Republic of Ireland: Eire of safety?

With the opportunity for investors to set up a fund with regulatory protection and significant taxation benefits, establishing a presence in Ireland's fund industry is surely a safe bet. Mark White reports

Across the hedge fund industry, the most consistently forecast development is the introduction of regulation for hedge funds and their managers.

In the Irish environment, an investment fund may be established that offers regulatory protection to prospective investors. This can be achieved without requiring the fund to sacrifice its investment objectives and alternative strategies or its dynamic and flexible structure. There are also significant taxation benefits that are available to investors in an Irish-regulated fund.

The establishment of a regulated fund in a well-recognised jurisdiction, such as Ireland, offers considerable benefits to investors, particularly in current market conditions. Ireland offers prudent but practical regulation of both retail and sophisticated funds and this is considered to be one of the key reasons for the success of the funds industry in Ireland.

Many investors who wish to gain exposure to alternative asset classes but do not want to invest in lightly-regulated jurisdictions, such as Cayman or British Virgin Islands, can do so by investing in an Irish fund authorised by the Irish Financial Regulator.

Fund structure and service providers

An Irish fund may be established as one of a number of legal structures: an investment company; a unit trust; a common contractual fund; or an investment limited partnership. Irish funds have, to date, been most commonly established as either investment companies or unit trusts.

The primary service providers to an Irish fund are its investment manager, administrator and custodian.

The role of the custodian, which is primarily to hold the fund's assets in a segregated and secure manner, offers significant comfort to investors. The custodian will be directly liable to the unit holders for any loss suffered as a result of the custodian's negligence or for any unjustifiable failure to perform its obligations or its improper performance of them.

Retail and sophisticated funds - UCITS and non-UCITS

The most important factors in choosing a fund structure are likely to include the profile and location of target investors and the proposed investment policy of the fund. Each of these factors will be extremely important in deciding whether to structure an investment fund under either the undertakings for collective investment in transferable securities (UCITS) or the non-UCITS regime.

UCITS

The principal advantage of a UCITS fund is that, pursuant to the UCITS Directive, once a UCITS is authorised in one European Union (EU) member state, it can, through a 'passport regime', be sold in other EU member states without requiring further authorisations. Given the challenging economic climate, it is reasonable to assume that investors will be looking for a much greater focus on governance, with more emphasis on transparency and risk management - all features that the UCITS regime requires. UCITS have effectively become the global brand for retail investment funds around the world and Ireland has established a reputation as an ideal domicile for well-serviced and well-regulated UCITS.

Since the implementation of certain changes to the UCITS regime in 2003, a UCITS is now permitted to invest in a broader range of assets, including transferable securities, money market instruments, units of other funds, deposits and financial derivative instruments.

As a result, 130/30 funds that combine the investment potential of hedge funds with the perceived traditional strategy of long-only funds can be established as UCITS. In addition, UCITS funds now have the ability to gain exposure to assets such as commodities and hedge funds that cannot be invested in directly by the UCITS. Structured products are now also commonly established under the UCITS regime by virtue of a UCITS' ability to enter into a variety of derivatives for investment purposes.

Non-UCITS regime

By contrast, since non-UCITS are established pursuant to domestic Irish law, as opposed to EU law, they do not have an automatic 'passport' for sale in other EU member states. It follows, therefore, that the Irish Financial Regulator has more flexibility regarding the imposition or relaxation of conditions generally.

A qualifying investor fund (QIF), which is confined to sophisticated investors, is the key non-UCITS fund available in Ireland and has proved to be an attractive option for fund promoters, particularly hedge fund or private equity managers.

In order to invest in a QIF, an investor must subscribe a minimum of E250,000 (£228,000) (or equivalent) and is also required to meet certain net worth tests.

All investment and borrowing restrictions are automatically disapplied in the case of a QIF. Therefore, a QIF is permitted to:

• carry on short selling without restriction;
• employ leverage without restriction; and
• engage in a wide variety of derivative contracts, repo and stock-lending agreements.

In February 2007, the financial regulator issued new procedures that allow QIFs to be authorised in one day, provided certain conditions are met. This procedure constitutes a step-change for the Irish funds industry and offers an advantage over many other funds jurisdictions.

Taxation of an Irish fund

An Irish fund is exempt from all Irish tax. The fund benefits from what is known as 'the gross roll-up regime'. This effectively means that the income earned from the fund's investments, such as dividends, interest and rental income, is earned tax free and any gain made by the fund on the disposal of investment assets is also not liable to tax.

Furthermore, the issue, transfer or redemption of shares/units in an Irish fund is not liable to any Irish tax.

From an investor perspective, an exit tax regime applies to Irish funds. Under this regime, no withholding tax applies on payments to non-Irish resident investors once that investor has made a declaration to the Irish fund that it is non-Irish resident for tax purposes.

In summary, therefore, the investor benefits from investing in a tax-free regime but, unlike investing in a tax haven, the Irish fund benefits from being regarded as an onshore tax jurisdiction for OECD purposes.

As mentioned earlier, a QIF can enter into borrowing arrangements without restriction. Consequently, it will often have a significant amount of debt on its balance sheet. By virtue of the gross roll-up regime, gross proceeds from the disposal of an asset are available to the QIF for reinvestment. If one compares this to an ordinary company, where a portion of the disposal proceeds would normally be used to discharge any resultant capital gains tax liability, it becomes clear why QIFs are so attractive for highly leveraged investment strategies.

Whereas the regulatory and tax benefits of establishing an Irish fund are apparent, some consideration might also be given as to how an existing offshore fund might be managed more efficiently alongside, or through, a new Irish fund. For example, it may be possible to amalgamate the existing offshore fund with the new Irish fund in a tax-efficient manner, which would then allow the fund manager to manage a single pool of assets, thereby reducing the costs of operating two funds. The new merged fund would then benefit from the tax and regulatory advantages available to an Irish fund. Two options that might be considered in this regard are as follows:

• The offshore fund could transfer its assets to the Irish fund in exchange for units in the Irish fund. In this way, the existing offshore fund becomes a feeder fund into the Irish master fund. All assets are now held at the level of the Irish master fund so there is now only one pool of assets to manage. The investors in the offshore fund remain as unit holders in that fund.
• Since the investors in the offshore fund remain invested in that fund, there is no actual exchange or disposal of units by the investors and so the investors should avoid a taxable event.
• The second option would be an exchange of units in an offshore fund for units in an Irish fund either by way of a 'paper for paper' exchange or a 'share for undertaking' exchange. The result of the exchange would be that, once again, all the assets are held at the level of the Irish fund, resulting in one pool of assets to manage. However, in this case the investors would also transfer to the Irish fund, rather than remaining invested in the offshore fund. The offshore fund could then be wound up and direct ownership of its assets transferred to the Irish fund.

Many jurisdictions offer tax relief on 'paper for paper' transactions and so the investors should not be obliged to account for tax in respect of this exchange, as the investors would not be deemed to have realised their investment. However, this taxation treatment is dependent on the taxation reliefs available to the investors in their relevant tax jurisdiction of residence.

Mark White is a partner at McCann FitzGerald and head of the investment management group.