It has been difficult not to notice the publicity surrounding the current extensive Inland Revenue (IR) review of the UK hedge fund industry. Rob Mellor sheds light on the review process.
What started as a fact-finding exercise has escalated over the last year as a number of IR investigations have been instigated into UK-based hedge fund managers.
There are at least 3 IR Special Compliance Offices (SCOs) involved in the review of the industry, mainly focusing on the transfer pricing adopted between the UK manager and the offshore investment manager.
Other concerns, and thus potential risks, which have been raised during IR investigations include tax residence, the application of the Investment Management Exemption and the fee structure charged where own money is being managed.
Under Corporate Tax Self Assessment (CTSA), a UK entity is required, where services are provided between entities under common control, to return its taxation results on the basis that the pricing adopted between the parties was at an arm's length rate.
The onus under CTSA is on the taxpayer to demonstrate that best endeavours were used to reach an arm's length price for tax reporting purposes. This shift in evidential onus has meant that taxpayers have to prepare documents to demonstrate that a reasonable effort was made to review the pricing adopted.
Ideally, one would aim to find a Comparable Uncontrolled Price (CUP) to evidence the transfer pricing adopted but reaching an arm's length pricing is an art and not a science - each instance will vary as circumstances differ. Also little true CUP data exists in the hedge fund world.
There are many commercial drivers for the existence of an offshore lead manager, e.g. the development of multi-branch sub-advisory operations over time, the need to oversee local regulatory needs and the attraction of capital/marketing to investors.
However, where an offshore manager exists, it must be demonstrated to the IR that the offshore manager has the substance in place to carry out the functions assigned to it and to justify its share of fees.
The IR have tended to focus on substance in terms of cost base items such as the bearing of expenses, staff costs and office accommodation and have not tended to give due consideration to the existence of intangible items of risk bearing and liability which reside with the lead offshore manager through its contractual relationships.
In practice IR enquiries are often launched by the local tax office of the hedge fund manager. What is not clear is how many of the "local" office enquiries are being "ghosted" by SCO investigation specialists who may well provide advice, draft letters or lists of questions to local inspectors with the intention of taking over the investigation at a later stage.
Do not therefore underestimate the importance of correctly dealing with every local office communication.
Increasingly the IR International Division are taking control of the transfer pricing aspects of IR enquiries, resulting in a great focus on the technical aspects of transfer pricing arguments.
If the IR conclude your transfer pricing is wrong, they will seek an adjustment to the taxable results of the UK company together with late payment interest and possibly penalties (which may equal the tax lost).
Anecdotal comments by the IR suggest that penalties have been applied on transfer pricing adjustments on UK hedge fund managers.
It is also clear that the IR are looking for a test case to take to litigation in order to send a very strong message across the UK hedge fund industry.
All indicators are that activity by taxation authorities in the hedge fund world will continue. Following the recent "spend to save" announcement in the 2003 UK budget, further resources will be directed to reviewing Financial Service activities.
Do not simply wait for the letter of enquiry to arrive, conduct a health check now on your tax risks. Are your transfer pricing documents in place and are they robust? Even if you do not have an offshore manager in your structure, do other areas stand up to challenge? Only pre-emptive action will ensure that should an IR investigation arise, you are well
placed to manage the risks and minimise the senior person time and
cost involved in dealing with such enquiries.
Rob Mellor, PricewaterhouseCoopers, London
Copyright Hedgeweek 2003