Ernst & Young

The Leading Hedge Fund Tax Practice

Originally published in the March 2013 issue

Tax is normally not a front page story or the top headline in the evening news but public dismay over Google, Amazon and Starbucks using offshore centres to avoid paying tax in the UK has changed that. Now, public grilling of CEOs and consumer threatening to boycott the companies for not paying enough tax is commonplace.

In the spot light
Although hedge funds conduct their business with less media spot light then, say, Google, Amazon or Starbucks, they should be aware that the sensitivity not only of the general public but also big investors is changing towards how asset managers handle their tax issues. Investor choices will eventually force fund managers to address this, says Russell Morgan, partner at Ernst & Young’s hedge fund tax practice.

“Hedge funds are not yet under pressure to answer questions from the press about tax but we are starting to see investors such as big pension funds asking that a hedge fund or private equity fund not be located in offshore jurisdictions and tax sensitivities are a big factor in that,” says Russell Morgan, partner at Ernst & Young’s hedge fund tax practice. The trend is most pronounced amongst European institutional investors and is forcing the creation of parallel onshore EU fund structures with all the cost implications involved. This, together with FATCA, the European Union financial transaction tax and AIFMD-driven tax changes promises to make 2013 a busy year for Ernst & Young’s 50-strong hedge fund tax practice. E&Y has been highly focused on the sector since hedge fund managers first emerged in the UK and the unit specifically dedicated to hedge funds is larger than most of its peers.

The hedge fund tax practice has seen a pronounced growth, both in terms of size of operations and in terms of revenue over the last ten years and has been able to cherry-pick the most experienced staff, be it at a junior level or a partner level, such as in the case of Fiona Carpenter. Carpenter, formerly chief financial officer at hedge fund TT International, who was also named as one of the 50 leading women in hedge funds by The Hedge Fund Journal last year, returns to E&Y where she had been the second youngest partner ever.

The tax practice advises alternative fund managers on three levels: that of the fund manager, the actual fund and from the perspective of the investor. These three combined bring up a veritable concoction of issues this year and will force fund managers to look long and hard at some strategies and regions before making the next investment decisions.

Financial transaction tax
On the top of the agenda will be the ‘Tobin taxes’ on financial transactions, versions of which have already been introduced in France and Italy. An EU financial transaction tax will come into effect in France, Italy and another nine European countries by January next year.

The tax is not dissimilar to stamp duty reserve tax in the UK but unlike the UK version, the European transaction tax will be levied on both the buyer and the seller. Also, again unlike in the UK, brokers will not be excluded from it and in transactions that involve a number of brokers all the intermediaries in the chain will be affected. For the time being the version introduced in France covers only trades in top French equities but once in full force the pan-European version will extend to bonds and derivatives too, excluding only foreign currency trade.

The most profound effect will be felt by funds set up in those 11 countries as their every trade will be taxed, but the ramifications are much broader than that. “Ireland and Luxembourg are not part of the 11-country block but nevertheless, asset managers need to be aware of it because it will affect any securities they buy that are issued in those countries, which includes the four largest Eurozone markets, Germany, Spain, France and Italy,” says Morgan.

The actual tax will be 10 basis points on equities and 1 basis point on derivatives and will hit the hardest those funds with a high volume of trades, low margins or those with a European focus. “Given the cost implications, in some cases such funds will cease to be viable,” says Morgan.

The European Commission wants to introduce the tax in January 2014 but the time table looks ambitious at present and may slip by another six to 12 months. However, it is unlikely to be abandoned as it is driven by politicians in Europe who see it as a way of covering a short fall in domestic taxes. The transaction tax adds one more item to the already growing list of additional costs incurred by hedge funds through regulation.

Another item on the cost list will be complying with the Foreign Account Tax Compliance Act (FATCA), an act designed to help the US Internal Revenue Service keep tabs on all the non-US investments held by US taxpayers. FATCA came into law in 2010 and requires banks, funds and other financial services providers to report to the IRS certain information about their US clients.

The final detail of FATCA is still in the making but the process should be complete by July this year, while the actual implementation of the rules will take place from 2014. In recent months a number of countries including the UK have signed intergovernmental agreements with the US by which financial institutions will have to report to their local tax authorities instead of to the IRS, but the general principles of FATCA remain the same. The UK has also announced it will bring in its own FATCA-like regime with Jersey, Guernsey and the Isle of Man being the first territories in scope.

