International Pension Plans

Use it or lose it!

Garry Mackay and Tim Trudgeon, Global Wealth Management
Originally published in the June/July 2005 issue

A significant factor in the success and development of a hedge fund management business is the ability to recruit, reward and retain quality employees. The importance of such packages are given extra emphasis by many allocators when reviewing the businesses infrastructure, with a keen eye being placed on assessing what the manager has implemented to reward and lock-in its key players.

It is for this reason that a correspondingly approved international pension scheme can provide an effective and tax compliant solution for non-UK domiciled professionals in the hedge fund sector. However as the current year is the last chance to establish such schemes in their current format it really is a "use it or lose it" scenario.

Most non-UK domiciled hedge fund professionals will be aware of the concept of a correspondingly approved international pension scheme from their employment at the large investment banks. Indeed many individuals will have substantial deferred international pension arrangements with their previous employer, which they would like to replicate within their new working environment.

The reasons for establishing an international pension scheme for a hedge fund are essentially analogous to a large investment bank, being absolute acceptance by the Inland Revenue, tax efficiency for both the employer and employee, and from April 2006, an extremely powerful staff retention tool.

The UK Inland Revenue permits attractive tax concessions to "foreign emoluments persons" working in the UK who participate in "foreign retirement schemes". An international pension scheme is a tax efficient way in which employers can provide retirement benefits and is a tax efficient tool for hedge fund management businesses looking to mitigate taxation when distributing bonus pools for employees.

In this context, a "foreign emoluments person" means a non-UK domiciled individual employed in the UK by a foreign employer and resident or ordinarily resident in the UK for tax purposes. Later in this article, I will outline how this is achieved for UK employers.

A "Foreign Retirement Scheme" can mean a home country tax-approved retirement arrangement or an offshore retirement scheme that is approvedin the jurisdiction in which the scheme is established.

Contributions

Unlike domestic UK pension schemes there is no limit on earnings that can qualify for benefit purposes – the earnings cap. Therefore highly remunerated individuals in the hedge fund arena can place significant contributions into the scheme, often totalling several million per annum normally by means of a "bonus sacrifice". Employer contributions are fully deductible for corporation tax purposes in the year of the contribution. No UK National Insurance (currently 12.8% of the prospective bonus) is payable inrespect of employer's contributions to an international pension scheme, and there are no UK National Insurance contributions for the employee. Clearly this may become of increasing importance as the current government has looked to increase the amount available to the Exchequer via the National Insurance system. Employer's contributions will not rank as taxable emoluments in the United Kingdom. Therefore no UK income tax charge (benefit in kind) at 40% on employee in respect of employer contributions.

IPP plans are established by an employer making contributions in respect of each individual to an individual trust. As a result of being invested offshore, the income and gains within an international pension scheme may accumulate largely tax-free.

Permissible assets

The rules surrounding the permissible asset classes are surprisingly wide, and subject to trustee approval, the individual member's scheme can invest into assets such as, single and multi-manager hedge funds (including their own), private equity, derivatives, residential and commercial property worldwide. Clearly the investment policy of a pension scheme has to be appropriate to its purpose – the trustees will not want to let the employee put it all in high risk investments when they are the ones who will have to answer for the consequences to his widow and children. Furthermore the investments must not confer a benefit on the employee, so using the IPP to fund your own residential property is difficult. Nevertheless, that aside, independently-run schemes tend to be very much more flexible than the in-house plans.

Many individuals who worked at the larger financial institutions, and who currently have deferred arrangements with their previous employers, may be surprised by this. The single limiting factor of the larger schemes is their back office ability to execute client specific transactions. Most simply offer you a range of long-only investment funds.

Benefits

Unlike a UK pension scheme, the international pension scheme's entire fund can be taken as cash lump sum. If the retirement benefits are taken after ceasing to be tax resident in the UK, any tax liability on the lump sum payment will depend on the tax rules of the host/retirement country at the time of payment.

If the home country's tax regime would be unfavourable (many are fine) on the lump sum, interim retirement in a suitable country (low or nil tax rate) after leaving the UK tax net and before becoming tax resident in the final retirement country offers the opportunity for effective retirement financial planning. In practice most members manage to position themselves in order to take the benefits free of taxation.

