Guest post: Are tax havens becoming irrelevant for emerging market funds?

Mauritius is a popular tax haven for PE/VC funds. Photo by Xavier Coiffic on Unsplash

Dave Richards is a managing partner at Capria, a global impact investment firm managing multiple funds. The opinions expressed here are his own and do not represent those of DealStreetAsia.

Data from EMPEA and Preqin shows that the majority of PE/VC funds investing in Africa and Asia are domiciled in island tax havens including Mauritius, Cayman Islands, and British Virgin Islands. Latin America funds have more mixed splits between domiciles but the majority still “offshore” to US and Canada vs. being based in the country where the funds are being invested.

Split of private equity funds (including buyout, growth and VC):

  • Africa: 55% domiciled in Mauritius
  • Asia: 43% domiciled in Cayman Islands; 14% Mauritius 
  • Latam: 33% domiciled in Ontario/Canada; 21% Delaware/USA; 9% Cayman Islands

Note: A tax haven is generally defined as a country or place with very low “effective” rates of taxation for foreigners. Historically, tax havens have also been associated with financial secrecy. The main argument funds make for selecting these domiciles is that they are “neutral” jurisdictions for investors from a variety of countries, and compared with most emerging market domiciles, have a solid reputation for investor protections.

Most funds are avoiding blacklisted tax havens such as the US Virgin Islands and Bahamas; however, other leading fund domiciles such as Cayman Islands and British Virgin Islands are complying with international standards of transparency (e.g. US’s FATCA) to ensure that they don’t lose their tax status and still remain attractive for investors.

Main driver of fund domicile is still tax efficiencies

The choice of fund domicile depends on a lot of factors including regulations in the country of jurisdiction for the fund, tax treaties for both countries where investments are being made and countries of the fund’s investors (“limited partners” or “LPs”), ease of setting up operations, quality of local professional service providers, cost of maintaining fund entities and doing business, and reliability of the legal system.

The current preference for tax havens is based on operating the fund vehicle as a pass-through vehicle in a tax-efficient jurisdiction to minimize the leakage of cash flows between the fund, the LPs, and the underlying portfolio companies.

Investor profile is becoming an increasingly important consideration given AIFMD in Europe and preferences of institutional investors

For funds which are targeting EU-based investors, the Alternative Investment Fund Managers Directive (“AIFMD”) is heavily impacting the fund domicile choice as one of the key provisions in AIFM restricts the marketability of funds formed in “third countries” to investors based in the European Union.

From a fund manager setting up a new fund to invest in West Africa: “We expect a majority of our investors to be from the EU or to be African investors who have experience investing in EU structures. Hence, it makes sense for us to domicile our fund in an EU country (e.g. Luxembourg) even though it has relatively higher operating costs.”

There is also a growing preference from institutional investors, especially development finance institutions (“DFIs”), against investing in traditional tax havens due to the public scrutiny and pressure they face. DFIs have justified the use of tax haven countries to make up for the legal and regulatory shortcomings in their countries of investment. However, they face pressures to avoid using offshore centers due to issues of transparency and providing reasonable tax revenues to developing countries. We see this in practice, when 63% of DFIs report that a fund domicile has prevented commitments in Africa (EMPEA Africa Fund Domicile Survey, 2015).

My conversation with a major government-backed institutional investor during due diligence for investing in one of our funds: “Our government now requires us to confirm that your primary reason for selecting the fund domicile was not to minimize paying taxes. It is ok if there is another primary reason.” (In legal circles, this is referred to as ‘leading the witness’).

Shift from traditional tax havens to other low-tax jurisdictions

There are many factors that are driving fund managers away from traditional tax havens. Public scandals, such as the Panama Papers leak, and an international push for transparency and sharing of information across jurisdictions to report on the identities of investors for tax purposes, has led investors to consider alternatives to the popular island tax havens.

This has led to a growing popularity of domiciling funds in countries such as Ireland, the Netherlands, Singapore, Delaware/USA, and Ontario/Canada. Governments in Singapore and Dubai are taking a proactive role in attracting venture capital funds to set up there. For example, in Singapore, the Monetary Authority of Singapore announced a simplified regulatory regime for VC fund managers and Dubai’s DIFC has an ambitious 2024 strategy to become a leading international financial hub in the Middle East, Africa and South Asia region.

Further, the presence of advantageous double taxation treaties in Canada and the Netherlands make them a preferred choice for many investors. Ontario, Canada is a popular fund domicile for many Latin America funds also for this reason. Finally, statutes such as FATCA in the USA and other local tax laws which require funds domiciled offshore to report identities of investors to the local authorities, have discouraged setup of offshore entities due to higher administration costs and severe penalties if tax avoidance is detected.

Country-specific initiatives seen to encourage more domestic fund domiciles

Some emerging market countries have taken a strong stance against tax havens. For instance, EMPEA analysis shows that, until recently, it was advantageous for Indian funds to be domiciled in Mauritius due to the India-Mauritius tax treaty which provided exemptions from the Indian capital gains tax. However, since 2017, the tax treaty no longer provides for such an exemption which has encouraged more India funds to be set up in India itself or alternative jurisdictions such as Delaware or Singapore.

Similarly, the Brazil government took a strong stance by including Ireland in its list of blacklist tax havens and only recently removed Singapore, Costa Rica and Madeira from this list in an attempt to encourage funds to domicile locally. Brazil also provides full tax exemption for foreign investors in local PE/VC funds (limited to 40% of the fund). Domestic tax regulations in Turkey encourage PE/VC funds to domicile in Turkey as there is no withholding tax or corporate tax on income and capital gains as long as 50% of their portfolio values are invested in Turkish companies.

Growth of local investors in emerging markets

There has also been a growing interest from local pension funds, institutional investors and large asset managers in impact investing in emerging markets. Often these investors are either required to invest in locally domiciled funds or have a preference to do so. For example, in Nigeria and Mexico, pension fund administrators have restrictions to invest only in locally-domiciled funds. This has led to more PE/VC funds being set-up locally to attract investments from the growing pension fund sector in emerging markets.

Global opinion is moving away from traditional tax havens; decision between local-domiciled vs. low-tax jurisdictions still unclear

The global preference for emerging market fund domiciles is changing as investor profiles and preferences, and local and global regulations evolve. While island tax havens currently remain the popular domicile choice for emerging market funds, it is to be seen if domestic country preferences will win over these tax havens and other low-tax jurisdictions.