Over the past couple of years, economic substance has become a growing global issue.
The launch of the Organisation for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) and EU substance provisions, along with evolution in the global tax environment since the global financial crisis, means the global marketplace has changed and continues to change, as domiciles address the need to demonstrate economic substance.
There are concerns from managers on the potential impact and rising costs of meeting these requirements – but they are being superseded by the need to adapt.
Substance is proving primarily important to general partners and fund managers – after all, they are the entities that have to comply with the requirements. But compliance with economic substance is relevant to a jurisdiction’s reputation, and an investor would not necessarily want to be seen to be investing in a blacklisted jurisdiction. So it is becoming an increasingly important issue on both sides of a fund.
The role of the investor has escalated rapidly in recent times.
Their needs may not have changed, but Guernsey-based administrators said that investors were seeing economic substance as a way to stamp their authority on the choice of domicile. “Investors don’t want to be going to jurisdictions which may not give them the protection they need,” one said.
Managers accept that client demands are now becoming paramount. The investment world has moved from almost a “rinse and repeat” with fund launches before the global financial crisis, to one where there is enhanced manager knowledge about jurisdictions, and clients seeking more bespoke structures, including funds-of-one and private investment vehicles.
An increasingly-educated client base matched against a changing regulatory landscape have influenced LP demands, and products, such as Guernsey’s Private Investment Fund (PIF), available only to a limited number of investors and offering lighter touch regulation and quicker regulatory approvals, has emerged as a result.
While jurisdictions such as Guernsey have had only to make relatively minor legislative changes to accommodate economic substance compared to others, more recent amendments introduced locally have opened up a new fast-track migration and licensing regime for funds and managers, which was followed by new regulations allowing the migration of limited partnerships into the island. This has been met by increased interest in migration inquiries from a range of jurisdictions, driven, it appears, by demand for economic substance, or the opportunity to simplify structures and streamline activities for both tax and substance reasons.
Experience of service providers on the ground helped to reinforce the island’s economic substance position, and, indeed, the focus on that issue has definitely led to Guernsey’s investment funds industry being more competitively placed and strongly positioned in the global market.
A Guernsey lawyer said recently that quality of service providers and substance on the ground should be seen as a key factor in domicile choice.
Guernsey recently launched its first cannabinoid healthcare fund. The island was chosen from five jurisdictions to domicile the fund, and chose Guernsey, in part, because it was transparent and clear on the policy of cannabis regulation.
There is no doubt that they could not have launched the fund from any jurisdiction – it is a move which reflects well on Guernsey both in diversifying into an innovative asset class, and demonstrating the quality of service providers.
This mix of stability and innovation reflects what most managers would be seeking from a domicile.
From the operational perspective of the manager, the launch of a new product is always a high execution risk. The domicile needs to be able to assist in mitigating that risk – designing products which are innovative and meet demands for product or distribution channels – and all jurisdictions set out to do that.
But also critical is the manager being absolutely clear on what they want the fund to achieve and their investment strategy.
There are advisers and experts who can guide them through that process to make sure they find the right domicile, in terms of experience, stability, location and the right regulatory regime, but having that clear picture of what they want the fund to do is critical.
