net assets in any one unregulated fund. This limit is relaxed to 10% where the fund is managed by the same investment manager. Where the investment manager of the underlying fund is authorised to provide investment management services in an OECD jurisdiction, then the respective limits are 10% and 20%. For all these purposes, related companies/institutions are to be regarded as a single investment manager. The funds into which the new retail fund of hedge funds can invest must be subject to independent audit in accordance with generally accepted international accounting standards and must have a custodian which is independent of the investment manager. The minimum subscription for the new retail funds of hedge funds can be as low as €12,500 (or foreign currency equivalent and where there is capital protection, then even this minimum may be disapplied).

There must normally be at least one redemption day per month and the maximum interval between submission of a redemption request and payment of settlement proceeds must not exceed 95 calendar days, although provision is made for the retention of up to 10% of redemption proceeds where this reflects the redemption policy of the underlying funds, as is often the case with U.S. funds.

In addition to the normal information provided, the prospectus must include specific information on the underlying funds including the investment policies and related risks and the levels of leverage. The prospectus must also set out the fees which are charged both at the level of the retail fund of hedge funds and the underlying funds and the expected impact of these fees on overall performance (including the cumulative effect of performance fees). The prospectus must set out any potential liquidity problems and also potential valuation difficulties and must also explain in plain English the strategies employed by the underlying funds. The prospectus must set out a prescribed risk warning to the effect that the unregulated underlying funds are not or may not be subject to the same legal and regulatory protection as funds regulated in the EU or equivalent jurisdictions. Finally, the prospectus will need to set out the policy which the retail fund of hedge funds will adopt regarding diversification among different strategies and the extent to which it will diversify the strategies and must also set out the extent in which it will invest in underlying funds which have historically shown a high volatility in their rates of returns.

As with all Irish funds, the manager must show that it has appropriate experience and expertise and, in the case of a retail hedge fund of hedge funds, this must include appropriate experience and expertise in relation to alternative investment schemes. As is the case with funds of funds which are listed on the Irish Stock Exchange, there must be appropriate controls and systems in place to monitor the activities of underlying funds. The IFSRA also requires monitoring of managers and risk assessment. The investment manager will be required to provide the IFSRA, on request, with a report on the risk profile and performance of the underlying investments. Where the funds in which the retail fund of hedge funds may invest are managed by the same investment manager or an affiliated company, the investment manager of the retail fund of hedge funds must waive all initial charges and redemption charges and any commission received in respect of an investment into an underlying fund must be paid into the fund itself.

Whilst it has been possible to establish hedge funds in Luxembourg for some time, the approval of the regulator was granted on a case-by-case basis which was a laborious and time consuming project. The reason for this is that whilst the relevant rules set out guidelines relating to futures funds, leveraged funds, venture capital funds and funds of funds, including funds of hedge funds, they were silent on the use by a fund of a prime broker and also on short selling.

The Luxembourg regulator, the CSSF, has set out specific rules for funds pursuing alternative investment strategies. The intention is to permit Luxembourg to compete with other jurisdictions whilst retaining the advantage of regulation.

The new rules clarify issues relating to the use of a prime broker, limits on borrowings, the use of leverage both through borrowings and short sales and the use of derivatives, amongst other things. There is now more flexibility and it is no longer necessary to detail the investment strategy and restrictions in advance to the regulator, although there may be advantages in doing so.

The new rules set out requirements relating to risk diversification as well as the taking of collateral by prime brokers. In respect of short sales, there is a requirement for liquidity and the equity sold short must normally be freely traded on a recognised market, although up to 10% may be off-exchange provided that the equity remains highly liquid. Aggregate commitments from short sales must not exceed 50% of the assets of the fund and the fund must always hold sufficient assets to enable it to close out open short positions.

Under the new rules, funds can borrow up to 200% of net assets or up to 400% where there is a high degree of correlation between long and short positions. The fund can transfer assets to the lender up to 120% of the debt. The fund can also guarantee exposures without the transfer of assets.

Generally speaking, the fund cannot invest more than 10% of its assets in securities which are not freely traded on a recognised market, acquire more than 10% of the securities of one issuer or invest more than 20% of net assets in any one issuer unless the securities are issued or guaranteed by, amongst others, a member state of the OECD or a supranational authority.

Where the fund uses derivatives, the prospectus must clearly indicate the maximum amount of leverage and also describe the risks associated with the transactions. Margin deposits may not exceed 50% of net assets and the fund's liquid assets must at least equal the margin deposits. The fund may not borrow to finance margin deposits or enter into contracts that may involve physical delivery, other than, potentially, precious metals. The fund must pursue a policy of risk diversification and no more than 5% of assets may be exposed to any open position.

