Tax Planning Methodologies Incentive Fee Deferral Planning

1. Tax Planning MethodologiesIncentive Fee Deferral Planning Anthony J. Artabane, Partner Gregory Culloo, Senior Manager PricewaterhouseCoopers LLP Institute for International Research Tax & Accounting Requirements for Private Investment Partnerships June 26-27, 2000 New York, NY

2. Presentation Outline • Factors to Consider in Decision Process • Fee vs Allocation • Fee Deferral Planning • Fund Compensation Structuring • Domestic and Offshore Fee Structures

3. Key Information Impacting Structure of Fund • Ownership Structure of Investment Manager/Sponsor • Individuals • Corporations • US or non-US • Portfolio Strategy and Investment Types • Investment level tax issues • Entity level tax issues • Investor level tax issues

4. Key Information Impacting Structure of Fund (con’t) • Target Investors and Distribution Channels • Target investors • Country of residence • Tax status (taxable vs tax exempt) • Type - individual, corporation, pension, FOF • Distribution Channel • Direct • Third Party • Private Banking • Broker/Dealer • Independent Fund Advisor

5. Typical Fee Structures • Domestic Performance Fee Structure • Incentive Fee • Incentive Allocation • Offshore Fund Unitized Performance Fee Structure • Pool level single class of shares • Multiple class of shares • Equalization

6. Compensation Options • Significant Tax Flexibility To The Advisor • Asset Based Compensation (e.g., 1%) • Fee • Incentive Based Compensation (e.g., 20%) • Allocation (mini-master structure) • Fee - Deferred or Current

7. Structural Options Allocation Fee Fund Advisor GP LP Fund M Mini-Master

8. Tax Planning Opportunities for Investment Advisors • Key Structural Choice • Character flow-through vs.... Deferral opportunity • Factors to Consider • Investment Strategy • High Turnover • Beneficial Income • Need For Cash

9. Tax Planning Opportunities for Investment Advisors • Fee Deferral Structure - advisor can defer the tax recognition of incentive compensation for a period of years • Deferred fee indexed to fund or other • Each new year’s fee - new election possibilities • Profit Allocation Structure - advisor can transform fee income (40% Tax) into an Allocation: (1) Beneficial Tax, (2) Unrealized Deferral, (3) 20% rate for LTCG

10. Tax Planning Opportunities for Investment Advisors Planning Point 1 - Structure of Advisory Entity • Deferral - cash basis advisors only • Accrual method - recognize income “as earned” • Partnership/LLC Advisor - No “Corporations” up the ownership chain • “Constructive Receipt” - WATCH OUT!

11. Tax Planning Opportunities for Investment Advisors Planning Point 1 - Structure of Advisory Entity • Structural Deferral Issues • Election to defer - Make before the year of deferral (e.g., elect by 12/31/00 for 2001 fee) • Remain an unsecured creditor of the fund - Not an equity investor • No legal set aside of money to fund deferred fee • The funds must be under substantial limitations or restrictions as to payment

12. Tax Planning Opportunities for Investment Advisors Planning Point 2 - Advisor Logistical Issues • Cash flow requirements • Flexibility to “poll” partners and tailor deferral. Not all or nothing • Deferral indexed to fund’s return or other

13. Tax Planning Opportunities for Investment Advisors Planning Point 2 - Structure of Fund • Deferral period should be specified • Industry standard - Maximum 10 • More aggressive - Multiple deferral periods (e.g., 3, 3, 4). • Always document the the election in writing and retain in advisor/fund’s files

14. Tax Planning Opportunities for Investment Advisors Planning Point 3 - Offshore Fund Tax Year Ends • Selecting a offshore fund year end • In pure fee/deferral structure - provides for smoothening of advisor’s income • In incentive allocation (mini-master) structure - provides additional deferral and smoothening of advisors income

15. Tax Planning Opportunities for Investment Advisors Planning Point 4 - Employee Compensation • With competition heating up for investment talent a deferred compensation plan provides an excellent vehicle for enhancing compensation • Establishment of sub accounts within the deferred fee structure for the payment of employee compensation represents an effective means of sharing the benefits of the tax deferral election

16. Tax Planning Opportunities for Investment Advisors Benefits of Fee Deferral • Using a fee deferral mechanism an advisor can avoid paying a current tax liability for a period of years • This facilitates pre-tax growth within the investment vehicle • Advisors can select to reinvest deferred fees in the fund or select an alternative investment benchmark for compounding purposes

17. Tax Planning Opportunities for Investment Advisors Disadvantages of Fee Deferral • Once deferred fee plan year’s term ends, income is taxed at ordinary rates • Income is inaccessible until a specified period of time • Limitations on owners of the advisor

18. Factors to Consider in Decision Process • Nature of Trading • Investment Performance Assumptions • State Domicile • Advisors Time Horizon • Ability to Manage The “fund” for GP tax efficiency

19. Fee Preferable Deferred Income Planning Opportunities Allocation Preferable Ordinary Income Realized STCG Realized LTCG * Applicable to Cash Basis Taxpayers Only

20. Compensation Arrangements G.P., management and affiliates generally are entitled to compensation for managing the business • Management or administration fee • Usually, an asset based fee • Incentive compensation • Profit allocations • Incentive fees

21. Compensation Arrangements • Fees • Treatment by GP or other service provider • Typically treated as ordinary income • Deferral potential only if eligible to use cash method of accounting (e.g., individuals, partnership, LLCs, etc.) • Constructive receipt issue

22. Compensation Arrangements Fees • Treatment by investors • Deduction by certain individual and other investors might be subject to limitations

23. Compensation Arrangements Profit Allocations • Treatment by GP or other service provider • Capital gain/loss character pass-through on all or some income • Foreign service provider generally can avoid U.S. (and some state and local) tax on capital gain portion of allocation • Deferral only on unrealized appreciation

24. Compensation Arrangements • Profit Allocations • Treatment by investors • Pro rata reduction of each investor’s share of fund income • Effect is substantially the same as expense allocated among partners • Avoids limitations on deductions

25. Partnership Accounting IssuesIncentive Fee Issues • Until recently there was a prohibition on SEC registered managers from accepting a performance fee until a full year of performance was generated • High water mark structures can significantly impact an advisors future financial participation through the requirement to “make-up” losses before future incentive compensation • Redeeming partners are assessed a pro rata share of performance fees upon redemption to prevent free riding of services

26. Typical Side-by-Side Structure U.S. Investors L.P.s U.S. Principal(s) Individuals U.S. Tax Exempt Entities Foreign Corporation U.S. General Partner(s) L.P. in past, now LLC U.S. Management Company Investment Manager S Corp. in past, now LLC Foreign Investor(s) 20% incentive allocation (%)? mgt. fee 2% mgt. fee & incentive fee (deferred) 2% mgt. fee Hedge Fund(s) (Investment Vehicle) L.P. in past, now LLC Managed Accounts (Investment Vehicle) Brokerage Account Foreign Corporation (Investment Vehicle) Organized in tax haven

27. Offshore Limited Partnership U.S. 40 Act/33 Act Registered Fund U.S. Registered State Business Trust Investors Investors Tax Sensitive Institutional/ HNWI PrivateLabel Offshore Cayman Fund U.S. 40 Act/33 Act Registered Fund U.S. 40 Act/33 Act Registered Fund Investors High Net Worth Private Banking Investors Investors U.S. Institutions U.S. Retail Offshore/OnshoreMaster Feeder 35