Background
Over the last decade the number of hedge fund managers has grown exponentially. As a result, the largest have become increasingly global, setting up overseas offices in search of new market opportunities which in turn have allowed them to trade in local time zones, research investments in local markets, utilise local knowledge and raise capital from local investors.As well as opening the door to potential planning opportunities, this has often brought hedge fund managers within the scope of local transfer pricing tax rules and subjected them to new tax risks and compliance obligations.
It is because hedge fund managers are often associated with high profits and an aggressive approach to tax management that some tax authorities have taken note of their multinational footprints. Tax authorities have focused on the application of the local transfer pricing rules in an attempt to enhance their local tax base, and at the very least, to ensure it is not reduced.
This combination of falling increasingly within local transfer pricing rules and being subject to closer tax authority scrutiny means that transfer pricing is a key issue for hedge fund managers with international operations. Furthermore, in some countries, such as the United Kingdom, transfer pricing is linked to other important tax issues, such as the tax status on the fund.
What is transfer pricing and why is it important?
Transfer pricing is commonly cited as the most important international tax issue facing multinational businesses and is one that many businesses struggle to effectively manage.Transfer pricing deals with the pricing of goods and services transferred between different parts of an organisation and generally relates to the pricing of transactions between different parts of an organisation based in different countries. Tax payers are interested in transfer pricing because they understand that by altering the prices that they charge or pay to related parties, they can potentially vary their profit profile in the countries in which they operate and therefore impact where and at what rate they pay their corporate taxes.
Because tax authorities understand the way in which transfer pricing can be used to manage tax rates, many countries have recently introduced transfer pricing legislation, enhanced existing provisions or revised the way in which existing rules have been implemented in order to discourage transfer pricing-related tax avoidance. At the heart of the international network of transfer pricing legislation is the Organisation for Economic Cooperation and Development (OECD). The OECD is the source of the arm's length principle, the central tenet of transfer pricing, which requires that parts of a multinational enterprise deal with each other as if they were completely unrelated. The OECD is also the source of 'Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations', which has been adopted by many tax authorities and is considered by many as the most authoritative publication on transfer pricing.
Like most developed countries, the most popular jurisdictions in which hedge fund managers base their offices all have transfer pricing legislation or anti-avoidance provisions that can be applied to transfer pricing. The United Kingdom, the United States and Japan, for example, all have specific transfer pricing legislation with specific transfer pricing-related penalties and documentation retention requirements. Hong Kong, Singapore and Switzerland meanwhile have anti-avoidance provisions that are not specifically aimed at transfer pricing but can be applied to restrict and penalise any perceived abuse.
The United Kingdom is a good example of the increasing importance of transfer pricing legislation. From 1999 onwards, the UK significantly widened the scope of its existing legislation by requiring that UK tax payers self assess the arm's length nature of their transfer prices at the time of submitting their tax return. Where tax returns were based on transfer prices that were subsequently found to have been submitted fraudulently or negligently, Her Majesty's Revenue and Customs (HMRC) has the power to apply penalties of up to 100 per cent of any underpaid tax. But it doesn't end there.
A key component of the UK Investment Manager Exemption (IME), which allows a UK investment manager to make investment decisions on behalf of an offshore fund without creating a UK tax nexus of that fund, requires that the manager pays tax on a customary fee for the service it provides to a fund.
In recent statements, HMRC has indicated that it will consider whether managers have passed the customary rate test by reference to the commentary of the OECD transfer pricing guidelines. Where a manager fails the customary rate test, typically because another group party has retained more than a fair share of the group's management and performance fee revenues, it is at least possible that the UK manager could create a taxable presence of the fund it manages - potentially subjecting part, or all, of the fund's profits to UK tax/penalties. This could cause a significant adverse tax liability for the investors in the fund.
As tax authorities have become more focused on transfer pricing in the financial sector, their specialist skills and experience in this field (and relevant sub-sectors such as hedge funds, banking and insurance) have also developed. Some now have specialist teams focusing on the financial services industry or its sub-sectors. In the United Kingdom, HMRC has a dedicated team of specialists focusing on the tax affairs of hedge fund managers. HMRC has been especially vigilant in assessing for incorrect self-assessment due to its perception of egregious transfer pricing arrangements that it feels exists in the financial services sector.
Despite growing scrutiny from the tax authorities, hedge fund managers are still able to make the most of transfer pricing to manage their effective tax rate. The key value drivers (or to borrow an OECD phrase, the key entrepreneurial risk taking (KERT) functions) are the activities of a small number of people performing core portfolio management or distribution functions (in addition to the capital that is put at risk by the fund). As these value drivers are so concentrated in a few personnel it is arguably easier to legitimately tax-optimise a hedge fund business than businesses in a lot of the other financial (and non-financial) sectors.
Many hedge funds have already done exactly this, by locating a significant portion of their overall functions in more tax-efficient locations such as the Cayman and Channel Islands, Switzerland or Hong Kong, while being more parsimonious with their presence in higher tax jurisdictions. Although the benefits are obvious, to be successful, arrangements of this type must be robustly evidenced and documented, and real value-driving functions, assets or risks, essentially real substance, must be located in more tax-efficient jurisdictions.
