UK Hedge Fund Managers

Exposure to UK Tax liabilities of offshore funds

ASHLEY KING-CHRISTOPHER, WITHERS LLP
Originally published in the March 2007 issue

The Limited Liability Partnership is now the most popular manager vehicle of choice for UK-based hedge fund managers. The aim of this article is to consider whether this manager vehicle remains attractive in a fast-moving UK hedge fund manager tax environment, in view of the increasing and relentless scrutiny of hedge fund managers by the UK HM Revenue & Customs. The increasing focus by the HMRC on the tax affairs of UK-based managers is ongoing. In addition, the key Statement of Practice (SoP) in relation to the Investment Manager Exemption (IME) legislation (currently in draft) is yet to be finalised by HMRC.

These recent developments provide an opportunity for UK-based managers to reconsider which is the most beneficial manager structure going forwards. The personal tax risk profiles of the key UK resident hedge fund LLP managers (Principals) should also be reviewed. In particular, key non-UK domiciled Principals should make sure that their cross-border manager structure retains the maximum benefit permissible under current UK tax law, without necessarily increasing their UK tax risk profile in relation to their cross-border fee income.

  1. Background

    As mentioned above, LLP’s are now by far the most popular UK management vehicle of choice for UK-based hedge fund managers, especially where there is no prospect of an IPO in the near future and where the ownership reward incentive of a partnership structure is key to recruiting and retaining key trading talent. The increasing scrutiny by HMRC of LLP hedge fund managers is perhaps not entirely surprising given the statement by Lord McIntosh of Haringey where he noted in his House of Lords’ Report on LLP’s at Stage 6 in March 2002 that:”We have become aware, however, that taxing LLP’s as partnerships might mean that there is scope for them to have alternative uses, for which they were not intended, where the primary or only attraction might be their tax status.” Whilst there may be many sound commercial reasons for utilising an LLP as the UK manager vehicle, it should also be noted that the original LLP legislation was primarily targeted at businesses organised as large professional partnerships. The original thinking behind the LLP proposal was that only members of a regulated profession should be able to form an LLP.

  2. LLP Manager Vehicle – Clear Commercial Rationale

    Undoubtedly, the LLP’s commercial flexibility is very compelling from a motivational and retention perspective, as opposed to forming a UK limited liability company as the UK manager vehicle (Managerco). It should be remembered that Goldman Sachs itself began life as a partnership in the 19th Century and only converted to a corporate form relatively recently in order to list and to more efficiently access the public markets. The limited liability partnership structure fits well with many traders and their vision of creating a nimble and flexible boutique manager vehicle, where the Principals are also direct owners of the underlying trading business and its goodwill. The UK LLP’s characteristics are also familiar to US Principals who relocate to the UK given its similarities to US manager vehicle structures.

  3. The Rise of LLP Managers & Increasing Tax Risks

    In considering the relatively short history of UK LLP managers of hedge funds, it should be noted that the recent trend to convert many existing UK Managercos to LLP’s iscoming to an end; however, in the LLP conversion heyday, the prospect of HMRC re-drafting its IME SoP was not on the horizon. In addition, the prospect of HMRC even contemplating taxing the offshore fund(s) clients, previously seemingly sacrosanct, did not feature on the tax audit checklist as much as it does now. The recent article in the Financial Times (FTfm supplement – 12 February 2007) provides an insight into HMRC’s current attitude on this key Principal and fund tax exposure point. The article states that whilst HMRC has no more intention of using its powers to tax offshore funds than in the past, and to date has not taxed any offshore fund, it goes on to state:”It is possible we would in the future, but that is not dependant on the statement of practice, it is to do with people being co-operative…”Consequently, we are currently in a very fluid and increasingly risky hedge fund manager tax compliance environment which is still playing out. In certain circumstances, this may now involve the assessment of a UK-based manager for the tax of its offshore fund clients in relation to the latter’s UK source trading profits.

    As can be seen the UK Principal tax compliance environment is increasingly uncertain and risky; alarmingly it may now involve the assessment of a UK-based manager vehicle where it constitutes the ‘UK Representative’ of the offshore fund (in relation to its UK trading profits), in circumstances where the IME protection does not apply. It is this ‘nuclear’ scenario that should be personally protected against by UK based Principals.

  4. Offshore funds UK Profits – Assessment of LLP Principals

    The UK tax regime treats trading LLP’s both for corporation and income tax purposes as tax -transparent, on the basis that the members of the LLP carry on its business. In other words, all the trading activities of the hedge fund manager LLP are treated for tax purposes as carried on by its members (partners) and not by the LLP as such. For self-assessment purposes, HMRC may, in certain circumstances, personally pursue the individual members (Principals) of the LLP (whether UK resident or non-UK resident) directly for any of its UK tax liabilities . The latter includes its tax liabilities in its capacity as the ‘UK Representative’ of any offshore trading fund under Finance Acts 1995 and/or 2003 where the IME does not apply to prevent any assessment.

    Consequently, where the LLP manager vehicle does not qualify for IME protection, HMRC has authority to assess the individual members of the LLP directly on behalf of the offshore funds they manage (in relation to their UK source trading profits not covered by the IME protection). It is this key ‘Armageddon’ risk scenario that should minimised in any way possible.

    Contrast the above LLP Principal/manager personal tax exposure with one where the UK manager is constituted as a simple UK limited liability company or Managerco and not as an LLP. As the Managerco is a separate entity for assessment purposes, unlike the LLP, HMRC only has the power to assess the Managerco and not its individual owners on behalf of its offshore fund clients. (Generally, the tax liabilities of Managercos do not flow through to its shareholders or employees personally). Please note that is it is generally possible to tax-efficiently convert from an LLP to a UK limited company with minimal immediate tax costs. This should now be considered by those UK LLP managers where Principals risk being assessed personally because there is now some uncertainty in relation to the protection of the IME under the new draft SoP.

  5. Conclusion

    As discussed above, the consequences of HMRC ever personally assessing a UK LLP Principal manager, on behalf of any offshore fund client(s), on the basis that the taxpayer was being ‘unco-operative’ would be disastrous. One way of preventing such an assessment being visited personally on any LLP Principal is to utilise a UK limited liability company as the UK manager and therefore assessable entity and not an LLP. This tax efficient restructuring option should now be considered by those LLP Principals who have any doubt as to the availability of the full protection of the IME under the finalised draft of the SoP. In particular, UK resident LLP Principals of US-based hedge fund manager groups should be indemnified or insured personally in relation to any such UK personal tax risk (as discussed above) by their US based manager group.