Out of Sight Out of Mind?

Stephen Rabel of RSM Robson Rhodes writes on tax residency issues

Stephen Rabel, RSM Robson Rhodes
Originally published in the November 2004 issue

Common to the majority of European based Hedge Fund structures is a divergence between the domicile of the fund and the individuals who will manage the assets of the fund.

The fund domicile is driven by regulatory and fiscal rationale i.e. a permissive regulatory environment with little or no fiscal implications. While the regulatory and tax environments are ever evolving we have yet to see a substantial move away from the traditional offshore jurisdictions used by hedge funds in the Caribbean and Channel Islands. Meanwhile the individual managers have traditionally based themselves close to the major capital markets.

This divergence is the tried and tested path for London based managers. It is important when following this route that managers are aware that with the regulatory and particularly fiscal advantages of an offshore fund comes operational and structural responsibilities that must be followed to ensure the divergence is respected.

The issues will be familiar to the majority of UK based managers;

  • The fund, if a corporate vehicle, must ensure that it is not tax resident in the UK
  • The manager if managing a fund considered to be trading must comply with the investment manager exemption (IME) if it wishes to protect the fund from taxation.

I do not propose to cover the second of these points in this article as it is worthy of a piece on its own. (?which I will be covering in a later article?).

In relation to tax residency we should bear in mind the consequences of not getting it right. If tax residency were found to be in the UK the fund as a corporate vehicle will be subject to tax in the UK on its worldwide income. It would not be an enviable position to explain to investors that fund profits are subject to UK tax.

I think it helps to take a step back and refer to first principles to see how tax residency is established and review some of the factors that can impact on residency.

Before continuing it is useful to comment on the position of other types of vehicle. As is well known a corporate fund may not be the most appropriate vehicle for all investors and funds structured as partnerships, typically limited partnerships, may be used. The general UK view of partnerships, established in jurisdictions with similar legal systems, is that they do not have a separate legal identity. A partnership is not therefore taxable in itself. From a UK perspective taxation of a partnership will flow from the residence of the partners and source of the income. Does that mean we do not have to consider any unique offshore issues when looking at a partnership? Unsurprisingly, no. A fund structured as a partnership will want to ensure that tax implications are not created in the UK due to the activities of the manager. Such a fund will want to ensure that it is not carrying on a business in the UK creating UK source profits for the investors. To the extent this business is carried on through the agency of the manager the investors can seek to rely on the IME. In addition a limited partnership will require a general partner with unlimited liability, typically a corporate vehicle. As limited partners do not participate in the management of the partnership it will be necessary to ensure that this company is not UK tax resident. UK tax residency will increase the nexus with the UK in addition to taxing profits earned by this general partner.

Central Management and Control (CMC)

A company will be considered to be resident in the UK when it is UK incorporated. In the absence of UK incorporation there is no legislative guidance as to when a company is resident in the UK. The applicable rules have developed through case law and Inland Revenue practice. The accepted test for determining whether a company is resident in the UK was set down in the De Beers case (De Beers Consolidated Mines v Howe (5 TC 198) where it was stated;

"A company resides, for the purposes of income tax, where its real business is carried on … I regard that as the true rule; and the real business is carried on where the central management and control actually abides."

The UK Inland Revenue have provided some useful guidance (Inland Revenue Statement of Practice 190) as to CMC based on their views of the established case law. CMC represents the highest level of control of a business. A distinction is drawn between CMC and the place where the operations of the business occur. These places may coincide but it is not necessary that they do so.

The Inland Revenue set out a three stage test to determine company residence

  1. … first try to ascertain whether the directors of the company in fact exercise central management and control;
  3. if so, …seek to determine where the directors exercise this central management and control (which is not necessarily where they meet);
  5. in cases where the directors apparently do not exercise central management and control of the company, the Revenue then look to establish where and by whom it is exercised

Tax residency is a question of fact and differing factors may have differing prominence depending on the circumstances. It is difficult to provide a formulaic approach that will fit all circumstances. There are however certain factors which should support the desired conclusion.

Do Directors Exercise CMC?

A common response when managers are queried as to the tax residency of an offshore fund is;

' No need to worry. I have a majority of non-UK resident directors and do not hold my board meetings in the UK.'

Problem solved? While these factors should be present, of themselves they would not be sufficient to establish CMC occurs outside the UK.