From July financial services companies will be able to begin registering for FATCA and a list of those companies who have registered by 25 October 2013 will be published by the IRS in December this year. The implication for hedge funds is that most of them will have to have a FATCA registration, says Morgan. “A fund manager may well think that if there are no US investors or US securities in the fund this will not affect him but my expectation is that in the market this is going to be a case of guilty until proven innocent and any unregistered fund will find itself under a lot of pressure to explain why it is not participating and may be frozen out by investors and counterparties,” says Morgan.

The impact of US taxation on hedge funds should not be underestimated as almost half of the inflow into European hedge funds still comes from US investors, a fact that is reflected in the make-up of Ernst & Young’s London hedge fund tax team, half of which consists of US tax professionals.

Morgan notes that FATCA is structured in such a way that it can ultimately be enforced by a withholding tax of 30% of the total payments relating to US securities. “This means that if a fund buys a security at $100 and sells at $105 the paying agent would not only withhold 30% of the $5 profit made but 30% of the $105 proceeds of sale – this will  effectively make trading US securities impossible for non-participating funds,” says Morgan.

Although hedge fund managers cannot actually start registering for FATCA until July they will need to think about which funds they want to register for FATCA, update their marketing material, ask their distributors to inform investors about the changes that will affect them and talking to their administrator about KYC (know-your-client) provisions.

“Our expectation is that all, or virtually all hedge fund managers will register their funds, even if they don’t have any US clients, if for no other reason but to prove to the world they are being compliant,” says Morgan.  

Changes in Europe
The introduction of the Alternative Investment Fund Management Directive (AIFMD) also in July this year will amongst many other things bring up tax issues around manager remuneration for hedge funds. The regulation has in general been a politically-driven process, but the remuneration provisions are at least aligned in spirit to a building pressure from investors for managers to have “more skin in the game” to show that their long term goals are aligned with those of their investors, says Morgan.

The hotly contested new regulation will require managers in some circumstances to defer at least 40% of an individual’s remuneration and to have 50% of it paid out in something other than cash, such as units in the funds managed or equity in the manager itself.

Existing fund managers will have another year before they change theway they compensate their personnel but new AIFMD-registered funds will have to comply with the regulation from the onset. Deferred and non-cash remuneration brings with it a host of tax considerations that many managers may not have had to deal with before. For instance, if a fund manager is paid £100,000 and in addition receives a bonus of £500,000 he can be paid £300,000 outright while the payment of the remaining £200,000 will be spread over the next three years. Under tax rules the employer may not get a tax deduction on the £200,000 until it is eventually paid, so will have to meet an upfront tax charge which might not be refunded until after the deferred remuneration is due to be paid, creating cashflow headaches.  

“The question now is how will the manager deal with the pot of deferred money?” says Morgan.

As most managers are set up as limited liability partnerships the challenges are particularly acute as all of the profits of the manager have to be taxed on somebody each year regardless of whether the profits are actually distributed out.

“This is not a new issue and one possibility is to bring in a corporate partner to retain the profit during the period in which the level of deferred profit is building up,” says Morgan, “but the Chancellor’s Budget announcements included a consultation to be launched in the spring on some aspects of how tax should apply to partners of LLPs and the impact of any new rules will need to be understood.” In any case managers are still waiting for the Financial Services Authority to put the final brush strokes on the UK version of AIFMD rules. The FSA is expected to complete its proposal on AIFMD-related regulation within the next month or two.

Similarly in Europe most countries have yet to transpose the Directive into their national law. So far, only the UK, Ireland, Germany, Luxembourg and Netherlands are in an AIMFD legislative process, while Italy, Spain, France and Belgium have not yet started on it.  

Tax increasingly a business issue
The whole gamut of new tax rules and regulation-driven change that will come into effect this year will not only have tax implications for funds and managers but will also have tax implications for funds’ investors be they US-based or based in Europe, and will colour the decision making about which fund structures and which domiciles to choose. Coming on top of other recent tax developments such as FIN48 tax accounting, these changes reinforce the reality that tax is a core business issue for both managers and funds.