War and Peace?

Taking a look at HMRC investigations

FIONA SHEFFIELD, ANDREW HINSLEY AND DAVID JOHNSTON, ERNST & YOUNG

Many hedge fund managers may have been involved in tax planning of one sort or another and for many the introduction will have begun during their time as employees of the investment banks.

Presently, many managers are likely to be feeling a sense of frustration at HMRC’s frequent requests for information. Others may have heard little or nothing: should they be concerned that this is the calm before the storm? This article explores the change of approach adopted by HMRC and what managers should do about it and how it should influence their future behaviour.

At the start of the new millennium, the tax world was a very different place. The risk involved in tax planning was relatively low. Frequently, it was not challenged and if it was, the well advised taxpayer was typically able to achieve a favourable financial settlement. However, following the merger of the Inland Revenue with Customs & Excise in 2004 to form Her Majesty’s Customs & Revenue (HMRC) the environment changed dramatically. The changes have been on three fronts: legislation; strategic approach; and working methods.

Changes to legislation
2004 saw the introduction of tax disclosure rules, which compelled advisers to disclose certain tax planning arrangements to HMRC as soon as they were made available to a client. This has enabled HMRC to counter schemes with new legislation much more quickly than before and has facilitated more intensive and better coordinated enquiries through central oversight.

Strategic approach
2006 marked the start of what is now a firmly embedded risk based approach to HMRC’s efforts to tackle what it perceives to be non-compliance. This entails HMRC targeting its resources to where they perceive the greatest risk, or in asset management terms, where they will get the greatest return on their investment.

In 2007 HMRC introduced the Litigation and Settlement Strategy (LSS) essentially to change behaviours by trying to increase the downside of entering into tax planning. The key aims of the LSS from HMRC’s perspective are as follows:

– Deal with each dispute on its own merits – i.e. “Do not enter into package deals”
– Settle all or nothing issues on all or nothing terms
– Where HMRC has a strong case seek full value from any settlement, or take the matter to litigation
– Drop cases where HMRC is not prepared to litigate.

Operational changes
The disclosure regime and the strategic focus of resourcing to risk has brought significant changes to how your affairs will be dealt with if you undertake certain forms of planning.

All disclosed schemes are handled by a specialist department called the Anti-Avoidance Group (AAG). The AAG allocates a scheme reference number to the advisor and this must be disclosed on the tax return of each client availing themselves of the planning. Disclosed schemes must be notified by the local office to AAG. In conjunction with the Solicitor’s Office, the AAG has overall responsibility for enquiries involving avoidance arrangements.

Arrangements typically found in planning for hedge fund managers will be dealt with by specialised teams. Examples include:

• employee benefit trust arrangements;
• the use of options; and
• specialised trust arrangements.

The inspector responsible for the day to day working of the enquiry liaises with the AAG which directs the course of the investigation including what information to request, what arguments to present and how to present them.

The discretion of local offices and even the Specialist Investigations Office, which in the past resolved planning issues, has essentially been eliminated.

In monitoring cases centrally, HMRC is not only looking to apply consistency, but also to identify what it regards as the weakest case, in order that this may be litigated first. Actions which can ultimately impact your case are being taken behind the scenes, so it is not a case of no news is good news.

It is HMRC’s expectation that where this results in successful litigation others involved in essentially the same arrangement will fold.

Also, HMRC has also been steadily building its transfer pricing capability over the last 18 months. The fact that a transfer pricing review has not been undertaken to date provides little comfort given the ease with which HMRC can reopen earlier years and make transfer pricing adjustments to collect tax should it discover an issue in later years.

The future
So in light of these new challenges, how should the hedge fund manager and their advisers respond?

Firstly, do not panic. It is important not to feel pressured into conceding ground to HMRC simply because they are threatening litigation. It may well be that should HMRC pick the weakest scheme to litigate, yours may be readily distinguishable even if HMRC were to be successful.

Also as pressure grows on H M Treasury’s finances, pressure is similarly likely to grow on HMRC to negotiate in cases perceived to be less questionable. In this respect, managers may wish to take soundings as to where they are likely to sit on this scale, and how this might influence their tactics.

Secondly, it is not all bad news. The risk-based approach means that enquiries into what is perceived as ‘contentious’ tax planning should be settled more quickly.

In terms of approach to future planning and compliance, there are two important considerations.

First, in relation to planning, if you undertake more complex forms of tax planning which HMRC questions you are unlikely to be rated low risk overall. HMRC will challenge the planning rigorously and may litigate the arrangement. This is not to say that such planning should not be undertaken as it may be a risk worth taking but not without a proper risk/reward evaluation. If the decision is taken to go ahead, implementation must be meticulous. Implementation failure, as opposed to the relative technical merits, is very often the source of a successful HMRC challenge. Clever planning badly implemented is likely to be a fruitless exercise. However, not all planning will be actively challenged by HMRC. It is possible to undertake planning which achieves tax benefits (often in combination with commercial benefits) without threatening a low risk status.

Second, in relation to compliance, HMRC has advised that those companies that are not able to demonstrate good compliance will be subject to detailed enquiries and possibly subject to penalties. For hedge fund managers the key risk is around their offshore activities and related transfer pricing issues. This is likely to become an increasing area of focus for the tax authorities in future.

It would be naïve to enter into certain tax scenarios at the expense of failing to meet due obligations and tax compliance. Any organisation that fails to get its compliance affairs in order is asking for trouble from HMRC under the new regime.

Robust implementation, effective compliance and proactive enquiry management should mean you are ready for war but on the road to peace.

Fiona Sheffield is a partner, Andrew Hinsley is a director and David Johnston is a senior manager in the Ernst & Young hedge funds tax practice