Within the asset management arena there are several strategies that managers employ to limit their global tax burden. In this article I will briefly describe several accepted methods managers can employ to legally reduce their U.S. tax costs including:

1. Affirmatively using the PFIC rules 2. Off-shore reinsurance companies3. Private placement life insurance4. Expatriation

AFFIRMATIVE USE OF PFIC RULESU.S. investors, including U.S taxable fund managers, in alternative investment funds, almost universally, invest into a U.S. master fund or a U.S. feeder fund. If such U.S. persons were to invest through the foreign feeder fund, they would be treated as holding an interest in a passive foreign investment company (a “PFIC”). PFIC investments are normally viewed as undesirable for a number of reasons, namely that capital gains from a foreign feeder fund do not flow through to the investor unless a special election is made (QEF, or Qualified Electing Fund, election). Without a QEF election, tax is deferred until distributions are received from the fund or the fund units are disposed. Then, all appreciation / distributions are taxed at the highest ordinary income rates and an “underpayment” interest charge is applied to the tax amount.

Nevertheless, in the asset management realm there is the possibility of using the PFIC rules in an affirmative posture. A U.S. fund manager can invest through the off-shore feeder and gain tax deferral for many years. When the manager eventually cashes out there will be tax at ordinary rates with interest as though the income had been earned ratably over the manager’s holding period. Moreover, using a PFIC allows the U.S. investor to avoid limitations on deductions (at both the federal and state level), interest expense, capital losses, wash sales and straddles. For funds that would otherwise produce long term capital gains on a regular basis this strategy may not be advisable but for all others it is worth considering.

OFF-SHORE REINSURANCE COMPANY Many large U.S. based fund managers have created off-shore reinsurance companies, converting ordinary income into long term capital gain in order to gain a tax rate advantage. In order to achieve this, the fund manager will work in tandem with a non-U.S. partner, typically a reinsurance company. The non-U.S. party owns a portion of the reinsurance company to ensure it is not treated as a controlled foreign corporation (a “CFC”) for U.S. tax purposes. The new reinsurance company then begins writing reinsurance policies and collecting premiums. The initial share capital of the company plus the insurance premiums collected are invested into the manager’s fund(s). The fact that the company takes on real insurance risk and operates a true reinsurance business means that the company will not constitute a PFIC and unlimited tax deferral is permitted.

U.S. investors are able to buy shares in the reinsurance company with the ultimate goal of taking the reinsurer public and providing investors liquidity in the market. Once publicly registered, the fund is open to retail investor money, not just qualified purchasers. The investors have no tax liabilities (absent any dividend distributions) until they dispose of their shares. When they finally do exit the investment they will have long-term capital gains (assuming a minimum one year holding period). The fund manager may also be an investor in the reinsurance company

PRIVATE PLACEMENT LIFE INSURANCE (“PPLI”)If you’ve ever been introduced to a variable life insurance policy then you can quickly understand Private Placement Life Insurance (PPLI). With variable life policies the insured pays a premium and part of the payment covers a standard death benefit amount while the remainder is invested. The policy offers myriad investment options - typically mutual funds. The invested amounts are able to grow tax deferred inside the insurance policy. PPLI works the same way except that the investment portion goes into selected private investments as opposed to publicly registered mutual funds. These investment options can range from hedge funds to real estate

Being an advisor to the alternative investment industry allows me to observe recurring issues

that leaders take into account, such as governmental regulation, investor preferences and

idiosyncratic asset problems. There is a constant issue which fund managers are always eager

to discuss, and that is the taxation of their own compensation.

TAX PLANNING FOR THE ALTERNATIVE FUND MANAGERBy Anthony J. Tuths, JD, LLM, Partner, atuths@withum.com

Continued on next page

to art. Moreover, the investment option can be one the insured creates —an insurance dedicated fund or “IDF.”

The tax benefits associated with PPLI are incomparable. The cash investment amount grows tax deferred and invested amounts can be borrowed at any time with proper arrangements. However, there is a fine line between legitimate PPLI and illegal tax evasion. Any manager investigating a PPLI policy should enlist the assistance of tax professional knowledgeable of the issues created by PPLI.

EXPATRIATIONExpatriation means to give up one’s citizenship. In tax terms expatriation comes in two flavors: full or partial. In full expatriation a fund manager would physically leave the U.S. and give up his or her U.S. passport. The expatriation would have to be disclosed to the U.S. government and there would be an exit tax imposed on the individual. The individual’s assets are treated as sold for fair market value on the day before the expatriation and taxed accordingly. The first $600,000 of gain (adjusted for inflation) is permitted to escape tax. Thereafter, the individual would be treated as a non-resident for both tax and immigration purposes.

