Hedge Funds Under the Microscope

The changing face of taxation

Neil Manaley, Financial Services Director, Deloitte
Originally published in the April 2006 issue

Many partners and principals of UK hedge funds have, until the recent past, bought "off the shelf" products to mitigate their high personal tax liabilities on profit shares and bonuses taxable in the UK. Most of the planning opportunities were developed as a positional play against the Treasury and were typified by low overall marginal costs as a result of volume sales achieved by the providers. The nature of these products was appealing to the sector, as the positional play aspect of the products was in the nature of a trade most hedge fund operators could identify with easily, without getting bogged down in the detail behind the arrangements.

The Treasury ultimately reacted with some ferocity to these schemes, initiated by a statement issued by Dawn Primarolo on 2nd December 2004, when the extent of the arrangements and more particularly the potential scale of the tax loss started to become apparent. Significant pressure was fuelled through continuing high profile media coverage, in an attempt to stem the flow of potential tax loss from these types of planning arrangements. The direct result is that, post December 2004, HMRC have put in place specialist teams to tackle tax planning generally and also concentrate on sector-wide tax issues.

Most, if not all, of the schemes are now under enquiry with HMRC. The enquiries are conducted in a highly co-ordinated way by HMRC's specialist teams and investigators. The final outcome of these enquiries is far from clear but HMRC are mounting an extensive and sustained attack on the schemes with a view to defeating them.

There are a number of unsubstantiated rumours in the market place that HMRC have made settlements with certain individuals in connection with some of these planning arrangements, which are raising hopes for an early settlement and tax repayments. However, recent conversations with HMRC in connection with national enquiries into the "Gilt Strip" planning variants, lead us to believe that no deals have been reached with any provider nor are there any in current contemplation. Further, we believe that these arrangements remain highly political with high level Treasury interest in their progress. It is therefore likely to be a long process before a result, if any, is achieved.

Legacy arrangements

HMRC seem to be making a distinction between pre December 2004 structures, which they refer to as "legacy planning", and post December 2004 arrangements. The approach to "legacy planning" arrangements appears to be slightly more conciliatory than their approach to later post 2004 schemes.

It is important that a distinction is made between both these types of enquiries and the sector-wide enquiries which HMRC is carrying out into the hedge fund sector as a whole.

The hedge fund sector focus

Part of the hedge fund focus by HMRC is driven by the explosive growth of the sector and, perhaps, concerns emanating from the types of operating structures typically used by hedge funds often based in tax haven jurisdictions.

These factors create a perception of "tax risk" for HMRC and the Treasury. There is a link between the types of individual planning arrangements mentioned above, and the more general sector-focused interest of HMRC. In assessing the tax risk, investigating officers from HMRC look at the tax avoidance activities of the principals of hedge funds and, rightly or wrongly, conclude levels of tax risk. Put simply, individuals in hedge funds who have been active in "positional plays" in respect of their own tax affairs are likely to become the focus of a holistic enquiry into the taxation aspects of their operations. Principals who have continued to use the packaged "positional plays" post December 2004 are more likely to be perceived as much higher risk than those who refrained following the highly publicised position of the Treasury around these types of arrangements.

Most of the original packaged positional plays were supported by undertakings by providers to defend the arrangements implemented and reach agreement with HMRC. It is therefore unlikely that enquiries into these arrangements will prove to be very disruptive for individuals who entered into them, assuming the provider has both the resource and commitment to follow through on their undertaking.

However the sector-wide focus by HMRC is not covered by such agreements and is quite distinct from them. The specialist teams running the sector-wide enquiries are part of a unit within HMRC that will not make an enquiry unless it has a realistic anticipation of achieving a recovery of tax lost in excess of £500K.

The practicalities

What are the practical implications for hedge fund traders in the UK?

Given that there are almost 1000 hedge funds based in the UK it is unlikely that HMRC has the resource to enquire into all of them simultaneously. It is likely that their initial approach will be focused on the funds where principals have been active in tax avoidance schemes, i.e. those that are believed to present "risk" to the Treasury.

