2006 Q4 research1 indicated that assets under management in the hedge fund sector were around $2.5 trillion2, a rise of over 16%3, since Q1 2006, of which 38% ($945.5bn) was in sectors that are likely to result in reclaimable taxes. This means that hedge funds are entitled to annual estimated tax reclaims of over $3bn, which, with statutes of limitation, compounds to an extant tax entitlement for the hedge fund sector of $15bn – with an upward trend of 16% a year4.
So, it may come as a bit of a surprise to learn that of this $15bn, it is estimated that less than 7% is ever likely to be recovered. This leads to two questions – why, and what do we do about it?
Why does the problem exist? When dividend or coupon payments are distributed to non-resident investors, tax is usually deducted and withheld at the 'statutory' rate for the country of issue concerned, even though the hedge fund, or its underlying partners, may be entitled to be taxed at a lower rate under very common international double tax agreements (DTAs).
The problem is that (i) the hedge fund manager doesn't know enough about withholding tax to optimise the position in advance by having a tax relief at source plan, (ii) even with such a plan, in many countries, neither the issuer, the paying agent nor the tax authority has any advance knowledge or process to know of the hedge funds' or the partner's entitlement to the lower rate of tax and in some cases total exemption and (iii) the prime broker generally has neither the expertise nor access to the underlying partner data to be able to provide a service to the hedge funds. At the income level for instance that can mean the difference between being taxed at 35% (Switzerland) or 30% (USA) as opposed to 15% or even 0% under the treaties.
Issues unique to hedge funds
Apart from a generalised lack of awareness of the issue, hedge funds also face issues that are unique to their structure and business model as investment vehicles. These can be summarised as: residency, status, structure and fiscal transparency. Residency relates to both the tax residency of the fund and also, in many cases to the tax residency of the partners in the fund also. It is one of the two basic elements forming the basis of any claim for entitlement to a foreign tax authority. Status refers to the legal form of the fund either as a partnership, typical in the US, or as an open ended collective investment vehicle (OECIV) more typical in Europe. Structure has to do with the relationships within the fund structure itself, but also to the relationship between the fund and its prime brokers. Finally, fiscal transparency is determined on a market by market basis by the tax authorities and establishes whether it's the fund that has an entitlement to claim or whether it's the underlying partners.
The difficulty for fund managers with all this often lies in the fact that each of these factors can, and all too often do, interact with the others to create what appears to be a complex almost insoluble problem at best and a misleading myth at worst – either of which can lead to a failure to attempt to recover tax entitlements. Let's look at a couple of examples.
Who can claim?
One of the most common myths for example is that offshore resident hedge funds, Cayman for instance, are not entitled to reclaim tax. It is not that this statement is not true, it is just an incomplete and thus potentially misleading statement. Inability to claim for this fund would depend on its structure. If, for example it were part of a master/feeder structure and the feeder were onshore, then there may be an opportunity to reclaim for the underlying partners via the onshore vehicle.
Another, to take the other side of the pond, is that European hedge funds organised as OECIVs under UCITS III regulations also cannot file reclaims. Again, not a complete statement. The basis of the myth is that UCITS III funds trip over a 'Limitation of Benefits' or 'LOB' clause in the treaties between the US and other countries. This can indeed be the case, but the LOB clauses are not ubiquitous in all treaties, so while US sourced income will sometimes fall foul of the LOB clause, income from other markets into such a fund may not suffer the same problem.
The hedge fund space is littered with such myths and the answer to whether any particular hedge fund can reclaim tax is always, without fail – 'it depends.' Knowledge and more importantly, practical experience of withholding tax is vital to improving performance and avoiding risk. So it is important that hedge fund managers make sure they have a tax optimisation plan in place with someone who has direct experience in their investment markets.
I mentioned earlier that prime brokers tend not to offer reclaim services directly. This is partly because of the specialisation required and the cost, but also because in many cases reclaim entitlements are not at the fund level but at the underlying beneficial owner level where a market has determined that the fund is fiscally transparent.
Prime brokers never see this underlying information. So, even if they could offer such services directly, they would not be able to get at the data necessary to file reclaims. Prime brokers therefore, while the first port of call for the hedge fund manager, usually refer hedge funds to a specialist in the area who can calculate and file reclaims for the funds or their partners without breaching confidentiality.
So, historically this combination of complexity and myth has meant that it has been easy to ignore or believe, falsely as it happens, that the administrative cost of reclaiming tax is higher than the ultimate benefit in tax recovered. However, increasingly volatile returns means that any performance improvement, which is after all an actual entitlement of the fund not a privilege, must be pursued. Increasing regulatory pressure for transparency in reporting will make those fund managers who are not pursuing tax reclaims more visible both to the market and to investors. Investors themselves are clearly taking a more active interest in optimising their returns and as a result are becoming more educated on the issues. From what could previously be avoided as 'not material,' the balance has tipped with a vengeance. There are already class actions companies taking an interest in the withholding tax area.
The picture is not, happily, all that black. Yes, there are certainly recoverable funds out there; yes, it is complex; no, complexity can no longer be a valid reason for inaction and yes, continued inaction could conceivably lead to liability. All that aside, those $3bn in tax reclaims annually are the rightful entitlements of the investors and their funds and it is in everyone's interests to do everything possible to put them in the right place.