Centralised Tax Planning

Correct implementation and appropriate safeguards

LACHLAN ROOS and SHABANA BEGUM, PwC

A time for change?
The hedge fund industry today is a global mobile workforce. However, traditional localised tax planning is becoming ever harder with changing laws such as a future potential General Anti Avoidance Regime (“GAAR”), and the sustainability of tax rate benefits harder to come by, there are pressures on hedge funds to centralise what have traditionally been onshore significant value functions such as marketing and capital raising activities.

In addition, despite many pan-European tax reforms, the current level and complexity of European corporate and personal taxation and ever increasing regulatory burdens including UCITS and AIFMD are having significant effects on competitiveness of hedge funds across the continent.

Centralisation can bring commercial as well as tax benefits for hedge funds in a number of ways. Benefits include efficient tax structuring for the attraction and retention of talent, identifying and adding tax efficiencies to operational savings; ensuring that operational change does not create tax exposure and providing additional funds by way of cost savings for reinvestment into new or existing funds.

The potential offshore locations?
Key to any centralised business model planning is the identification of the key value drivers and profit generators/associated risk that may be transferred. Once the key profit generators/risks have been identified it is then necessary to consider the extent to which these generators can be centralised within an offshore entity. This will require substantive commercial activity conducted from these locations. Locating the offshore jurisdiction involves evaluation of a number of factors; these include both tax and non-tax considerations.

Important tax considerations include the existence of moderate income and capital tax rates, beneficial profit allocation and availability of tax losses. Non-tax considerations include the availability of qualified staff, the proposed location’s banking system, macro considerations including infrastructure and political stability and finally personal life choices of any individual concerned.

Typical jurisdictions that are proving popular due to existing infrastructure already in place include Switzerland, Malta, Singapore, Hong Kong, the Channel Islands and the Caribbean.

Centralisation and off-shoring functions
Centralisation of traditional significant value functions such as marketing and capital raising activities will involve consideration of a number of factors. These include but are not limited to the following matters:

Investor relations
While new investment management businesses raise capital from new investors, as a business matures more of the capital for a new fund is likely to be sourced from existing investors and the retention of this capital in today’s market is critical.

As such, the investor relations function often becomes more valuable to the business over time and can move from being considered a routine service to being considered a value-driving part of the capital raising process. Therefore, in order to prevent activities related to the raising/sourcing of capital from moving onshore, meetings with existing investors should be undertaken by individuals acting on behalf of the offshore company.

In order to ensure that the investor relations function is not deemed to occur onshore, an onshore advisor must not enter into or negotiate contracts with an offshore entity. Contracts with new investors should be agreed and signed by the offshore company outside of the home territory.

Capital raising, meetings and intangibles
Often the key intangible for the capital raising function is the client relationships which facilitate the raising of capital. The holding of capital raising meetings with potential investors, away from the home location, supports the assertion that the capital raising partners carry out this role as part of their position within the offshore company. The ownership of client relationships by these personnel is key and it is important that they are not diluted by personnel located elsewhere in the business.

Pricing and negotiation
Pricing of products and negotiations with clients are important parts of the capital raising process, and therefore, correspondence with real substance regarding the pricing of products and negotiations with clients by appropriate personnel should be properly communicated from the offshore jurisdiction.

Dual contracts
Where an employee has a role within two separate entities and is employed by separate entities under a dual contract, it is important that they are aware of their authority and responsibilities under each role. The individual should make clear, especially when speaking to third parties, which role he or she is acting under at the time and this should be clearly documented in any meeting minutes, for example.

Tax authority challenge
When considering which functions are to be centralised and substance implemented, it is important to consider how the local tax authorities may try to attack the structure and ensure that the structure is fully defendable. As these structures become more complex the tax authorities’ thinking and attacks become more considered and thorough.

For hedge funds, if the local tax authorities see a decline in taxable profit, they will want to know why – this is generally the first line of challenge. Traditionally, tax authorities have been reasonably comfortable with commercial business change structures and concepts.

However, in recent times, tax authorities have begun to focus on business change, placing closer scrutiny on functional and risk alignment, looking for demonstrable change, with territories scrutinising “lost revenue raising opportunity” and challenges arising where insufficient or inappropriate substance is prevalent.

What are the risks?
Arguably, the key tax implication arising from centralisation is transfer pricing risk. Due to the transfer pricing requirements of the UK and other territories, it will be necessary to reward the offshore company on the basis of functions performed, risks borne and capital employed.

Such an analysis will rely on the extent to which any new centralised company has substance to support its new business activities. This is where we have undertaken in-depth work with the industry to ensure clients are pricing according to market practice.

Other key risks include exit risk, permanent establishment risk and the need for true substance. These risks naturally increase the greater the degree of centralisation.

Transfer pricing implications
Centralisation, if implemented effectively, should result in a reduction in cross-border transactions, and therefore a reduction in resources dedicated to transactions as well as simpler transfer pricing documentation processes, ultimately resulting in a more effective management of tax exposures.

The basis of the level of revenue that should be allocated to the offshore company is essentially based on the level of substance that can be attributed to it. For new capital that is to be introduced to the funds, the transfer pricing allocation that can be made to the offshore company for capital raising and marketing activities is typically higher than existing capital retained in the funds. For existing capital retained in the funds, it is common to see a low fee allocation initially but as the functionality of the offshore company develops, the allocation can be migrated over to the offshore company over a period of time. Such allocations can be built into any agreements with the offshore company.

So what does all this really mean?
Centralisation can impact the entire hedge fund value chain and it is important that all factors are evaluated and appropriate advice is sought should the desired returns be achieved. The robustness of a structure will be dependent upon the overall substance and contribution made by the hedge fund in the foreign jurisdiction. Adherence to certain practical measures and appropriate tax advice will help reduce the risk of challenge and increase the success of future economic returns.

Tax planning is clearly becoming more complex; however, with correct implementation and appropriate safeguards, it can be undertaken in a palatable fashion for the authorities.

Lachlan Roos leads PwC UK’s hedge fund tax team; Shabana Begum is a manager in the FSTP team. Both have extensive experience of business restructuring and offshore funds issues in the alternatives sector.