The original UCITS Directive was passed on 20 December 1985 and set out a common framework for the operation and European marketing of funds established in Member States. Ever since that date, it has been clear that there were significant issues with the Directive and that there was no effective single market. Some of the difficulties related to the types of funds contemplated (funds of funds, money market funds, etc. were not permissible) and others reflected the inherent difficulty in much European legislation which is that Member States are left to determine the actual implementation of the legislation. Further, there was no unified marketing regime. Whilst the qualifying fund could be promoted into other Member States, local securities laws had to be complied with. Accordingly, whilst many funds have qualified for a UCITS certificate, relatively few have in practice taken real advantage of the opportunities.

There have, for some time, been proposals to amend the UCITS Directive to broaden the range of funds which can qualify as UCITS and to simplify the various requirements. Such proposals have often faltered during detailed negotiations. However, in January 2002, the European Council finally approved two amending Directives. The first of these Directives (the "Product Directive") extends the range of UCITS funds that can be sold cross-border and the second (the "Management Directive") establishes simplified prospectus rules and a unified passport regime for managers of UCITS similar to that in place for investment firms under the Investment Services Directive. Member States should have implemented the changes at a national level by 31 August 2003 and the changes are to take effect, across Europe, on 13 February 2004.

The Product Directive has significantly widened the range of investments in which UCITS can invest and hence the funds which can qualify for a UCITS certificate. In particular, UCITS are no longer restricted to investing principally in "transferable securities" and it has been made clear that transferable securities includes both equities, debt and other negotiable securities carrying the right to acquire any such transferable securities. The Product Directive also now permits money market funds and, perhaps most relevantly to the current discussion, funds of funds.

Until now, UCITS have only been able to invest in other open-ended funds in limited circumstances. UCITS can now invest into other authorised UCITS and in other funds meeting qualifying criteria such that they provide a similar level of protection. UCITS funds of funds cannot invest into other funds of funds. Derivative funds are also now permitted. Hitherto, UCITS have only been permitted to invest into derivatives for the purposes of efficient portfolio management or to hedge foreign currency exposure. UCITS funds may now invest in derivatives dealt in on regulated markets and/or OTC derivatives provided that certain conditions are satisfied, including the creditworthiness of counterparties. In the case of OTC derivatives, there must be a ready valuation and the UCITS must be able to liquidate the derivative as and when it so desires. Where a UCITS is authorised to invest in derivatives, it must include a prominent statement in its prospectus as to whether the activity is for hedging or is integral to the investment strategy.

The original UCITS Directive applied only to the product, i.e. the fund, and not to the management company. The second Directive, the Management Directive is intended to bring management companies of UCITS into line with other investment firms which have had the benefit of the single passport under the Investment Services Directive. The Management Directive also provides a simplified marketing regime for UCITS which includes the introduction of a short form prospectus.

Future European Developments

Whilst both the Product Directive and the Management Directive are welcome advances, they still do not extend to funds such as hedge funds, feeder funds and private equity funds and some of the proposals may be difficult to implement in practice. Further, whilst the simplified prospectus is a good advance, local marketing requirements will still apply.

Nevertheless, it is conceivable that the UCITS Directive may be amended even further, especially following developments in the same Member States, to permit other types of funds and to clarify further the existing rules. Certainly, it seems likely that the appetite for alternative products will continue to increase among European investors and if the intention of the regulations is to create a fair and stable market place, then further developments will be required.

To this end, in August 2003 the Committee on Economic and Monetary Affairs of the European Parliament produced a working document on hedge funds and derivatives. This was essentially a brief statement of the current market place, but also, and more significantly, it raised the possibility of a directive, along the lines of the UCITS Directive, to provide a single well-regulated European market for hedge funds and questioned whether there was a need for some harmonised guidelines or rules across the EU or even globally. In particular, it raised the issue as to whether harmonised rules and tax treatment was an "essential pre-requisite for the EU providing a favourable environment" for hedge funds.

Regulation of Investment Managers

European investment managers are typically required to be authorised in their home jurisdiction. Under the provisions of the Investment Services Directive, a firm which is authorised in one Member State may be able to provide services or establish a branch in another Member State without being separately authorised. For those managers in the U.K., the provision of investment management services to a fund from the U.K. constitutes a regulated activity for the purposes of the U.K. Financial Services and Markets Act 2000 and regulated legislation and, accordingly, any firm providing such services would need to apply for authorisation to do so from the U.K. Financial Services Authority.

Significantly, it usually takes between three and four months after submission of the application pack for the FSA to approve an application and, it is, therefore, important when planning the establishment of a fund to factor into the timetable that the U.K. investment manager will not be authorised to conduct investment management activities until such time as the FSA has authorised it to do so. There is no "interim" or "conditional authorisation". Undertaking unauthorised investment business is a criminal offence.