Key transfer pricing issues for hedge fund managers
The key transfer pricing issue for hedge fund managers is how to split the management and performance fees that they receive from the funds that they manage between their offices. In many cases, this first involves splitting management and performance fees between the different functions that a hedge fund manager performs and then splitting those fees between the different locations. Consider two examples:- A UK-based hedge fund manager sets up a US office because one of its key investment managers wants to move home and work in New York. The office is staffed by the investment manager, a trader and one or two support staff. In setting the transfer prices in this example, the tax payer should first identify an appropriate split of fees to reward the investment management function and support functions. Then, the tax payer has to consider how to divide that reward between the two offices. The head office will invariably continue to employ its own investment managers and support staff.
- A US based hedge fund manager sets up offices in London, Switzerland, Singapore and Tokyo to raise capital for a new hedge fund in association with its existing New York office. In setting the transfer prices in this example, the tax payer might first identify an appropriate way to allocate fees to the internal distribution function. Then, the tax payer has to consider how to divide that distribution reward between the four offices.
As the two examples above illustrate, the transfer pricing challenges facing a hedge fund manager often focus on the best way to reward the investment management or distribution functions.
In the past, investment management functions have typically been priced on some form of revenue or profit split, calculated as the residual revenue or profit after rewarding the more routine business functions with a mark-up on their costs. Where portfolio management functions are split between two offices, as in the example above, the starting point for splitting the residual profits and revenues has always been to consider the performance of the individual investment managers in each location, since this is most closely related to the profit generated by each office. Where this is impossible, perhaps because the investment managers work as an integrated team and the business does not, or cannot, track individual performance accurately, other measures of contribution are used to allocate this residual profit. This has historically been relatively uncontroversial.
Rewarding a distribution function however, as in the second example above, has historically been less clear cut. This is often because the distribution function is based in a lower tax jurisdiction and tax payers have maximised the fees they allocate to distribution to obtain a favourable effective tax rate. As such, the pricing of distribution functions has often received a far higher degree of tax authority scrutiny, and taxing authorities have increasingly focused on the distribution aspect of hedge fund transfer pricing as a means of successfully securing adjustments and penalties.
Historically, the approach to rewarding distribution functions has typically been via three main methods:
- Characterising the capital raising function as an integrated function of the hedge fund managers' business and incorporating it within a revenue/profit split method;
- Rewarding the capital raising functions directly with a portion of the management fee (and sometimes the performance fee though practice has been inconsistent); or very rarely
- Identifying distribution as a routine business function and rewarding it with a mark-up on costs.
Benchmarking distribution directly in the hedge fund context has traditionally been difficult because of the unavailability of third party benchmarks and lack of internal comparables. While market practice is to reward distribution with 20 or 25 per cent of the management and performance fee, there has been little direct evidence to support this and tax authorities typically guide against unsupported market averages for pricing.
"Fund managers are still able to make the most of transfer pricing to manage their effective tax rate."
Where benchmarking has been collated it has tended to draw evidence from the long only fund world and comparability has been a difficult issue. Further, other studies have tended to focus on data used for regulatory purposes such as ADV II data (for SEC filings purposes) which is comparable to the traditional fund model distribution but not comparable to hedge fund distribution.
Given these problems of comparability between industries, and recognising that there can be significant tax and/or penalties at stake for most hedge fund managers (or fund managers that have hedge funds), during the course of 2006 PricewaterhouseCoopers LLP undertook research to develop a benchmark for this function (The Hedge Fund Distribution Benchmarking Report).
The Hedge Fund Distribution Benchmarking Report
The Hedge Fund Distribution Benchmarking Report (Benchmarking Report) took almost a year to complete and is drawn together from detailed interviews with more than 100 hedge fund managers and independent distribution agents. In addition, the Benchmarking Report incorporates reviews of industry publications and publicly available filings of US hedge fund managers.This benchmark is unique in the marketplace and provides a robust basis upon which to either support existing arrangements or to plan new structures. The results illustrate, as is common with transfer pricing comparability analysis, that a range of possible compensation levels could be supported, given the functionality of the distribution function centring on the industry standard of 20 per cent. Further, the analysis focuses on the following issues which have direct commercial and transfer pricing relevance to the hedge fund manager:
- How the distribution fee is calculated;
- Different components of the fee;
- The range of functions that agents perform for hedge fund managers;
- Factors influencing the agents' fee; and
- Duration of the payments made to agents.
Increasingly, these are the very issues that the taxing authorities are focusing on as part of their tax audits.
As hedge fund managers have become more and more international, they are increasingly falling within the scope of transfer pricing tax rules and have obligations to review their transfer pricing arrangements and retain documentation supporting their filing positions. Where managers inadvertently breach local transfer pricing rules they may be subject to potentially significant adjustments and penalties.
Furthermore, as tax authorities have recognised the profitability of hedge fund managers they are now looking much more at their tax arrangements and focusing on aspects such as their transfer pricing. The key issues that hedge fund managers face in dealing with their transfer pricing include identifying ways in which to correctly remunerate the core areas of their business. This has historically revolved around how to reward distribution and how to reward investment management. Recently, at least, part of this challenge has become easier, with the completion of the Benchmarking Report.
Aamer Rafiq and David McDonald are in the financial services transfer pricing team of PricewaterhouseCoopers LLP and Lachlan Roos is in the alternative investment tax team of PricewaterhouseCoopers LLP.
