As any regular reader of the Financial Times will know, tax avoidance has been a topical subject over the last few years, with those receiving unwanted press including British comedians, US multinationals and continental politicians. With regular attention being paid to perceived tax avoidance globally, along with an abundance of fiscal deficits, it is not coincidental that in 2013 the G20 mandated that the OECD focus on global tax avoidance. The mechanism through which the OECD is doing that is now referred to as the BEPS (base erosion and profit shifting) project.
So, why should your average reader of The Hedge Fund Journal be concerned with the BEPS project? Well, although it is predominately focused on the tax planning done by multinationals, given its broad mandate there could be an impact on alternative investment funds. This article will not discuss the expansive list of work streams within the BEPS project but will instead focus on some potential implications for alternative investment funds and what fund managers need to be thinking about now.
Relevance of tax treaties
The most obvious area where BEPS could impact hedge funds is through its focus on the perceived abuse of tax treaties. As applied to the hedge fund community, there are at least three areas which may be relevant. First, it could have an impact on the tax benefits derived from synthetic trading, i.e., the reduction/elimination of withholding taxes and/or capital gains taxes associated with trading in certain jurisdictions – for example, dividend withholding tax on German equities, interest withholding on certain UK debt instruments or capital gains taxes in Spain. If an outcome of the BEPS project was a material restriction in the tax benefits associated with synthetic trading, there could be a material impact on the net returns that certain funds earn, especially those which focus on investments in equities.
Second, the returns within so-called NewCITS could be impacted, again as a result of increased withholding and capital gains taxes. At the moment, UCITS funds running hedge fund strategies are most commonly formed in Luxembourg or Ireland. Because they are onshore, these funds are eligible to obtain tax treaty benefits in certain investment jurisdictions. However, as currently drafted the BEPS guidance on tax treaty abuse could significantly restrict a UCITS fund’s ability to claim these tax treaty benefits. A number of industry participants have raised this issue with the OECD working group and it is hoped that a workable solution for publicly traded retail funds will be included in the final guidance.
Finally, holding company structures which are used predominately for illiquid investments and more recently for investments in European credit could be impacted. Within Europe, these structures are commonly formed in any of Luxembourg, Ireland or the Netherlands and used for a variety of commercial and tax reasons. Based on the current draft guidance, the tax benefits of such structures could be restricted.
On the whole, any or all of the above would not be entirely helpful for many hedge fund managers. However, as many managers will note, increases in taxes will almost certainly have some impact on capital flows. Thus, it is currently unclear whether countries will view the cost associated with a reduction in the attractiveness for the inbound investment of foreign capital to be worth the benefits of the potential incremental tax revenue.
There is something important to remember when considering this subject in the context of alternative investment funds. Namely, most investors in these funds qualify for tax treaty benefits in their country of domicile as either local taxpayers or statutorily tax-exempt (i.e., pension funds) entities. In the case of most alternative investment funds, even where tax is mitigated at the investment level, it is still reported and normally taxed at the investor level.
As the investors themselves are eligible for tax treaty benefits, the tax planning at the investment level simply replicates what the investors would have received had they invested directly. It is hoped that the final guidance and/or its ultimate application will take this into account. This may also ultimately factor into how the industry might respond should this guidance be widely adopted, namely through the structuring of the funds themselves so that investors’ ownership is more directly seen.
The digital economy
Turning to other areas of the BEPS project, one of its main focuses is on the “digital economy”, what your authors might refer to as computer stuff. While this work stream is predominately focused on e-commerce, it nonetheless could have an impact on certain hedge fund strategies. For example, hedge funds which engage in high-frequency trading could be impacted where they have servers located in certain trading jurisdictions. In this case, the result might be an increase in the allocation of profits to the countries where the servers are located along with the attendant tax filing requirements, etc.
Finally, the BEPS project could have an impact on the affairs of hedge fund managers themselves. Increasingly, hedge fund managers run international businesses with offices in any or all of the Americas, Asia and Europe. As a result, the tax structuring for management companies is of an international nature and can be complex, made even more so when one considers the multiple nationalities of key principals.
The most obvious space where BEPS could impact the tax affairs of management companies is in the area of transfer pricing. As with the digital economy, the G20 have high expectations as to what the OECD can do, per se, to repair perceived transfer pricing abuse being undertaken by multinationals. At a minimum, this could result in managers’ having to maintain additional documentation to support the allocation of profits between countries where they maintain offices. It could also restrict the amount of profits which can be allocated to certain services and/or to intangible assets. However, at this stage it is quite difficult to predict the outcome of the transfer pricing work stream because of the complexity of the issues and interests involved, so we will simply have to watch this space and should get some initial visibility later this year and into 2015.
So, is BEPS a “today” issue for thehedge fund community? The better question is probably whether it is a late 2014/2015 issue, and the answer to that is that it is difficult to say. BEPS in its formal sense is unlikely to go live prior to 2016, at the earliest, as the instrument which would allow mass adoption by countries is not due until the end of 2015. However, due to the breadth of the BEPS project, it will increasingly be in the news. For this reason, it is possible that investors will start asking funds about tax risks, especially for funds which make illiquid investments. Also, it is not impossible that certain countries, especially in the less liquid markets, could attempt to apply aspects of the BEPS project unilaterally in their domestic tax laws, which depending on where a fund invests, could make BEPS a more immediate issue.
Adam Miller is a Partner, International Tax Services, at EY Luxembourg and Stuart Chalcraft is an Associate Partner at EY London.