Fund formation: Singapore asserts its onshore qualities

It comes as no surprise that the traditional approaches - such as routing funds from a Cayman-based private equity vehicle through entities in Luxembourg and the Netherlands - have been abandoned. For years, buyout firms operated under the assumption that their capital gains couldn't be touched. Profits could leave the country under the protection of Australia's double tax agreement (DTA) with the Netherlands and then be shipped out of Europe thanks to Luxembourg's low withholding taxes.

In 2009, the Australian Tax Office (ATO) told TPG that it wanted a large chunk of the $1.46 billion profit accrued from clothing chain Myer's IPO was due in taxes. The ATO's reasoning was that buyout firms' profits counted as business income and were therefore subject to local tax. It subsequently said it would look through all entities thought to exist solely for the purposes of leveraging DTA benefits. Further clarification of these rules is pending.

"As a starting position it's generally better to be routing your investments through countries that have exchange of information agreements with Australia than those that don't," says Mark McNamara, a partner in Baker & McKenzie's Sydney office. "Singapore also has a favorable DTA with Australia."

When professional services firms provide offshore tax advice to private equity clients, they normally present several options - using different jurisdictions - for consideration. McNamara claims to have recently seen Singapore included in the mix for the first time. Other industry participants note that the jurisdiction has been used by some pan-Asian buyout funds, but not widely. Having previously barely appeared on the radar, Singapore is now bleeping loudly.

Australia isn't an isolated case. Singapore is growing in popularity among private equity firms targeting India as they look for alternatives to Mauritius-based structures. Change in each country is driven by different forces as tax authorities seek ways to gather more revenue. But there is a single, simple reason why private equity firms are turning to Singapore: substance.

Investors globally want onshore security with offshore perks - jurisdictions that are not tax havens yet offer favorable tax policies. At the same time, to qualify for DTA benefits, meaningful business activity must be conducted in the relevant jurisdiction. It leads investors to established, diverse financial centers that don't exist purely for the sake of offshore structures.

"It's easy to build substance in Singapore," says Ho. "It's a financial center, it has tax incentives, people actually live and work here, the regulators are progressive."

Uncertainty over Mauritius

Ho claims to have seen a flurry of activity among India-focused funds that completely overwhelms discussions about a change in approach regarding Australia. This is unsurprising. Mauritius' role in Indian foreign direct investment (FDI) - not just private equity - is enormous and questions have been asked about its sustainability for several years.

In the 2004-2005 fiscal year, Indian FDI amounted to $2.4 billion and 30% of it came from Mauritius, according to the Indian Ministry of Commerce and Industry. Three years on, FDI reached $24.5 billion and the Mauritius share was 45%, but it has dwindled since, decreasing to 35% in 2010-2011. At the same time, the portion of funds emanating from Singapore has grown from 3% in 2006-2007 to 8% in 2010-2011. It averages at about 10% over the last four years.

Under the countries' DTA, a Mauritius entity doesn't have to pay tax on capital gains stemmed from investments in India. Furthermore, the Indian Supreme Court ruled that any company in possession of a Mauritius tax residency certificate qualifies for treaty coverage.

Singapore is working from a low base, but its emergence more or less coincides with Indian tax authorities targeting the Mauritius DTA, principally to crack down on round-trip investments. "The regulators aren't concerned about our industry but wealthy Indians who have money offshore and who are bringing it back onshore through these tax treaties," Mukund Krishnaswami, a partner at Lighthouse Funds, said at AVCJ's Singapore conference in July. "However, PE will be in the line of fire."

India and Mauritius set up a joint working group to review the DTA in 2006. Despite several rounds of talks, little if anything appears to have been resolved, although it has been reported that two measures are under consideration: better exchange of information on banking transactions, and detailed substance requirements for treaty benefits. More importantly, the Indian government has laid down proposals for a new direct tax code, which would come into effect in April 2012. It includes anti-avoidance provisions that would allow it to target structures deemed only to exist for the purpose of leveraging tax benefits.

Slow decline?

A simple solution is to create sufficient substance in Mauritius, but this is easier said than done. The country is perceived to lack strong transport connections, top-class schools, high-end shopping malls and restaurants - in short, all the trappings that cultivated fund managers want for themselves and their families.

"You could have senior level executives move to Mauritius but people are more comfortable moving to Singapore," says Bhavin Shan, executive director for tax at KPMG India. "That is the most significant drawback."

Although under pressure, Mauritius is not in its death throes. A collection of GPs, lawyers and accountants tell AVCJ that they or their clients are sticking with the jurisdiction. The reasons include cost, flexibility, confidentiality, precedent, convenience, culture, treaty access to other countries such as China, and doubts as to whether India's direct tax code will reach the statute books in its current form. As for the future of the DTA, Craig Fulton, head of the Mauritius office for Conyers, suggests that the benefits "would be watered down but they wouldn't be washed out."

Mauritius' share of Indian FDI, though falling, is still dominant, and a source tells AVCJ that of the 50 resident fund vehicles that the Monetary Authority of Singapore (MAS) approved between January and August, 10 were for India. This suggests steady rather than stellar progress.

"It seems to be the larger Indian PE managers who are moving," says Arnold Tan, a partner at Rajah & Tann in Singapore. "We get the sense that they are being asked by their institutional shareholders what their long-term plans are in terms of the coming India direct tax code."
Nevertheless, the pace of client enquiries - as well as follow-through business - is tipped to accelerate.

Clifford Chance's Ho says most first-time fund managers don't hesitate in picking Singapore over Mauritius because of the substance requirements. A growing number of established private equity firms, which have run several funds out of Mauritius, are coming to the same conclusion. Once the names of these established players get out, Ho expects private equity's herd mentality to kick in and others to follow suit.

