In an increasingly interconnected world, national tax and regulatory laws have not kept pace with global corporations, mobile capital and work forces. This has fuelled a movement by the G20 and Organisation for Economic Co-operation and Development (OECD) to tackle Base Erosion and Profit Shifting (BEPS) under a major action plan. The BEPS project consists of 15 actions which will result in perhaps the most significant changes in international tax rules for a generation. The impact may be significant enough to force hedge fund managers to change the way they do business.
Whilst the aim of the 15 BEPS actions is not to specifically target the hedge fund sector, the latest and expected releases will undoubtedly make an impact on the industry – be that intended or unintended.
In particular, the implications of the latest releases (released in January and March this year) on treaty abuse and Country-by-Country reporting (CbCr) requirements are likely to impact the way in which fund managers function and are structured. Given the potential impact on how businesses operate, now is the time to get involved in the process by contributing to the debate as part of OECD consultations or industry lobbying as the proposals are yet to be finalised. The latest developments and key areas of impact for hedge fund managers are considered below.
Impact: Potential for greater tax leakage eroding investor returns
The treaty abuse discussion document (BEPS Action 6) is drafted to address instances such as ‘treaty shopping’. Treaty shopping is where businesses seek to structure transactions through group entities located in certain legal jurisdictions with a view to benefiting from provisions that reduce exposure to withholding (or other) taxes.
Where these structures will be challenged iswhere the ‘main purpose’ of these structures is tax avoidance, and the relevant legal entity has very limited substance (in effect employees and/or investors). The discussion draft seeks to impose restrictions on entities benefiting from treaty provisions where certain substance requirements are not met.
The discussion draft gives examples where sufficient substance and commercial purpose exists which would mean that the proposed rules would not apply. One such example is where the majority of a fund’s investors are resident in the territory where it is also resident and the investment strategy is not driven by the tax position of its investors. In addition, the fund in question annually distributes almost all of its profits to its investors while itself paying taxes on income not distributed during the year. Whilst the draft recognises that in making its decision to invest in shares of corporations resident elsewhere, the fund would consider the existence of a benefit under the relevant jurisdiction’s tax treaty on dividends and withholding taxes, in such a scenario, this consideration alone would not be sufficient to trigger the application of the proposed anti-abuse rules.
Such stringent examples have alarmed many in the industry and this concern is extended when considering the tools that the OECD is announcing to tackle treaty shopping. Arguably one of the most drastic tools being considered is the inclusion of a specific anti-abuse rule based on the limitation of benefits provision included in treaties concluded by the US and a few other countries which will apply to non-qualified persons (where non-qualified persons are those not resident in the contracting state).
Such a specific rule will address a large number of treaty shopping situations based on the legal nature, ownership in, and general activities of, residents of a contracting state. However, the OECD recognises that the intent of tax treaties is to provide benefits to encourage cross-border investment and, therefore, to determine whether or not the proposed rules apply to an investment, it is necessary to consider the context in which the investment was made. Nonetheless, as it stands the current draft and proposed changes have the potential to remove significant withholding tax benefits available for funds and thereby directly impact returns to investors.
For start-ups, or those considering overseas operations and/or the establishment of new funds, the attractiveness of jurisdictions with good tax treaty networks in the EU such as Luxembourg and Ireland may be reduced in comparison to jurisdictions that have not typically been associated with strong treaty access.
For hedge funds operating as part of a wider traditional asset manager or investment management arm of a major banking institution, the changes to the treaty abuse rules are likely to have an even more significant impact. Specifically the impact will be greatest for those fund managers that trade non-listed Collective Investment Vehicles (CIVs). This is because a non-listed CIV does not explicitly fall within the definition of a regularly traded asset on a recognised stock exchange and is therefore at risk of not being treated as a “qualified person” and thus falling foul of the proposed limitation of benefits clause. The concern of many in the industry is that mutual funds that are not regularly traded face the same challenges as non-listed CIVs and it would seem that any difference in tax treatment between listed and non-listed CIVs for treaty abuse purposes could represent an unnecessary burden for the fund management industry.
Taxable presence (permanent establishment definitional changes)
Impact: Potential to influence distribution and capital raising processes
Whilst the proposed changes to permanent establishments (PEs) (BEPS Action 7) are yet to be announced (the discussion draft will likely be issued in the first half of 2015), a widening of the existing rules can be expected. The concern is how wide these rules will go. Given the perceived abuses that the OECD is endeavouring to address, and the discussions already had around permanent establishments and the digital economy, it is possible that there will be some entitlement to tax for those countries where ‘customers’ are based. A principle such as the “economic agent” concept, where a portfolio manager is seen to bind a fund manager as part of their ordinary business, could be one applied in determining whether a permanent establishment exists. As an example, profits achieved by the fund manager may be partly attributed and taxed where investors are based or approached in jurisdictions where the fund manager doesn’t already recognise a tax presence.
The potential changes will, at a minimum, result in a significant administrative burden for the fund manager. For example, the need to identify where all investors are based which may be complicated when intermediaries or funds of funds are involved, and also the need then to complete tax returns in those jurisdictions. The administrative burden could be significant enough such that it influences how management, distribution and marketing activities are performed by forcing managers to take into account this burden when deciding on marketing channels and investor targeting.
Substance (risks and capital)
Impact: Potential changes to operational management structures and responsibilities
Typically, management structures include both onshore and offshore entities. In deciding how much of the management fee should be attributed between these entities, consideration has historically been given to the functions, risks and assets owned for each business, in accordance with transfer pricing principles.