It will be necessary to determine which persons actually exercise CMC. The assumption has always been that the highest level control and decision making occurs at the director level and is exercised at meetings of those directors. This is an assumption and if the directors do not exercise the highest level of decision making the composition of the board and place of meeting will not be relevant to tax residency. Tax residency will exist where that highest level decision making occurs.

It is important therefore to first ensure it is the directors at board meetings who are exercising this level of decision making. In a fund scenario it is possible that the Inland Revenue would argue that it is actually the manager that exercises this high level decision making. Some of the factors that should be considered to ensure that such decision making is in the right place include;

  • Giving the directors sufficient power to exercise appropriate decisions. The prospectus should ensure that directors are given sufficient scope to exercise decision making i.e. their powers should not be fettered so that they are simply nominal. There can be a conflict where the manager seeks to preserve certain powers to it through founder shares. If these powers are too broad it could be argued that decisions indicative of CMC are not being taken at board level by the directors.
  • Directors should have sufficient knowledge and experience to carry out their duties as director of the fund. They should also be able to devote sufficient time to carry out their duties. The implication of having sufficient time to dedicate to such duties should be reflected in the remuneration offered to directors. As pointed out above CMC is a question of fact and excessively low remuneration could raise queries with regard to whether it is intended directors will have a full participative role in the company. Can a director who has a full time job and 20 directorships give appropriate time to demonstrate CMC? Perhaps, but it would likely warrant further investigation.
  • When assessing the balance of influence and credibility in the board what is the weighting in favour of members with other roles in the fund structure i.e. managing the fund? If there are two managers and three, for example, corporate directors, friends and family, local lawyers is it the UK mangers that are exercising CMC and not the board? In addition manager board members are likely to be UK resident members.
  • It is important to remember that the directors should have the CMC of the company as their priority. They may have a relationship with the manager and indeed individual managers may be on the board but they should act for the fund not any other parties in carrying out their duties.

Where Do Directors Exercise CMC?

Having determined whether it is in fact the board of directors that exercise CMC it is necessary to ensure the exercise does not occur in the UK. If it is not possible to demonstrate the directors exercise the CMC in a fund scenario the presumption is likely to be that the CMC is being exercised by the managers and unless this can be shown to be outside the UK a problem would arise. So what aresome of the practical considerations when looking at the place of CMC?

  • It may be obvious but do not hold directors meetings in the UK. It would be helpful if this were prohibited in the constitutional documents of the fund.
    A question often arises about the possibility of directors participating by telephone. This has not been reviewed by the courts but it is considered best practice that if participating by telephone directors should not be present in the UK at the time of the call. Additionally it would be helpful if the meetings held with participation by telephone would be in the minority of board meetings held.
    It is important that by holding meetings outside the UK you are not simply shifting a tax issue to another jurisdiction i.e. to a jurisdiction, which has a similar CMC test. Unless a conscious decision is made to demonstrate the place of CMC elsewhere it would be expected that the place of CMC would be in the country of incorporation.
  • Other useful features in the constituting documents would be to require that the chairman is not UK resident and that a quorum could not be formed unless UK residents formed the minority.
  • Minutes should be prepared on a contemporary basis that accurately reflects the discussions and decisions reached. It would be unusual for every board minute to cover exactly the same topics, although certain topics would be standard, and to have reached all decisions in the same way. Minutes for similar but separate offshore companies such as a master and a feeder should be distinct.
  • Board members who also participate in, for example, the management of the fund should be clear and be seen to distinguish between their activities as members of the board and activities as managers.
  • How many board meetings should be held? The answer is as many as is necessary to carry out CMC of the company. If there are unusual or large transactions contemplated it would be expected that the board may meet outside any scheduled meetings.

Corporate Governance

It is interesting to consider, independently of any tax considerations, what would be best practice for directors from a corporate governance viewpoint. This is an area that is likely to become more of an issue with increased regulatory oversight and demands for transparency from investors including Funds of Hedge Funds. It is possible that many of the points considered above would be expected to be present. In the future it may be a case of the tax considerations not representing an imposition on the business but are being fulfilled in any case.

The divergence of the fund and the manager domicile in the current environment is a sensible structuring approach but the manager should not forget the fiscal considerations such a divergence gives rise to. Included among these considerations the tax residence of the fund. The tax residency rules are not difficult to understand. The tension comes in ensuring that they are carefully considered and not over-ridden by operational practices.

For further information and guidance on hedge fund manager issues, visit our website www.rsmi.co.uk/financialservices