To access Singapore's DTA benefits and avoid income tax at fund level, private equity firms must apply to the resident fund scheme. A fund is required to be managed and administered locally but with no beneficial ownership to local investors, and at least S$200,000 ($151,000) must be spent in Singapore each year, effectively to prove substance. An enhanced tier fund scheme was introduced on top of this, minus the restriction on local investor participation.

"The policy makers in Singapore are always conscious of balancing the need for strict regulation and maintaining the reputation of Singapore as a financial center," adds Danny Tan, a partner at Allen & Gledhill. "Regulations are enacted to make sure that those who deserve to be regulated are regulated, while allowing business to continue."

Imperfect structures

Though user-friendly, the Singapore system isn't perfect. First, the exemption from capital gains permitted under the Singapore-India DTA only comes into effect after a two-year holding period. For pure private equity players this shouldn't pose much of a problem, given that investments are typically held for at least three years. Hedge funds, however, would find the regulation inconvenient. So, too, would private equity players who seek quick turnarounds on PIPE deals - a popular strategy in India.

Second, there are concerns about the treatment of carried interest. In the West, the portion of a fund's profit that goes to the GP is seen as a capital gain. According to Rajah & Tann's Tan, Singapore has no definitive guidelines or rules on the treatment of carried interest. "In the absence of that, it is considered corporate income and is therefore taxable," he says.

One way around this is to restructure carried interest as fees. The corporate tax levied on carried interest is 17% but this can be reduced to 10% via the Financial Center Incentive (FCI) scheme. Paying the carried interest in the form of annual fees, typically 1.5-2% of assets under management, reduces the tax rate even further.

Dean Collins, a Singapore-based partner with O'Melveny & Myers, says that some GPs are adopting this approach but he doesn't recommend it. "What we have been doing is putting Cayman structures on top of Singapore structures so the carry comes out of Cayman vehicle, not Singapore vehicle," he says. Other accountants and lawyers note that the Singapore authorities are aware of this approach but haven't sought to eliminate it. The onus is on bringing in managers whose presence stimulates the domestic fund industry.

Third, Singapore introduced limited partnerships in order to broaden its appeal in the US and Europe but these structures aren't recognized as legal entities under the resident fund scheme, which predates the partnership structure by about two years. The enhanced tier fund scheme came into effect more recently and so limited partnerships qualify for treaty benefits if they take this route.

A slight drawback is the enhanced scheme's S$50 million minimum capital requirement. A private equity firm seeking to raise an S$100 million fund might want to do a first close at S$40 million but this wouldn't be sufficient for enhanced status.

Many fund managers attest that these imperfections are counterbalanced by regulatory certainty. One industry participant contrasts the situation with Hong Kong, where taxes are seldom paid on carried interest or management fees and funds take cautionary measures such as holding investment committee meetings in Macau in order to separate the decision-making process from the host jurisdiction.

"This is all done in the hope that the Hong Kong Inland Revenue will not drag them onshore, but there is no guarantee. Singapore appears to be offering a guarantee: If you pay a certain amount of tax up front and pay S$200,000 to local service providers we will not drag anything else onshore," the participant says, despite adding that Hong Kong is hardly struggling as a funds destination.

This certainty can also trump cost. Smaller private equity funds may find Singapore's requirements dauntingly high. Aside from the S$200,000 annual expenditure requirement to qualify for resident fund status, the jurisdiction has traditionally asked much of fund managers in terms of know-your-customer (KYC) and anti money laundering (AML). But if Australia-focused private equity firms are opting for Singapore structures, it could be argued that they have more faith in the MAS than the ATO.

As the Australian authorities began to clarify their position on tax treatments for buyouts, they indicated that limited liability partnerships (LLPs) would be viewed favorably. What this means is that the ATO would look through a Cayman-based LLP entity to the investors participating in it - and should these investors reside in countries with treaty coverage they can access the associated benefits. However, it is up to the GPs to prove that their LPs qualify for the tax breaks.

"Most are pretty reluctant to hand over that information to the ATO for various reasons," says John O'Connell, a senior associate at Freehills.

If a buyout firm is able to establish substance in Singapore, it can take advantage of the DTA with Australia and the resident status of its LPs doesn't come into question. This saves the firm from sifting through the investor manifest for those who don't qualify for treaty coverage and then breaking the bad news.

"The issue for the global funds is that they are not just raising funds from the US anymore," says Mark O'Reilly, an M&A partner at PricewaterhouseCoopers in Australia. "They are looking at Asia, the Middle East, Europe and South America as well. In this respect, it's useful to have Singapore in the fund structure."

O'Reilly's caveat is that Singapore makes sense provided it doesn't raise other regulatory complications. The implication is that few jurisdictions can match the Cayman Islands, which remains the formation entity of choice, in terms of well defined corporate laws that make it easy and comfortable for investors to do business.

Although opinion on Cayman is divided - some people say it is regarded with suspicion by regulators, others say it has cleaned up its act - most Singapore fund structures are set up as subsidiaries to Cayman vehicles.

"GPs are very wary about pure Singapore structures as LPs are not familiar with them," says Collins of O'Melveny & Myers. "A North American pension fund might never have invested in Indonesia before and once they get over that they find it's a Singapore structure they've never used before. It just creates an extra hurdle in the fundraising process."

Having said that, given Singapore's aggressive efforts to promote its funds capabilities and the gradual emergence of more LPs outside Europe and the US, few are willing to bet against the jurisdiction closing the gap with Cayman in the long term.

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• Topics
• Southeast Asia
• Regulation
• Financing
• Investments
• South Asia
• Australasia
• India
• Australia
• Singapore
• professional services
• Fund formation
• Fund administration
• TPG Capital
• Lighthouse Funds
• Mauritius
• Cayman
• Offshore