The master/feeder structure is seen on an increasingly common basis and it continues to play a key role in the global hedge fund industry. This is because it allows hedge fund managers and sponsors to structure or restructure a new or existing fund in order to source investors from the US and then access European, Asian and US capital markets.

The master/feeder structure involves two feeder fund entities being established – the 'offshore fund' for non-US investors and US tax-exempt investors, and the 'onshore fund' for US taxable investors. Each feeder invests all of its assets into a third entity – the master fund. Capital contributions or subscriptions received by the feeder funds are passed down to the master fund in return for interests in the master fund. All fund trading is done at the master fund level.

A master/feeder fund is an offshore investment fund that is able to accept investment from all three categories of investor in a manner that is tax efficient for all. It also eradicates some of the inefficiencies inherent in operating the alternative, separate funds. This is because there is only one consolidated portfolio to manage, the number of transactions is reduced and reconciliations are simplified, operational costs are kept low and the chances of the fund's assets under management reaching a critical mass are enhanced, thus enabling the fund to obtain and maintain credit lines.

In a master/feeder structure, the key determining factor in what kind of entity is used for the two feeder funds and for the master fund is the need to ensure the tax treatment of one category of investor does not affect or prejudice the tax treatment of other categories of investor.

European and other non-US investors will wish to avoid coming directly within the US tax regulatory regime that is applicable to US taxable investors. US tax-exempt investors (such as individual retirement accounts, qualified pension and profit sharing trusts) will be concerned to avoid a charge to unrelated business taxable income (UBTI) that can arise where they hold an interest in a US limited partnership.

As a result, non-US and US tax-exempt investors will typically come into the fund through the offshore feeder fund, which is often established as an offshore corporation in a tax neutral jurisdiction such as the British Virgin Islands (BVI), thus blocking any potential for a liability to UBTI. Note that the offshore feeder could equally well be formed as a BVI limited partnership.

US taxable investors will want to avoid a potential charge to taxation that arises as a result of holding an investment in a passive foreign investment company (PFIC) – a non-US entity which engages in investment activity. The offshore feeder fund (whether it is a BVI company or limited partnership) will almost always meet the definition of a PFIC, and hence the requirement for a separate onshore feeder fund, typically a domestic limited partnership which makes certain tax elections on incorporation, for the US taxable investors.

For US investors not to be deemed to hold in investment in a PFIC, the master fund, which acts as an intermediary between the onshore and offshore feeders, must be treated as a partner-ship for US taxation purposes. It is usually incorporated as a BVI company to preserve the offshore nature of the fund, which is eligible to make a 'check the box' election and be treated as a partnership for US taxation purposes.

By far the majority of offshore master/ feeder structures established in the BVI use BVI companies as the offshore feeder and the master fund a domestic limited partnership, incorporated, say in Delaware, as the onshore feeder. This, however, creates a need for two sets of documentation to be prepared, which have to be identical in their effect, one drafted in partnership terms and the other in corporate terms. This can be avoided, if needed, by using BVI limited partnerships for the offshore feeder and the master. A BVI limited partnership is eligible to make a 'check the box' election and be treated as a corporation for US taxation purposes, and so may be used (with the election) as the offshore feeder and (without the election) as the offshore master. The fund documentation – the limited partnership agreements and the offering documents – will therefore be largely identical in all respects, greatly simplifying their preparation, making it easier to ensure that the terms of the onshore and the offshore offerings are identical in all respects and reducing the burden of maintaining the fund's records and accounts.

Management and performance fees are typically charged at the feeder-fund level, as this avoids difficulties and unfairness that arise where fees are charged at the master fund level, and it increases the flexibility to be able to add additional feeders with varying fee structures, or to vary the fee structure for within feeders.

The conversion of an existing fund into a master/feeder structure is generally straightforward, although it presents a few issues that require consideration. The existing fund will become one of the feeder funds, avoiding a necessity to move investors, and a second feeder and master are incorporated. Implementation will require the transfer of the portfolio assets of the existing fund down to the new master fund, in exchange for interests in the new master fund. In the case of an existing US partnership, the transfer of assets to a non-US entity will trigger a charge to an excise tax which may be avoided by using a US limited partnership as the master fund with its principal place of business being kept offshore. In addition, each entity will need to make the relevant tax elections for the purposes of US taxation.

Once a master/feeder fund has been implemented, the structure lends flexibility and versatility to a fund. Where the offshore and master funds are BVI companies, each may have the authority to issue any number of shares in any number of classes and series, thus enabling an umbrella or multistrategy fund to utilise the master/feeder approach and enabling the common series accounting methodology for the tracking and equal-isation of performance fees.

Additional feeders may be created and bolted on, either by creating additional classes of shares in the existing feeders (which requires only a resolution of directors), or by creating a new feeder fund company. This addition of a bespoke private label feeder fund for a particular investor with particular requirements and/or demands is simple and fast.

Extra protection may be afforded in an umbrella or multistrategy fund by incorporating and registering the master fund as a segregated portfolio company (SPC). This has been possible in the BVI since the enactment of the BVI Business Companies Act 2004. An SPC enjoys statutory ringfencing under BVI law of the assets and liabilities of one subfund from the assets and liabilities of other subfunds.

The offshore jurisdiction in which the offshore fund and the master fund are organised often depends on the countries in which investors reside and the type of entity the sponsor desires to form. The BVI represents an excellent choice, with a well-developed legal and regulatory system for organising and maintaining investment funds and a tax free environment in which the assets of the fund may be managed.

Patrick James is an associate in the investment funds and regulatory department at Harneys in the BVI.