Recent crackdowns, by the SEC, have put one question at the top of many fund managers’ and investors’ minds: When are ‘finders’ required to be registered as broker-dealers? Not an easy question and one that must be approached with caution and proper education.

According to the Securities Exchange Act of 1934 (“Exchange Act”), any person who effects securities transactions in the U.S is required to register as a broker dealer, unless that individual is an associated person of a registered broker dealer. That’s a pretty broad definition and one that has caused some serious headaches to friends of start-ups and private fund managers.

CONSIDER THE FOLLOWING SCENARIOYou are a partner in a law firm who works in the areas of trust and estate law. By nature of your practice your clients are primarily high net worth individuals (translation - accredited investors). A good “friend” of yours is starting a technology company based around some social media application and he is looking to raise some capital. He asks for your help and you agree to present this opportunity to some of your clients.

From a regulatory perspective, you’ve acted within the law to this point. (Ethically, the area is grey.) Where things start to get cloudy, and where the SEC, catching on, has taken up recent enforcement actions, is if you go beyond this point.

For example, suppose you provide your clients with some fact sheets surrounding the potential investment and tell them a little

Partial expatriation is a relatively new concept and involves the U.S. fund manager relocating to a U.S. territory like Puerto Rico. In this case, the individual is able to keep his or her U.S. passport and U.S. citizenship. However, the individual will take advantage of special U.S. tax rules for territories. In the case of Puerto Rico this can be compelling for an asset manager. The island’s government has special tax programs available for asset managers designed to encourage relocation. Under current law, managers relocating to Puerto Rico can achieve a zero percent capital gains tax rate and a 4% tax rate on management fees. Moreover, the manager will escape state tax.

CONCLUSIONThe fact that asset management is an advisory function which is highly mobile creates unique tax planning opportunities. These planning options are valuable and should be used, but never abused. Shortcuts, slipshod planning and questionable techniques have no place in tax planning. Always consult with an experienced and reputable tax planner before undertaking any tax reduction strategies.

about the company they may be investing in —The SEC will raise their eyebrows.

Now, let’s take it a step further and consider the same scenario but you get compensated for your investor referral. If you are compensated with a one-time flat fee, regardless of the company’s success: you are probably okay. However, taking compensation based on the amount raised or anything contingent on the success

of the transaction without a broker-dealer license can land you in some hot water. Recently the SEC has been quoted as saying that even a single instance of transaction-based compensation may be enough to find that an individual was “engaged in the business” of a broker activity, and subject to registration or penalities for failing to hold registration.

Finally, suppose this isn’t the only “friend” you have done this for. In fact every year a “friend” comes to you with a similar opportunity. Guess what? In industry terms, you are what is commonly referred to as a “finder:” someone who assists companies and private fund managers in raising capital. And you are required to be registered as a broker-dealer.

The penalties associated with acting as an unregistered broker-dealer can be severe. Thus, care must be taken when “helping” your “friends” find investors. Finder compensation agreements need to be properly structured and the scope of services needs to be clearly defined with activities limited to merely making introductions. In matters even remotely breaching the realm of federal securities regulations, it’s always best to consult with legal and compliance professionals before crossing that line.

HELPING A FRIEND OR ACTING AS AN UNREGISTERED BROKER-DEALER?By Brian Wallace, CPA, Partner, bwallace@withum.com

“Employing Finders and Solicitors: Proceed with Caution.” Morgan Lewis: Venture Capital & Private Equity Funds Deskbook Series, www.morganlewis.com. | “Finders” and the “Issuer’s Exemption:” The SEC Sheds New Light on an Old Subject. Latham&Watkins Client Alert, no. 1503 (7/24/2013):1-7

In June 2013, the Financial Standards Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) No. 2013-08, Financial Services – Investment Companies (Topic 946) Amendments to the Scope, Measurement and Disclosure Requirements. This amendment was the joint effort of the FASB and the International Accounting Standards Board (IASB). The IASB is responsible for International Financial Report Standards (IFRS). Together the FASB and the IASB have been working to merge their respective standards into one cohesive and uniform standard.

Under U.S Generally Accepted Accounting Principles (GAAP), investment companies typically measure their investments at fair value, including controlling financial interests in investees that are not investment companies. In contrast, IFRS did not include the concept of an investment company.

The main provisions of this amendment are as follows: to clarify the definition of an investment company, requirement of all investment companies to measure non-controlling ownership interests in other investment companies at fair value, and required additional disclosures for investment companies.

Under this new ASU 2013-08, an entity will be required to meet the following fundamental characteristics to be considered an investment company:

Obtain funds from one or more investors and provide the investor(s) with investment management services.

The entity commits to its investors that its business purpose and only substantive activities are investing for returns solely from capital appreciation, investment income or both.

The entity and its affiliates do not obtain, or have the objective of obtaining, returns or benefits from an investee or its affiliates that are not attributable to ownership interests or that are other than capital appreciation or investment income.

