When transparency is not such a good thing - funds and the limited partnership issue

By Anuj Kagalwala, Partner, and Tan Hui Cheng, Senior Manager, PricewaterhouseCoopers Services LLP (Singapore)

This article was contributed and first published in The Business Times on 13 January 2009.

2008 proved to be a tumultuous year for the fund management industry. While this may have taken some of the attention away from the tax incentives that Singapore has to offer for the time being, this should not stop the Singapore government from continuing to improve the tax incentive schemes to ensure that Singapore continues to be an attractive location in Asia for fund managers. The upcoming Budget will be a timely opportunity for the government to consider fine-tuning the current rules to make Singapore stand out against its competitors, as we ride out the global recession.

Revisiting the new rules

In 2007, the Singapore government announced the replacement of the infamous “80:20 rule” after receiving feedback from the fund management industry. The Monetary Authority of Singapore released details of the much awaited new rules replacing the 80:20 rule on 31 August 2007. The main features of the new rules are as follows:

Foreign funds will now have to be “qualifying funds” to come within the tax exemption scheme. To be a qualifying fund, one of the conditions is that it must be a company or a trust that is not 100 percent beneficially owned by Singapore investors.
A second level test in respect of the investors in the funds was introduced – investors are to be segregated into “qualifying investors” and “non-qualifying investors”. Non-qualifying investors will be subject to a “tax” referred to as a “financial amount”. Stripping the definition down to its basic elements, the investors that are likely to fall within the non-qualifying investors category seem to be Singapore investors (other than individuals) who own substantial stakes in the funds (generally more than 30 percent).

What the rules mean basically is that only non-qualifying investors pay tax, rather than, under the old 80:20 rule, the whole fund. On the whole, the new rules should also help alleviate some of the compliance issues and uncertainties previously faced by fund managers in applying the 80:20 rule. Nonetheless, as with all new tax rules, there are teething problems that have to be sorted out for smoother implementation. The authorities have to their credit clarified various aspects of the new rules. However, some problems have yet to be addressed satisfactorily.

Catering to funds in the form of limited partnerships

One major issue with the new rules, as was the case with the old 80:20 rule, is that they do not cater for funds set up in the form of limited partnerships (LPs). Such vehicles are commonly used for funds targeted at investors from the United States, the United Kingdom and Japan, amongst others. Very often, fund management groups from overseas already have fund structures involving the use of an LP. It is difficult to restructure these existing funds into a corporate or a trust structure just so that they can set up a Singapore office. This is for many reasons including investor preference to invest into funds set up as an LP and costs associated with restructuring. Often, after conducting a cost-benefit analysis, these fund management groups decide to either set up an office elsewhere in Asia or limit their level of activities in Singapore to avoid triggering Singapore tax issues for their funds. While the former is clearly not good for Singapore, the latter is not good either since it means fewer senior personnel in Singapore. It is surprising that the tax exemption rules for foreign funds have not been amended for LP vehicles given their widespread use in the fund management industry, and the recent introduction of LP legislation in Singapore.

Concern with look through of LP funds

What then is the problem of using an LP as a fund vehicle from a Singapore tax perspective? LPs, like general partnerships, are treated as transparent for Singapore tax purposes. While not explicitly stated in the new rules, the same treatment will apply for the purpose of determining whether a fund is a qualifying fund or whether the investors are non-qualifying investors. This may not sound like an insurmountable problem at first, but once you attempt to apply the new rules to an LP fund, the practical difficulties become quickly apparent.

To illustrate the complexities, we will briefly take you through the steps of applying the new rules to an LP fund. The first step is to apply the qualifying fund test. Because an LP is treated as transparent for Singapore tax purposes, the qualifying fund test is to be applied at the level of the partners in the LP fund. In other words, the fund does not exist, and each investor thus becomes a fund in his right. This brings about a number of issues, including the following:

Some of the limited partners may not meet the definition of a qualifying fund, for example, companies resident in Singapore that own a small percentage of the LP fund and non-Singapore companies with Singapore operations. Had the qualifying fund definition been applied at the LP fund level, these investors may not have been exposed to Singapore tax on their investment in the foreign fund. It also does not appear to be the policy intention to impose Singapore tax on these investors.
Assuming the fund manager has gone through the trouble of filtering out those limited partners who are not qualifying funds, the fund manager would have to then attribute a portion of the net income of the LP fund to each limited partner that is not a qualifying fund. This can be cumbersome administratively and again takes resources away from the core functions of the fund manager.

Assuming that the fund manager is able to overcome these difficulties, the next step is for the fund manager to apply the qualifying investor test. However, this test is to be applied to the shareholders of the investors in the LP fund. Will the fund manager be brave enough to ask for information on the investor’s shareholding to the extent required under the qualifying investor definition? It may be unrealistic to expect investors to divulge this information readily. Furthermore, the qualifying investor test was never designed to be applied to persons other than the actual investors in funds. This look through treatment for LPs only moves all tests a layer up causing some needless complications.

You do not have to change the old with the new

The next question to ask is why the authorities have not looked into amending the rules? Perhaps the concern is that such a change will erode the existing government policy of treating all forms of partnerships as tax-transparent in Singapore.

This does not have to be the case. The over-arching tax policy of treating partnerships as tax transparent can remain, even if the rules are changed for foreign funds to cater for LP funds. All this requires is a tweaking of the rules for the qualifying fund definition to be applied at the LP fund level and the qualifying investor definition to the limited partners. This does not mean levying tax on the LP fund as a taxable entity. If an LP fund cannot meet the definition of a qualifying fund, the normal Singapore tax treatment of partnerships will apply, i.e. tax will be levied on all the partners accordingly.

In fact, with many countries introducing different forms of entities, the authorities should perhaps also consider amending the rules to cater for legal forms other than companies, trusts and partnerships (and variations of it).

Conclusion

The new rules certainly signal the Singapore government’s readiness to respond to the needs of the fund management industry in providing a flexible and conducive environment for fund managers to operate in. One further aspect that the Singapore government can look into enhancing is fine-tuning the rules to cater for different legal entity forms, including limited partnerships.

This move will help Singapore to continue to position itself as a location of choice for fund managers looking to set up or to expand operations in Asia, and provide the impetus for growth of Singapore as a fund management centre as the Asian region rides out the recession.