In this article Stephen Rabel and Anne Reese discuss some of the implications of this potential liability and the Investment Management Exemption (IME), which is available to offer protection to UK based investment managers.
Having established that the fund is not UK resident, it may still be subject to UK tax on any UK source income and profits or gains arising from a trade carried on within the UK. The latter circumstance is the one of most concern to UK based investment managers. For a tax transparent fund this will bite at the investor level.
Given the non-residence status of the fund there will be issues with regard to collection. Because of these implications, the obligations and liabilities in relation to income tax or corporation tax that are imposed on the fund or its investors, are also imposed on the branch or agency or permanent establishment which is the UK representative.
An investment manager granted discretionary management of the fund's assets may be seen as a branch, agency or permanent establishment and thus create a tax exposure for its UK manager. If this were to apply without relief, it would seriously prohibit the possibility for investment management in its fullest sense to occur in the UK. Because of this, the Investment Manager Exemption (IME) was introduced in order to retain the UK status as a fund management centre. Where certain criteria are met, the UK representative and the fund will not be subject to UK tax despite the presence of an investment manager in the UK.
Trading funds – what constitutes trading?
Before considering whether it is necessary to satisfy the IME the fund must be trading. The principles of what constitutes trading have been developed in case law over the years. It has been established that the active management of an investment portfolio does not constitute trading, neither does use of derivatives for hedging of the underlying investments. Whereas using derivatives in their own right to make profits would indicate trading.
The use of more sophisticated investment management techniques and the introduction of Qualified Investment Scheme's (QIS) for non-retail investors have provided an impetus for re-visiting the prevailing views. The QIS's regime allows for investments in derivatives, short sales and also some degree of leverage. The initial assumption was that the tax treatment of such schemes would be similar to other authorised retail funds, which have operated under the accepted view that they are investing instead of trading. Given the breadth of strategies within the hedge fund industry, it would not be unusual and indeed it could be expected that the funds strategies would be squarely within a QIS, and are not too dissimilar to the retail funds such that an investing argument could be sustained.
In July 2004 the Revenue issued a discussion paper questioning the appropriateness of applying the same taxation treatment to QIS's as to retail funds and therefore fuelling the trading vs investment discussion further. The relevant industry bodies have requested confirmation of treatment of QIS. It will be interesting to see whether the prevailing view has changed.
Partnership vs company
The IME criteria were first introduced in the Finance Act 1995, when the trigger for whether a company had a UK tax presence depended on whether they could be said to be carrying on a trade in the UK through a branch or agency. In the Finance Act 2003 the position for companies changed. Now a non-resident company will be within the charge to UK tax if it carries on a trade in the UK through a permanent establishment. This makes the position for companies consistent with the OECD model tax treaty on which most of the UK's double tax treaties are based.
With thechange to permanent establishment, the intention was that there was no substantive change in application of the IME. It is hoped that this is the case, as there are now slight differences in application of the IME. Now for companies the IME has the effect, if satisfied, of regarding the investment manager as an agent of independent status acting in the ordinary course of his business. Such an independent agent cannot be a permanent establishment and hence no UK tax exposure. This seems satisfactory and the equivalent treatment that went before. It however would be disconcerting if under general principals you could establish you were an independent agent and therefore prima facie not a permanent establishment, but because you were an investment manager, you also had to comply with the IME requirements.
If we are in a position where we are trading or it is uncertain whether a trade is being carried out it is likely, given the possible taxation consequences, that we would want to satisfy the IME. The overall goal of the IME is to ensure that the manager is acting on a commercial basis and not simply managing their money. The IME applies to investment transactions that are carried out by an investment manager. Investment transactions are broadly defined but do not include transactions in land.
The key criteria that have to be satisfied are as follows:
1. Independent Capacity
The manager must be shown as operating independently from the fund. In other words the business relationship between the two entities must be performed at an arm's length basis.
2. Customary Remuneration
The UK manager must be receiving remuneration from the fund that '…is not less than is customary for that class of business…'.
3. Investment Services
The investment manager must be in the business of providing investment management services.
4. Ordinary Course of Business
The transaction between the manager and fund must be carried on in the ordinary course of business.
5. Permanent Establishment/Branch or Agency
The manager must not be determined to be the permanent establishment or branch or agency of the fund in relation to any other transaction.