Together with the completed application pack, the FSA will, on submission, also wish to see the draft fund offering documentation and the draft investment management agreement under which the firm will provide its investment management services. These documents need only be in draft on submission of the application which, from a practical perspective, leaves time for their completion while the FSA processes the firm's application for authorisation.

Another key consideration for those applying to the FSA for authorisation is the requirement to provide information about the firm's controllers and those persons within the firm undertaking controlled functions. Due to the detailed information required, these items can delay submission of the application if not dealt with at an early stage. Applicants should also note that depending on the particular circumstances of the individuals concerned, it may be necessary for them to take FSA approved examinations to demonstrate their competence to perform the relevant controlled function.

It should also be noted that an authorised firm will be subjected to a financial resources requirement so as to ensure that it has sufficient capital. For an investment manager this is basically €50,000 together with one quarter of annual expenditure (the intention being that the firm has sufficient capital to carry on its business in the absence of income). There are strict rules as to the nature of this capital.

In order to avoid delays to the application process, it is vital to ensure that the application is complete and of good quality prior to submission.

Marketing

There is no unified European regime governing the marketing of hedge funds in Member States. Rather, the rules in each jurisdiction need to be examined and complied with. These vary widely between each jurisdiction and in certain cases, such as in the U.K., there may be differing rules for managers who are authorised in the jurisdiction and managers who are not authorised in the jurisdiction.

In the U.K., under the Financial Services and Markets Act 2000, hedge funds are treated as unrecognised collective investment schemes and, consequently, may not be marketed to the public in the U.K. However, the regulations permit the marketing of hedge funds, within certain limitations, by firms authorised and regulated by the U.K. Financial Services Authority. Hedge funds may be marketed by FSA-authorised firms to certain classes of person, including investment professionals, institutional investors, existing investors in other similar schemes and, potentially, to individual investors, subject to suitability requirements. It should be noted that although there is a limited exemption for promoting to high net worth individuals, this will not normally be available in the context of a hedge fund.

In many jurisdictions, unsolicited sales are permitted, including in France and Italy. In Germany, new rules are to be introduced in 2004 which do permit the distribution of certain types of funds, especially funds of hedge funds. Non-EU domiciled funds cannot, however, be publicly sold, although limited private placement is allowed. In Switzerland, a foreign fund must be authorised by the Swiss Federal Banking Commission before being offered, unless the offering is made to a restricted circle, usually thought to be less than twenty investors. There must be no general solicitation and it must be emphasised that it is the number of potential investors to whom the offer is made, rather than how many actually invest, which is relevant. There are some additional carve-outs, including offers to certain institutional investors, such as investment managers and banks in Switzerland purchasing shares for discretionary managed accounts.

Many funds seek a listing on the Irish Stock Exchange. This does not in itself facilitate marketing, but may give access to a wider range of investors, including those who are unable to invest in anything other than a listed vehicle. It should be noted, however, that there is no secondary market and thus investors who can only invest in shares which are "listed and traded" on a recognised exchange will not be able to invest in a listed fund.

It should be noted that the EU E-Commerce Directive, when fully implemented in Member States, may impact cross-border marketing of hedge funds via the internet. The Directive imposes a "country of origin" approach to regulation, which means that, for example, U.K. managers marketing funds into other EU Member States will be subject to the applicable U.K. marketing rules rather than having to comply with the rules of the other states. It should be noted, however, that it will only apply to promotion on the Internet; other laws, such as tax and data protection laws and laws against unsolicited email, will still need to be complied with.

Management Issues

Where the investment management of a fund is carried on from the U.K., investors will be concerned to see that the fund is not associated with the U.K. in such a way that the profits and gains of the fund are subject to U.K. tax.

A company will be treated as resident in the U.K. (and hence subject to U.K. tax on its worldwide profits and gains) if the "central management and control" of the company is exercised in the U.K. This concept is generally understood to denote the strategic control and direction of the company's affairs, as opposed to the day-to-day running of its operations, and is generally exercised by the board of directors.

There are a number of guidelines that a fund should observe in order to ensure that it does not become U.K. resident. Key indicators are as follows:

• The board of directors should meet regularly (at least quarterly) in a jurisdiction outside the U.K., and preferably in the jurisdiction in which the fund is incorporated, to make strategic decisions in relation to the company. Of course, wherever the meeting is held, local advice should be taken so as to ensure that there are no adverse tax or other consequences.
  


• The board should have a majority of non-U.K. resident directors. All the directors should have appropriate expertise and experience and be able to contribute fully to the meeting and any decisions.
  


• All meetings of the board of directors should involve genuine discussion and strategic decision-taking. It should be clear that the board of directors is not merely approving decisions taken by one of the directors or the fund promoter. Full minutes for all board meetings should be taken and the minutes of the meetings should be prepared outside the U.K..
  

