Striking a Balance Over Hedge Fund Taxation

Striking a balance over hedge fund taxation

ROBERT MELLOR, PRICEWATERHOUSE COOPERS LLP

UK tax authorities are seeking to accommodate some of the newer hedge fund strategies within the UK's investment management "safe harbour" provisions. Considering London's position as Europe's hedge fund centre, this has important implications.

Reacting to the hedge fund industry's evolution to include increasingly complex strategies, HM Revenue & Customs (HMRC) issued a draft statement of practice in late October 2006 to clarify the tax treatment of offshore hedge funds, advised from the UK. Close reading reveals that HMRC is not seeking to catch hedge funds as a whole in the UK tax net. However some with newer 'trading' strategies may well have to think very carefully as to how they organise themselves or risk potentially having the fund's profits subjected to UK tax.

The degree of certainty provided by the UK Investment Manager Exemption (IME) has been an important factor in the growth of London's hedge fund industry. It has provided a framework whereby the capital profits of non-UK investors from assets managed by UK based asset managers fall outside of the UK's tax net.

It is clear from the draft statement that HMRC wants to strike a balance. While keen to support the continued development of the wider asset management industry, it wants to ensure a level playing field exists between offshore funds and onshore operations carrying on similar activities. The draft statement of practice makes it clear that some strategies, such as those trading in commodities or land, will not enjoy the IME's protection although consideration is still being given to the exact status of carbon credit certificates. But the draft also provides greater clarity in some newer areas, such as loan origination or debt syndication which HMRC has now accepted fall within the IME.

The key distinction to be drawn in this area is that the capital yield on the passive holding of debt instruments is intended to be protected by the IME whilst fee based returns from non-investment activities, such as arranging the syndication of a loan, will fall to be taxable in the UK. However, there are still areas of uncertainty in this area. What is meant by 'passive' and are some fees to be treated as part of the capital return (for example a commitment fee) whilst other fees will have the character of an activity based reward to be taxed in the UK?

There is still a major open issue around non-commodity financial instruments which include the capacity to be non-cash settled. It is not clear what policy objective is served by HMRC taking a stance that Credit Default Swaps (CDS) which can be settled by receipt of the underlying defaulting bond, are not a permitted transaction for IME purposes.

Consultation process

In order to clarify uncertainty over the IME, the Alternative Investment Management Association's tax committee entered into informal consultation with The Treasury and HMRC at the end of 2005. During this process HMRC invested considerable time in seeking to understand the issues facing the industry. This led to the draft statement of practice, now subject to industry consultation prior to the HMRC issuing a formal statement, expected in March 2007. This will replace Statement of Practice 101, issued in 2001, which has provided guidance on application of the IME over the past five years.

Importantly, the draft document retains the differentiation between trading and investing. The point is made that active investment of a portfolio of investments may not constitute trading. Therefore the question for fund managers operating in areas such as commodities is: "What should I do to ensure the fund I manage is not trading?"

Another key amendment eases the position of US hedge fund managers seeking to establish UK operations. HMRC has accepted that profit allocations paid by funds structured as partnerships or limited liability companies can be treated as fees for the purposes of the 20% test. Absent this amendment, any connected party money invested in the fund, is likely to result in a breach of the 20% test.

HMRC also acknowledges that the current test for UK investment advisers, regarding the permanent establishment of a fund conducting non-investment transactions may be harsh. As currently drafted this is a 'cliff edge' test. Whilst HMRC is considering whether some form of proportionality could be adopted, to do so would require legislative change, a process which cannot be achieved within the current Statement of Practice consultation exercise. So, for now, this issue remains a major concern for asset managers as, potentially, an inadvertent breach of the IME could impact the profits of the whole fund. Managers will need to build solutions in respect of this risk into both their structures and their operational framework.

Transfer pricing and independent agent

But consultation is not without risks. This is exemplified in the redrafting of the customary rate test regarding the passing fees from offshore fund to onshore investment adviser. HMRC has taken the opportunity to set out its view that the 'customary rate' test within the IME is aligned with the Organisation for Economic Co-operation and Development's (OECD) arms length principal of transfer pricing. While this may seem more onerous than the previous test, the reality is that HMRC has been seeking to apply these principles in relation to asset managers for the last few years. It also accords with HMRC's desire for a level playing field.

The proposed amendments to the independent agent test remove the certainty provided by the current Statement of Practice. In this case HMRC has removed the five structural tests and replaced them with a test modelled on the OECD guidelines. Consequently it is now necessary to consider all the circumstances to conclude on balance whether or not the UK investment adviser is an agent of independent status.

Whilst HMRC has indicated that it does not see this as more onerous, and would not expect it to cause difficulties, the removal of the certainty provided by the current wording will give rise to problems when drafting fund prospectuses, particularly for managers who advise a single corporate fund where the position under the proposed drafting is far from clear.

Clearance procedures

One area where HMRC is particularly keen to receive comments is whether the legislation should include a clearance procedure. At present opinions seem to be divided on this point. On one hand this could be seen as giving certainty to investors. Conversely any clearance is dependent upon the facts disclosed in the clearance application. Therefore, in an industry which changes rapidly, there must be a question mark over the value of any clearance given. Further, HMRC has a concern that if a clearance procedure exists a fund manager launching a new fund will feel compelled to submit a clearance application irrespective of whether one is required. This would, in their view, not be a good use of limited resources.

An alternative to a formal clearance procedure is to have an ongoing dialogue with HMRC, for example on a quarterly basis, to apprise them of current developments particularly in relation to investment strategy. This would enable them to publish general guidance on new strategies through publications such as the Tax Bulletin.

Conclusion

Overall the draft statement's contents are to be welcomed, particularly because it is hoped that some of the remaining areas of uncertainty, particularly around the "independence test" will be removed following the consultation process.

Robert Mellor is a partner at Pricewaterhouse Coopers LLP and Debbie Payne is a senior manage at PricewaterhouseCoopers LLP