6. 20% Test
Broadly the manager must not be entitled to more than 20% of the fund's income arising from transactions carried out through the manager.
These criteria are well known for the majority of UK based managers and no doubt discussed in some length on the formation of the UK operation. It is important that after this initial review in the spotlight it is not assumed that a manager will continue to comply. A regular review should be undertaken to ensure there are no nasty surprises ahead.
We have expanded on some of the more topical and relevant issues below.
The 20% rule
Broadly this requires that the UK manager and persons connected with it must not be entitled to more than 20% of the profits arising from transactions in the funds. There is often a tension between investors wanting to see managers investing in their own fund and compliance with the requirement. This is especially so where management may be able to participate in special share classes which may grow disproportionaly to other shares. This may also impact the customary remuneration point discussed below. Payment of management and performance fees should not be counted as entitlement to income. The treatment of incentive allocations is less clear.
The 20% test relates to beneficial entitlement of the manager and his connected parties. Persons will be connected to their fellow partners in a partnership. What happens when the fund is structured as a partnership? All other investors' entitlement would then be counted in relation to the 20% test, thus the test would automatically be breached where the manager or a connected person had an interest however small.
Thankfully the Revenue have indicated that a transparent fund should be treated as a corporate fund when assessing connected parties of the manager and the other investors will therefore not be treated as connected parties.
What is Customary?
The customary test requires that the UK manager receive remuneration that is customary for that class of business being carried out. Issues will arise where less than 100% of the management and performance fees are paid to the UK because of a retention offshore by an 'associate' of the UK manager. Additionally management or other share classes that do not pay fees may dilute what would have been customary. Unfortunately the Revenue has not provided guidance on what they consider customary. It is difficult to see a situation where a remuneration arrangement that satisfied a transfer pricing arms length criteria would not also be customary. The terms however are not the same and if there is an option to stress either the IME or transfer pricing considerations, the choice should be the latter, given the consequences of failing the IME.
Independence Capacity – it is not all about safe harbour
The legislation provides that independent capacity would be satisfied where having regard to the UK manager's legal, financial and commercial characteristics, the relationship between it and the fund is a relationship between persons carrying on independent businesses that deal with each other at arm's length.
In a statement of practice the Revenue has provided guidance as to the application of the test. They have indicated that where the other criteria of the IME are satisfied, the independent capacity requirement will be satisfied where the following requirements exist:
a) where the provision of services to the non-resident and persons connected with the non-resident is not a substantial part of the investment management business. 70% is regarded as substantial;
b) from the start of a new investment management business provided the above condition was satisfied within 18 months;
c) where the manager intended to satisfy either of the above conditions and failed to do so for reasons outside his control, having taken any reasonable steps to fulfil the intention;
d) where investment management services are provided to a collective fund, the interests in which are quoted on a recognised stock exchange or otherwise freely marketed, for instance as units in a unit trust;
e) where investment management services are provided to a widely held collective fund.
Conditions (a), (b) and (c) are unlikely to be satisfied as the fund will generally be the sole or main client of the UK Manager.
In relation to (d) it is interesting to consider what freely marketed may mean. Could a fund be freely marketed if it is marketed to the pool of investors available to it as a result of regulatory restrictions? Obviously listing is a clear route to follow. (As of March 2004 the Cayman Islands stock exchange has been a recognised stock exchange.)
It is likely that most hedge funds would seek to rely on fulfilling the condition in (e). In relation to (e) the Revenue consider that the fund is widely held where no majority interest in the fund is held by five or fewer persons and persons connected with them, or no interest of more than 20 % was held by a person and persons connected with him. During the initial start up period this may be difficult to satisfy.
What we think is important to note is that the conditions (a) to (e) above are simply safe harbour situations and a UK manager could be acting in an independent capacity, even when not on all fours with the situations above where they fulfil the legislative requirements.
Choosing to domicile your fund in an offshore jurisdiction provides concrete tax and regulatory advantages. It is important that having taken that step you arrange thestructures to ensure that both the residence and the tax impact of managing from the UK are appropriately considered. This should be considered at the outset and monitored on a regular basis. The consequences of getting this wrong do not bear thinking about.
For further information and guidance on hedge fund manager issues, visit our website www.rsmi.co.uk/financialservices