Liability to U.K. Tax of a non-U.K. Resident Fund

Even if the necessary steps are taken to ensure that the fund is not resident in the U.K. for tax purposes, the profits of the fund can still, in some circumstances, be subject to U.K. tax. Where a non-U.K. resident company is carrying on a trade in the U.K. through a U.K. permanent establishment, the profits and gains of the non-resident company which arise as a consequence of the activities of the U.K. permanent establishment are subject to U.K. tax. A U.K. permanent establishment for these purposes is a fixed place of business in the U.K. or a U.K. agent through which the business of the non-U.K. company is carried out.

Feeder funds are not likely to be regarded as trading. In most cases, feeder funds will simply invest in the master fund and hold that interest in the master fund as a long-term investment. The strategies of most hedge funds will mean, however, that a fund which is actively managed (whether it is a stand-alone fund or a master fund) will be regarded as trading through the agency of the U.K. investment manager which will accordingly be a permanent establishment of the fund.

There should be no charge to U.K. tax, however, if the investment manager exemption is available. The exemption has a number of conditions, including:

• the U.K. investment manager must carry on a business of providing investment management services and carry out transactions on behalf of the fund in the ordinary course of that business;
  


• the investment manager must receive the "customary rate of remuneration" for the kind of business that it is carrying on. What counts as the "customary rate" is a question of fact in each case;
  


• the investment manager must be acting in an "independent capacity". The Inland Revenue has set out a number of "safe harbours" where it will regard the "independent capacity" test as met including where the investment manager is providing services to a "widely held collective fund";
  


• the "20% test" must be met. This requires that the investment manager and persons connected with it for tax purposes must not be entitled, over the course of a qualifying period of up to five years, to more than 20% of the net income of the fund. Fees paid to the investment manager and connected persons are generally disregarded in determining whether the 20% test is met.

U.K. resident or ordinarily resident investors also need to consider the U.K. tax treatment of their investment. Unless the fund is certified by the Inland Revenue as a "distributing fund" throughout the time they hold their interest in the fund, any gain they realise on the disposal of their investment will be subject to U.K. tax as income rather than capital gains (the "offshore funds regime"). Income treatment is generally less advantageous than capital investment, in particular individual investors are not able to take advantage of capital gains tax taper relief to reduce the effective rate of tax on their gain.

Despite this, hedge funds will generally not seek certification as a distributing fund. This is because it is a requirement of distributing fund status that the fund must distribute at least 85% of its net taxable income in each account period to investors. Since hedge funds are generally regarded as trading, the requirement to distribute at least 85% of their income would require hedge finds to distribute at least 85% of their profits from the realisation of assets. This is clearly contrary to the aim of most hedge funds to accumulate profits and reinvest for long-term gains.

The Inland Revenue has recently concluded a consultation on possible changes to the offshore funds regime and has announced that charges will be introduced in the Finance Act 2004. It is, however, unclear what changes (if any) will be introduced to the regime for non-distributing funds.

EU resident individual investors may also be affected by the EU Savings Tax Directive, which is intended to be introduced from 01 January 2005. In broad terms, the Directive requires that where a fund is invested as to more than 40% in debt instruments or other interest-bearing assets, a paying agent located in a Member State of the EU (or one of the dependent or associated territories, such as the Channel Islands or the Cayman Islands) who makes a payment of share redemption proceeds to an individual investor resident in another Member State of the EU (or one of the dependent or associated territories) will be required either to levy a withholding tax or to provide information about the payment to its tax authorities, which will pass that information on to the tax authorities of the investor's state of residence.

Where the fund is itself established in a Member State of the EU or one of the dependent and associated territories, the fund will itself be regarded as a paying agent and may be required to operate a withholding tax or information reporting regime. The entry into force of the Directive is, however, currently dependent upon agreement being reached with the dependent and associated territories that they will adopt "equivalent measures" to those intended to take effect throughout the EU and so, for the present, it is impossible to predict precisely in what form the Directive will take effect.

Offshore Management Company

In many cases, especially where non U.K. domiciliaries are promoters of the fund, an offshore company will be incorporated in a low or no tax jurisdiction such as the Cayman Islands which will enter into the main investment management and marketing agreements with the fund and thus be entitled to be remunerated for its services. The offshore manager will then enter into sub-agreements with the U.K. investment manager under which it will delegate the performance of some or all of these functions to the U.K. investment manager.

Generally speaking, the remuneration received by the offshore manager would need to be paid on to the U.K. investment manager to ensure that the "customary rate of remuneration" is received. However, where activity such as marketing or promotion is being performed outside the U.K. by the offshore manager it may be possible to retain some of the remuneration offshore.

For so long as the effective investment management takes place in the U.K., the scope for retaining remuneration offshore may be limited. However, where the investment manager may set up additional offices and/or move offshore, then the use of an offshore manager will provide much greater flexibility and potentially prove tax-efficient.

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