In its report titled: “Fund of funds tax considerations: Managing investor and regulatory demands”, PwC summarizes the issues discussed at its webcast by a set of panelist including asset managers, tax and technology specialists.
Fund of Funds: Competing demands
According to the PwC report, preparation of Schedule K-1s is more burdensome and increasingly time consuming thanks to enhanced demand for information reporting and transparency. However, investors want Schedule K-1 information sooner. Thus asset managers have to confront these competing demands.
To meet these competing demands, many asset managers have started using estimated information to prepare and release their Schedule K-1s more quickly. The PwC panel at the webcast discussed some of the tax consequences arising out of using such estimates rather than final information to prepare Schedule K-1s.
The PwC report highlights that even best estimates won’t include all the information. For instance, estimates will usually include basic information on income and loss, without considering the character of that income or loss. The report highlights that several factors are required to be kept in mind before deciding to use estimates for federal and state and local taxes. Citing an example for federal tax consideration, the report points out that even when the estimate is immaterial, the underlying footnotes and any disclosures should be considered.
As regards state tax considerations, state and local laws are more complex as the asset managers have to interact with 50 separate jurisdictions.
The PwC report notes the panel’s agreement that the IRS will be receptive to the use of estimates as long as documented methodology is followed.
Fund of Funds: New tax disclosures
Touching upon some of the new tax disclosures, the PwC report highlights that in a Fund of Funds context, the Net Investment Income (NII) rule has enhanced the amount of information that needs to be disclosed to investors, besides all the other disclosures already being made.
The report notes funds should expect to receive footnote disclosure relating to the G Election, which is a conformity election to treat PFIC income for regular tax in the same way as for NII tax. The G election available for investors is confusing, especially within the context of a FoF, which may invest in some partnerships that have made G elections and others that have not. The following pool highlights only 7.2% of participants say they plan to make the election at the FoF level:
Touching upon Section 1298(f) PFIC reporting, the PwC report highlights that thanks to issuance of the temporary regulations and the expansion of Form 8621 filing requirements, U.S. funds are required to report any direct interest or indirect interest that is held through a foreign entity. The following pool results depict the increase in the number of Form 8621 filings:
Fund of Funds: Tax waterfall computation
The PwC report also captures the distinction made by the panel between cash carry, book carry, and tax carry and how those differences relate to Fund of Funds. The report notes it’s extremely important that every fund track a separate tax waterfall computation at a minimum at every year end:
The PwC report concludes that to obviate a last-minute crunch, funds can start doing a few things while they are waiting for the rest of their Schedule K-1s to come in. For instance, they can start getting consent where G elections will be made for NII purposes. Towards achieving this objective, the PwC report suggests the funds can leverage technology to keep pace with its double-digit growth. Thus by focusing on technology from a scalability perspective, the funds can stay ahead of enhanced regulatory and investor reporting demands.
The full report can be found here fund-of-funds-tax-considerations-pwc (1)