Certain conditions are laid down by the UK Inland Revenue in respect of such schemes, which have to be complied with, to be able to obtain Corresponding Acceptance. In view of the fact that the standard documentation for an international pension scheme has been pre-agreed with the Inland Revenue, obtaining "corresponding" acceptance is normally a relatively straightforward matter.

Overseas employment

The scheme must be established for non-UK domiciled individuals employed in the UK by a foreign employer and resident or ordinarily resident in the UK for tax purposes. The issue of organising foreign employer status for a London based hedge fund is relatively straightforward but invariably leads to additional corporate planning opportunities such as transfer pricing.

A foreign entity can be formed in order to give a corporate identity to the extensive activities currently carried out by the hedge fund outside the United Kingdom. These activities mainly involve the marketing of the hedge funds to non-UK clients and can also involve the management of those funds outside the UK if relevant.

As the hedge fund matures and expands, activities globally can increase. It can therefore be appropriate to establish an overseas "centre of operations" in order to establish a consistent contractual basis for the provision of these services (and also to provide additional resources in terms of personnel and office space to cater for growth in these areas). The foreign entity will employ all individuals currently active in the provision of the services referred to, and will also supervise the carrying out of those activities.

It is likely however, that the overseas employer may wish to recharge its employment costs to the UK 'user' of the employee's services. The recharge would almost certainly be calculated by reference to the salary and benefits (including international pension scheme contributions) being provided by the overseas employer. Alternatively the UK user of the employee's services may contribute directly to the plan. It is therefore the UK entity which would be seeking a tax deduction for its costs and hence, effectively, seeking a deduction in respect of the input to the international pension scheme.

Whichever route is chosen the tax advisors should confirm that a UK corporation tax deduction will be available. The precise route of funding the plan also carries VAT implications which should be discussed on an individual basis to ensure there is no VAT loss.

Pensions simplification: A-Day

In the 2004 Budget on 17 March, the Chancellor of the Exchequer announced the go ahead for arguably the most radical reform of UK pensions legislation since the introduction of the old age pension in 1908. The simplified regime will come into effect on 6 April 2006 ('A' Day).

Every member of every existing pension scheme is affected by these proposals. This includes both UK and international 'correspondingly approved' schemes.

From A-Day, the existing system of corresponding approval will change and will be replaced with a system of migrant relief. Some of the requirements to obtaining this relief will make it much harder for hedge fund companies to establish international plans for their employees.

For example, the individual joiner must have been a member of the scheme before coming to the UK. Also, the individual must have been entitled to tax relief on contributions to the scheme in the country in which he was resident immediately before coming to the UK. The reality is most individuals either joining or starting a hedge fund in London are already UK residents, therefore this new relief will not apply.

However there are important concessions in the new legislation for companies with existing correspondingly approved international schemes.

Where individuals are entitled to corresponding relief at A-Day, they will automatically qualify for migrant relief under the same scheme, regardless of whether the individual and/or scheme could have qualified under the rules applying to new applications. You can therefore use the existing correspondingly approved international pension schemes post A-Day. Consequently this tax year is the last chance to establish a correspondingly approved international pension scheme in its current format, which will in turn allow its member to utilize the scheme post A-Day.

In addition, a very important aspect of the new legislation is the ability to "grandfather" existing substantial benefits in correspondingly approved schemes. Where the scheme benefited from corresponding relief before A-Day, benefits accrued under the scheme before A-Day will not be taken into account in calculating the lifetime allowance. Therefore, for any hedge fund company setting up a correspondingly approved international pension scheme this tax year, it seems expedient to maximum fund the scheme in this tax year.

In summary, the correspondingly approved international pension scheme can provide hedge fund principals and employees with an Inland Revenue approved tax solution which can provide a great deal of flexibility over the medium to long term. However it is essential that interested parties take action immediately as this solution has a finite life as far as implementation is concerned.

Global Wealth Management is an independent specialist firm providing a range of services to the hedge fund space. Its work includes aspects of fund launches, global remuneration plans, transfer pricing and structured tax planning through operations in London, Jersey and a shortly to be opened office in Hong Kong.