OECD Pillar Two: considerations for investment funds

On 20 December 2021, the OECD published model rules to assist in the domestic implementation of the Pillar Two minimum global tax rate of 15% (the GloBE Rules). This article considers how the model rules would apply to common collective investment structures. For a more general commentary on Pillar Two, please see our earlier publication.

Overview

During the OECD’s consultation ahead of its publication of the model rules, certain trade bodies (including AIMA and an international consortium of private capital industry bodies, including the BVCA) gave their views on the proposed Pillar Two regime.

A common theme of the views put forward during the consultation was that the principle of the tax neutrality of collective investment vehicles should be protected and that investment funds should be carved out from the scope of the GloBE Rules.

The model rules seek to protect the tax neutrality of investment funds in two ways. First, the minimum global tax rate only applies to large multinational entity groups (MNE Groups), which should generally catch trading companies with a cross-border presence but not investment funds with an international portfolio. Second, certain investment funds, alongside pension funds, NGOs, government entities and others are treated as Excluded Entities under Article 1.5 of the model rules and therefore exempt from the minimum global tax rate.

On the basis of the model rules, we expect that the Pillar Two minimum global tax rate should not adversely affect most genuine collective investment vehicles. With that said, political conversations regarding the local implementation of Pillar Two are ongoing, which means that certain more granular aspects of the rules remain unclear. In particular, it is not clear how structures with a US nexus will be affected, given that the US has a regime in place that is similar to Pillar Two (ie its tax on Global Intangible Low-Taxed Income (GILTI)), but it is currently uncertain whether the US will adopt the OECD’s rules. The finer detail of the tax risks that this regime creates for investment fund structures will therefore depend on how local implementations of the rules unfold.

This article discusses the two layers of protection for investment funds and the types of fund structures that may fall outside of this protection.

MNE Groups

The GloBE Rules apply only to members of an MNE Group that has annual revenue of EUR 750m or more in the consolidated accounts of the ultimate parent entity in at least two of the four fiscal years immediately preceding the relevant fiscal year. The GloBE Rules are only relevant where at least one entity or permanent establishment of the MNE Group is located in a different jurisdiction to that of the MNE Group’s ultimate parent entity.

The primary protection for investment funds with an international portfolio will be that, in general, investment funds are not required to file accounts that are consolidated with those of their portfolio companies.

Investment funds holding minority stakes in portfolio companies are not generally required to prepare consolidated accounts with those portfolio companies. Accordingly, most hedge funds, which are typically structured as corporate vehicles and take non-controlling equity positions, are unlikely to be treated as part of the same MNE Group as their portfolio companies.

Where an investment fund acquires a majority of a target’s issued share capital, that investment fund may subsequently be required to file accounts that are consolidated with that target. However, the private equity vehicles that typically engage in these transactions are often structured as unincorporated funds (for example, an English or Delaware limited partnership or a Luxembourg special limited partnership). These flow-through vehicles are tax transparent and do not generally file accounts. Accordingly, provided that the fund’s investor base is sufficiently diverse, neither the fund nor any of its investors should be required to file consolidated accounts with portfolio companies in which the fund holds a controlling interest.

In most cases, investment funds will therefore not be deemed to have relevant subsidiary entities or permanent establishments outside of the jurisdiction in which they are established. These investment funds will be outside of the scope of the GloBE Rules. However, investment funds that are structured as corporate vehicles and take controlling stakes in portfolio companies may be required to file accounts that are consolidated with those companies. Managers and advisers to such funds should consider whether the Excluded Entities exemption, discussed below, may provide relief from the GloBE Rules.

Investment Funds as Excluded Entities

Even where an investment fund falls within the scope of the GloBE Rules in principle, a fund that is an ultimate parent entity may benefit from a specific exemption as an Excluded Entity if it falls within the GloBE Rules definition of an Investment Fund.

An Investment Fund is an entity that meets each of the following criteria:

(A) it is designed to pool assets (which may be financial and non-financial) from a number of investors (some of which are not connected);

(B) it invests in accordance with a defined investment policy;

(C) it allows investors to reduce transaction, research, and analytical costs, or to spread risk collectively;

(D) it is primarily designed to generate investment income or gains, or protection against a particular or general event or outcome;

(E) investors have a right to return from the assets of the fund or income earned on those assets, based on the contributions made by those investors;

(F) the entity or its management is subject to a regulatory regime in the jurisdiction in which it is established or managed (including appropriate anti-money laundering and investor protection regulation); and

(G) it is managed by investment fund management professionals on behalf of the investors.

We would expect that most genuine collective investment vehicles would fall within the definition of Investment Funds (and therefore would be Excluded Entities). However, there are a few criteria that may not be met by certain structures, namely the requirements for:

(A) the fund to be designed to pool assets from a number of investors (some of which are not connected). Funds of one will clearly not meet this criterion, and although members of a carried interest scheme should not be deemed to be connected by virtue of any shared employer, it is arguable that such schemes do not entail a genuine pooling of the carry members’ assets; and

(B) the fund or its management to be subject to a regulatory regime in the jurisdiction in which the fund is established or managed (including appropriate anti-money laundering and investor protection regulation). It is not clear from the GloBE Rules and the OECD’s related commentary what is meant by a regulatory regime in this context. It seems unlikely that this term would map to the asset management industry’s distinction between regulated and unregulated funds, but local implementing legislation will need to be considered for greater clarity in this area.

Key points

With the caveat that local implementations of the GloBE Rules have not yet been fleshed out, it is currently expected that most investment funds should not be adversely affected by Pillar Two. As an exception, captive funds (ie funds without a diverse investor base) are likely to be caught by the GloBE Rules. Managers of such funds (which typically include, for example, insurance groups) may wish to consider how to restructure their investment vehicles to incorporate elements of diversified ownership.

Whether or not an investment fund falls within the GloBE Rules, managers of such funds should be mindful that there may be new reporting requirements in connection with Pillar Two. These reporting requirements will be set at a local level and are likely to vary from country to country. For example, it is unclear whether an investment fund that qualifies as an Excluded Entity would be required to report the fact that it qualifies as an Excluded Entity in annual filings to relevant tax authorities.