If the initial enquiries are limited to a targeted number of funds, this presents an opportunity for others to take stock and review their particular circumstances. Such reviews could potentially save time and real money in the future and are therefore very worthwhile. This is particularly so when you consider that many UK based hedge fund management companies, the initial targets for HMRC, pay out most of their profits in salary and bonuses and have little or no reserves for unplanned or contingent tax liabilities.

Starting the process of review is straight forward and, however you view the situation, a small investment now could pay large dividends in the medium term.

Firstly, it is important to take a view on your Tax Risk profile and take specialist advice if you feel it might be higher than you would like. Where hedge fund principals have been influenced by suggestions that mass marketed avoidance schemes remain acceptable post December 2004 and have participated in such schemes, it would be worth taking an independent view of the arrangements before submitting their tax returns for the period. It may be, for example, that there is sufficient merit in not proceeding with a claim for income tax losses in certain high profile cases.

Secondly, you might consider potential areas of vulnerability. For example, HMRC are likely to review claims for non domicile status, particularly where large amounts of UK PAYE has been avoided, perhaps through transfers to international pension fund structures or through the use of dual contract arrangements. Equally, international pension fund structures could themselves become a focus for HMRC attention. HMRC's approach will likely centre on any incongruence between the documents establishing the fund and its rules as against the operational reality or the facts. Exactly the same approach would follow with an HMRC review of dual contract arrangements.

Next, a further pressure point might be the hedge fund operational structure itself. It is worth reviewing the circumstances of the original advice when the structure was set up. For example, when the fund was established was the advice at that time entirely bespoke, or was it based on standard documents run off a word processor, altered to fit your circumstances. In itself there is nothing wrong in following industry practice. However problems can arise when structures used for larger operations are adapted for smaller start up situations. For example, overseas management companies interposed between offshore LLPs and the fund could be challenged around residency, typically Cayman, particularly if the principals of the UK fund management business are the same director shareholders as the offshore management company. Arguments that the directors are different because of the existence of Cayman directors may hold little sway with HMRC if the Cayman directors hold many hundreds of directorships and have little economic interest in the entity itself.

If the Revenue can represent that the offshore management company is in fact UK resident, the potential tax exposure could be significant. Similarly if the terms of the Investment Management Agreement are not being followed so that, on paper, the operation is sound but, in practice, over the years a degree of complacency has developed, such that the tests for Investment Management Exemption are frustrated, then again there would be a potentially significant tax exposure.

Many hedge funds operate an LLP in the UK which amongst other things has NIC savings for the partners. It is not thought that this type of structure in itself is necessarily an HMRC pressure point. Whilst the structure does afford savings, it also, in most cases, commercially reflects the relationships that subsist between principals of hedge funds on an operational level. However, this again is a question of fact and where, for example, a partner retired from the partnership in one year, perhaps to maximise contributions to his international pension plan, there is a danger, if he was subsequently readmitted to the partnership, that HMRC will challenge the commercial reality of the LLP for all participating partners and not just the retiree. Clearly, if you consider the difference between Class IV National Insurance Contributions and Primary and Secondary Class I contributions multiplied by the number of partners involved for the years the partnership operated, it willnot be an insignificant sum.

With all of these issues a little care and attention to detail now may save a lot of trouble in future if questions are raised by HMRC.

It is important to consider that many planning arrangements do not fail on tax technical issues but they fail because of the divergence of the arrangements from the reality of the situation. Put another way, it is the implementation of the planning that causes the biggest headache and, armed with that knowledge, it is this area that HMRC focus on in great detail.

This article is an introduction to the problems that could lay ahead for hedge fund operators in the current UK environment. However the key point is that these issues are not insurmountable if you plan ahead.

Key Action Points can be summarised as follows:

  1. Estimate the Tax Risk profile of the business (using size of the fund and the scale of tax avoidance activities of the Principals as a guide)
  2. Get some specialist help from a consultant with direct experience in this type of HMRC investigation
  3. Undertake a reality check. Question the commercial reality of the situation and check that it fits with what is represented by documents:
    • International Pension Funds
    • Dual Contracts
    • Non Domicile claims
    • Investment Management agreements
    • Residence of overseas management companies
  4. Start to consider the commercial reality of the business and its needs, then develop with specialist advisors corporate strategies that take a medium to long term view on tax strategy and remuneration so that tax can be managed in an effective and realistic way going forward.