At the Investment Company Institute (ICI) 2023 Tax and Accounting Conference held recently in San Antonio, regulatory readiness, the swift pace of the regulatory agenda and exploring investment alternatives were key focal points of the event.
Panel after panel touched on regulatory change and the impactful modifications necessary for compliance. The proposed amendments around money market reform, swing pricing for open-end funds, private fund reporting modifications, the proposed safekeeping and custody framework, and conflict of interest and covered technology together have industry participants prioritizing where they will focus resources and strategizing their plan of attack.
It seems many in the industry have already identified staffing needs and much required system modifications to ensure the mountain of looming regulation can be implemented not only effectively, but efficiently. Others found the conference to be an awakening regarding the tasks at hand and their impact.
Some regulatory topics, such as Rule 2a-5, have already been implemented and the conversation turned to key success stories and lessons learned in the year since implementation. Others, such as the proposed safekeeping and custody framework, focused on the significant impact, if adopted as proposed, the increased scope would have on investment advisers and auditing firms.
Two sessions our team found to be particularly impactful covered complex accounting and reporting considerations and tax issues for business development companies (BDCs), private credit and other alternative type funds.
Complex Accounting and Reporting for Alternative Asset Classes
The panel on complex accounting and reporting focused on many differences in alternative asset classes — such as private credit, private equity and real estate — typically found in BDC and interval/tender offer fund structures.
Entrants from the private fund space may not be prepared for the regulatory challenges of the 1940 Act arena, from the complexity of the affiliate rules to other more straightforward compliance requirements. While historical ’40 Act managers are more ready for the regulatory restrictions, they also may experience challenges. Valuation, structuring complexity requiring significant consolidation analysis, and tax issues are just a few important considerations.
Challenges also often arise when developing and supporting a daily valuation with asset classes that historically do not lend themselves to such valuations. While management’s general familiarity with the valuation process is a good start, the more frequent timing, more rigid policies required and the audit pains contemplated due to being SEC registrants can be overwhelming. This complexity left many in the audience contemplating if they had access to the right talent.
In the end, it will be important to have the necessary experts and the SEC involved early. The runway to market is typically much longer in this space, requiring more time up front to be prepared in the end.
Tax Issues for BDCs, Private Credit and Other Alternative Type Funds
One of the ICI tax panels also tackled the area of alternative investments. As the demand for alternative investments — such as private credit, private equity, hedge fund of funds, real estate and digital assets rises, especially in the regulated investment company (RIC) space — increases, it’s important to minimize tax risks before it is too late. The conference highlighted important action items to consider in the initial stages of developing an alternative investment strategy:
- Contact your tax adviser immediately to proactively address any tax issues prevalent to an alternative investment strategy.
- Identify target investors and the types of income they will receive. This will help highlight key tax considerations that could sway the ultimate decision on the tax wrapper selected. For example, knowing whether there will be international investors or tax-exempt investors can identify whether effectively connected income (ECI) or unrelated business taxable income (UBTI) are concerns.
- Once the investor base and income source are determined, the final question can be asked: What tax structure works best?
The panel stressed the importance of identifying the right tax structure; not all are equal in accommodating income from alternative investments. The structures most common in the industry fall into three buckets:
- Closed-end funds
- Closed-end interval funds
- Hedge funds
- Offshore corporations
- Private equity funds
- Disregarded Entities
- Separately managed accounts (SMAs)
- Grantor trusts
For example, certain income may be more suitable for investors in an onshore entity than an offshore entity, making the upfront decision on tax structure of utmost importance. Reporting for tax structures may also drive the decision on entity type. For example, RICs report their income on Forms 1099 versus pass-through entities, which issue schedules K-1. Understanding whether the target audience prefers simplicity of tax reporting over less restriction on investment options can have considerable influence.
The RIC wrapper is attractive for alternative investment strategies, and as a result it is important to take a deeper look into the action items above and how to approach them from a RIC lens. A RIC must meet an annual gross income test and a quarterly asset diversification test to enjoy the benefits of single tier taxation and a semi conduit pass-through of the character of income to shareholders. Due to the uptick in RICs with alternative strategies, ask your tax adviser some of the tailored questions below to help avoid unintended consequences once the decision to use a RIC wrapper is made:
- What investments could generate nonqualified income?
- Are the assets considered nonqualified assets?
- Will the information be available to determine qualified versus nonqualified income on an annual basis?
- Will the information be available on a quarterly basis to determine the RIC meets the asset tests?
- Is the value of the assets readily ascertainable to determine whether there are asset diversification test concerns or gross income test concerns based on market fluctuations?
- What options are there to shield nonqualified assets and income, and potentially increase exposure to qualifying assets, and how will these options impact the RIC’s shareholders?
- What are the consequences of failing the gross income test or the asset diversification test?
With investment strategies growing more and more complex, it is important to focus on selecting the correct structure for the ultimate user, the shareholder. Whether using a RIC wrapper or hedge fund, having a conversation about the tax consequences of alternative and illiquid investments upfront with a tax adviser could make or break the future success of a business.
From regulatory change to alternative investments, and the complex accounting and tax concerns that come with them, the insights shared during the ICI conference helped bring some clarity to investment companies and their advisers during a time of significant regulatory change.
Contact Lori Novak at email@example.com, Lisa Downing at firstname.lastname@example.org, Ryan McKenna at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.