The proposed changes to transfer pricing (BEPS Action 9) will place greater weight on functions and where people performing those functions are located, and less on assets and assumption of contractual risk. Therefore, for those fund managers who have historically placed significant emphasis on who holds the investment management mandate with the fund to determine profit allocation and for those who have attributed returns for the bearing of contractual risk, it will be necessary either to change the roles or responsibilities of individuals within those legal entities to show that people are actually managing those assets or risks, or to change their transfer pricing policies.
Impact: Increased administration and scrutiny on transfer pricing methodologies
In January 2014, the OECD released its initial draft guidance on transfer pricing documentation and CbCr (BEPS Action 13). The draft was viewed by many as an unrealistic demand for disclosure at a legal entity level and industry lobbying is making an impact as the latest proposals (from the 31 March OECD conference), have been somewhat diluted from the original discussion draft. That said, hedge fund managers still need to brace themselves for increased disclosure requirements of fund manager profits.
As a minimum, and based on tentative OECD conclusions, this will include revenue, pre-tax profit, the amount of taxes (cash) paid, current year tax accruals, number of employees, amount of capital, and value of tangible assets, capital and accumulated earnings for all manager entities.
The impact of the CbCr requirements is to highlight to tax authorities the global results of transfer pricing policies across the full value chain of fund managers in an unprecedented manner.
This disclosure is likely to be used as an audit road map by tax authorities and consideration as to how this risk can be mitigated needs to be given now. Consideration also needs to begiven as to how data will be extracted and reported as well as how tax authorities will perceive it. Where disclosure requirements are likely to raise more questions than answers, a recommendation for either additional narrative explaining the results or upfront dialogue with the relevant tax authority is advised to pre-empt any tax enquires and to be able to address any attention received from non-governmental organisations.
Scrutiny on transfer pricing methodologies
As well as the new reporting requirements, we also anticipate changes to the application of the transfer pricing rules to result in a move away from a one-sided analysis where market or industry prices have historically been used to reward functions such as a capital raising fee. Instead the move towards profit or fee splits which take into consideration the entire value chain of the business are beginning to become much more common. The CbCr requirements will certainly help highlight to even the most inexperienced of tax inspectors where anomalies in the transfer pricing results exist and if a one-sided approach should continue to be applied.
While many of the established fund managers have prepared transfer pricing documentation for some years, the need to do so on an annual basis with updated comparables is unprecedented, particularly for start-up operations and those funds that are not as established. The new requirements will undoubtedly place a heavy compliance burden on many fund managers that will need to be managed appropriately. Given the fluid nature of the hedge fund industry and sometimes rapid fund life cycle and resulting impact on employment, this will often involve preparing documentation for business operations that have morphed into a new existence or ceased completely. A regular and timely functional analysis of the business will ensure that appropriate documentation and supporting analyses are in place for any historic or current fund manager fact pattern.
Neutralisation of the effects of hybrid mismatch arrangements
Impact: For certain fund structures, the hybrid mismatch proposals could result in less efficient recognition of income in the fund vehicles
According to the OECD, hybrid mismatch arrangements (BEPS Action 2) can be used to achieve double non-taxation or long-term tax deferral by, for instance, creating two deductions for one borrowing, generating deductions without corresponding income inclusions, or misusing foreign tax credit and participation exemption regimes. However, the changes to the provisions may not be relevant for many hedge fund structures unless they use special purpose vehicles for investments separate from the main fund vehicles and hybrid instruments are utilised within these structures. Where this is the case, the proposals are likely to bite. In such circumstances, a review of the structure is advised to assess risk exposure and the identification of alternative and commercial as well as tax-palatable financing structures.
EXPECTED FUTURE CHANGES AND FURTHER BUSINESS IMPACT
The OECD is issuing releases from the BEPS project on a regular basis, and whilst the final announcements for some of the actions are not expected until December 2015, many of the outcomes are fairly clear.
So far, the discussion drafts have been released earlier than expected and, given the effective automatic inclusion of the transfer pricing rules in many jurisdictions’ legislation, the new rules will not take years to become effective. If anything, the announcement of the final transfer pricing guidance will apply with immediate effect for many OECD and non-OECD member countries.
The most relevant of the further expected BEPS changes to the hedge fund sector will be on the review of permanent establishments and the review of transfer pricing outcomes with value creation under the spotlight of risks and capital. Both actions have a finalisation date of September 2015 but it is likely that changes will be announced before then. Furthermore, the new CbCr requirements are likely to be effective from September 2015.
The time is therefore right for hedge fund managers to review their structures and assess likely impacts under a BEPS lens. To the extent possible, mitigating action should be taken to address the risks that will arise on finalisation of many of the drafts. Where mitigating actions are not taken, then fund managers should get involved in the debate by either participating in OECD consultations or industry lobbying; particularly to minimise the risk of collateral damage to them, given that many of the BEPS implications that will likely result are arguably a consequence of changes being implemented to address abuses not relevant to this industry.
In a world where regulatory and further tax changes are constantly evolving, the BEPS proposals should be used as a catalyst for reviewing existing structures and intra-group transactions to give investors confidence that tax is being appropriately managed and that fund manager attention is not distracted and remains on investor returns. Not doing so could have a reputational impact and as investor bases become increasingly institutional, reputation becomes an even more critical factor in securing commitments and reducing redemptions.
Greg Martin is KPMG’s UK transfer pricing investment management leader and Shabana Begum is a senior manager in the financial services transfer pricing team. Both have extensive experience in advising on the transfer pricing implications of fund management structures and transactions. The authors would like to thank John Neighbour and Dan Roman for their contributions to the article.