Taxes within a fund: deemed distributions or fund expenses?

21 November 2023

An interesting question to consider when drafting or reviewing a limited partnership agreement (LPA) is whether taxes arising within the fund structure should be treated as expenses of the fund or whether they should be deemed to be distributed to investors in their proportionate shares in the fund partnership.

Why does it matter?

If amounts are treated as fund expenses, then they are deducted from income in calculating the fund’s profits and therefore are deducted before the profits are run through the waterfall. If amounts are instead deemed to be distributed, they will be run through the waterfall and treated as though they have been distributed to investors. This means the hurdle is met more quickly and the carry is accelerated.

In practice, the basic position that GPs often take is that taxes within the fund structure are treated as an expense of the fund, other than:

  • withholding taxes in respect of which investors may be able to claim a credit; and
  • other taxes attributable to the status or actions of a particular investor.

Withholding tax

Most funds will be arranged such that no withholding tax is imposed at the level of either the fund itself or at the level of any investment holding company.

However, if a withholding tax is imposed in respect of which an investor may potentially be able to claim a credit, then the investor will effectively have received the financial benefit of that amount. It would therefore be reasonable for the amount withheld to be run through the waterfall (i.e. the tax withheld is deemed distributed to the investor). This will generally be the case for any withholding tax on payments by the fund partnership to investors, and payments from a fund investment holding company to the fund partnership, and the LPA will typically provide for this (even though in practice it should not need to be relied on).

The LPA will typically also deem to be distributed to an investor any withholding or other taxes arising within the fund structure which are considered to be specifically attributable to that investor. For example, if FATCA withholding were to apply as a result of an investor’s failure to provide the relevant information to the GP, then the expectation of the GP, and other investors and limited partners (LPs), would be that the “recalcitrant” investor should bear the cost of their own failure. This approach is generally accepted market practice, and many LPs will actively want this provision to be included in the LPA in order to ensure that they are not bearing the economic cost of tax expenses caused by another investor.  

What happens in practice?

One of the points which we see come up in practice is to what extent a withholding or other tax should be treated as attributable to a particular investor for these purposes. Clearly, any FATCA withholding as described in the above example should be attributed to the recalcitrant investor in question as it is directly caused by their failure to act. But what if an investor’s status causes a hybrids issue for example? Is it fair for the cost of being denied a tax deduction to be attributed solely to that investor? You might say that the fund will have known the status of its investors when making the investment, so it should have structured that investment in a way that mitigated or resolved the hybrids issue in question. On the other hand, the investors who have not caused the issue will be reluctant to bear the economic cost of the deduction being denied. 

In practice, a GP’s preference will typically be to maintain some flexibility. For example, it should resist agreeing with investors that it will (as opposed to may) allocate the full amount of any such taxes attributable to an investor to that investor, because there may be situations when this is not possible (for example, if the tax due exceeds the amount of distributions to be made to that investor). By retaining discretion in this area, the GP can decide whether such tax expenses are allocated to an LP in situations where it considers it to be appropriate.  

If you would like to discuss any of the points raised in this article, please get in touch.