After consideration of the fundamental characteristics, the following typical characteristics may be considered:

• Multiple investments • Multiple investors • Investors that are not related to the parent entity or the

investment manager

• Ownership interests in the form of equity or partnership interests

• Fair value management of investments

The absence of one or more of the above typical characteristics does not necessarily preclude an entity from being an investment company.

Under this amendment, an entity that is regulated as an investment company under the Investment Company Act of 1940 does not need to undergo an assessment. An entity should make an initial determination of its status under this guidance. It will only need to reassess whether it meets or does not meet the guidance if there is a subsequent change in the purpose of the entity or if the entity is no longer regulated under the Investment Company Act of 1940.

This new update contains three examples to illustrate the assessment to determine whether an entity is an investment company. The first illustration shows that an entity was formed with multiple investors but due to its start-up nature, only held one investment during the first three years of its existence. It was determined that this entity was in fact an investment company, even though not all of the typical characteristics were present.

The second illustration emphasized that a technology fund that was formed with various investors making multiple investments was determined not to be an investment company because one of the investors held options to acquire investees of the fund and assets of the investees if the technology developed would benefit the investors business.

The third illustration was that of a master-feeder structure. This example showed that the master feeder and other feeder funds were determined to be investment companies.

Entities reading this guidance would benefit greatly from reviewing these examples.

The FASB decided not to address issues related to the applicability of Investment Company Accounting for real estate entities and the measurement of real estate investments at the current time.

“Financial Services-Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements.”

FASB Accounting Standards Codification, no. 2013-08 (2013): 1-72.

FASB ISSUES NEW GUIDANCE FOR INVESTMENT COMPANIES By Frank R. Boutillette - CPA/ABV, CGMA, Partner fboutillette@withum.com

FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDSBy Matt Pribila, CPA, Partner, mpribila@withum.com

In May 2011, the Financial Accounting Standards Board issued Accounting Standards Update 2011-04, outlining amendments to fair value measurement standards, as part of the ongoing convergence efforts between generally accepted accounting principles in the United States (U.S.GAAP) and International Financial Reporting Standards (IFRS). The update (effective for annual periods beginning after December 15, 2011), among other things, addresses:

Continued on next page

1411 Broadway, 9th FloorNew York, NY 10018

Return Service Requested

WithumSmith+Brown, PCCertified Public Accountants and Consultants

w i t h um . com

Finance That Matters is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Financial Services Group with your inquiries.

FAIR VALUE DISCLOSURE REQUIREMENTS FOR PRIVATE INVESTMENT FUNDS (CONTINUED)

• More detailed quantitative disclosure of the use of valuation techniques and their unobservable inputs

• Qualitative disclosure of the process the reporting entity uses to generate its valuations

DISCLOSURE OF UNOBSERVABLE INPUTS:Prior to the Update, reporting entities were required to list the techniques and inputs used in their valuations, but not specific quantitative information. The Update now requires quantitative input in an effort to bring standardization across all reporting entities.

Under the new standards, for each valuation technique used for Level 3 assets, the reporting entity is required to disclose in tabular format quantitative information for significant unobservable inputs, including the following:

• Type of security, including any meaningful classes of fair value measurements, for which the valuation technique is used

• Cumulative fair value estimate for the type of security• Significant unobservable inputs that are developed by the

reporting entity • High and low end, as well as the weighted average values

used for the unobservable inputs

The fund is not required to include quantitative unobservable inputs that are not developed internally when measuring fair value. The fund should include all significant inputs that are reasonably available. Examples of unobservable, quantitative inputs that are typically developed by the reporting entity, and are now required to be disclosed include, but are not limited to:

• Adjusted valuation multiples (e.g., revenue or EBITDA)• Adjustments to historical third-party transactions and

quotations• Discounts for lack of marketability• Loss severities Control premiums Time to expiry (value)• Non-controlling interest discounts• Cost of capital • Growth rates • Volatility

WHEN IMPLEMENTING THIS DISCLOSURE, THERE ARE SEVERAL THINGS TO CONSIDER:Unobservable inputs that are used in the valuation technique which are developed by others do not have to be disclosed to the extent that they are unadjusted. Observable inputs do not have to be disclosed. Meaning, certain level 3 valuations may not exclusively rely on unobservable inputs developed by the reporting entity, and the fair value balances in the disclosure may differ from those included in the schedule of investments.

Insignificant unobservable inputs to valuation do not need to be included. The determination of significance is the responsibility of the fund.

The list of unobservable inputs listed for each valuation technique may not be equally applicable to all of the investments in a respective category. For instance a market comparable model technique might use an EBITDA multiple for certain companies and use a revenue multiple for other companies, but may not necessarily use both inputs for all market comparable companies.