The number of hedge funds has seen exponential growth over the last decade. As the market begins to mature, the largest fund managers have become increasingly global, setting up overseas offices in search of new market opportunities which in turn have allowed them to trade in local time zones, research investments in local markets, utilise local knowledge and raise capital from local investors. As well as opening the door to potential planning opportunities, this has often brought hedge fund managers within the scope of local transfer pricing1 tax rules and subjected them to new tax risks and compliance obligations. Transfer pricing is commonly cited as the most important international tax issue facing multinational businesses (including an increasing number of multinational firms in the hedge fund sector) and is one that many businesses struggle to effectively manage.
Why Transfer Pricing Matters
Taxpayers often seek to vary their profit profile in the countries they operate by altering the prices that they charge or pay to related parties, and hence impact where and at what rate they pay their corporate tax. Tax authorities understand the way in which transfer pricing can be used to manage tax rates, and many have recently introduced new or enhanced existing transfer pricing legislation in an attempt to enhance their local tax base, or at the very least, to ensure it is not reduced.
This combination of falling increasingly within local transfer pricing rules and being subject to closer tax authority scrutiny means that transfer pricing is a key issue for hedge fund managers with international operations. Furthermore, in some countries, such as the United Kingdom, transfer pricing is linked to other important tax issues, such as the tax status on the fund. Further, the most popular jurisdictions in which hedge fund managers base their offices have either developed specific transfer pricing legislation with specific transfer pricing related penalties and documentation retention requirements, such as the UK, US and Japan; or have anti-avoidance provisions that can be applied to restrict and penalise any perceived abuse, Hong Kong, Singapore and Switzerland for example.
As hedge fund managers are often associated with high profits and an aggressive approach to tax management, some tax authorities, including the UK, even have specialist teams focusing on the tax affairs of hedge fund managers. In the UK, failures in transfer pricing can even lead to a breach of the customary rate test within the investment manager exemption (“IME”), potentially exposing the income of the offshore fund to UK tax, in addition to raising the tax authority’s vigilance in assessing and imposing penalties due to their perception of egregious transfer pricing arrangements.
Common Transfer Pricing Issues
The key issues that hedge fund managers face in dealing with their transfer pricing include identifying ways in which to correctly remunerate the core areas of their business. This has historically revolved around how to reward distribution and investment management functions:
- Investment management functions have typically been priced on some form of revenue or profit split, calculated as the residual revenue or profit after rewarding the more routine business functions with a mark-up on their costs. This approach has historically been relatively uncontroversial.
- While market practice is to reward the distribution function with 20-25% of the management and performance fee, there has been little direct evidence to support this and tax authorities typically guide against unsupported market averages to support transfer pricing policy. Benchmarking the distribution function directly in the hedge fund context has traditionally been difficult due to the unavailability of third-party benchmarks or lack of internal comparable data. Given these problems of comparability between industries, and recognising that there can be significant tax and/or penalties at stake for most hedge fund managers (or fund managers that have hedge funds), during the course of 2006, PricewaterhouseCoopers LLP undertook research to develop a benchmark for rewarding this function (The Hedge Fund Distribution Benchmarking Report).
The Hedge Fund Distribution Benchmarking Report
The Hedge Fund Distribution Benchmarking Report (‘Benchmarking Report’) took almost a year to complete and is drawn together from detailed interviews with more than 100 hedge fund managers and independent distribution agents across the US, UK, other European nations and Asia. In addition, the Benchmarking Report incorporates reviews of industry publications and publicly available filings of US hedge fund managers.
Further, the Benchmarking Report focuses on the following issues which have direct commercial and transfer pricing relevance to the hedge fund manager:
- How the distribution fee is calculated;
- Different components of the fee;
- The range of functions that agents perform for hedge fund managers;
- Factors influencing the agents’ fee; and
- Duration of the payments made to agents.
Increasingly, these are the very issues that the taxing authorities are focusing on as part of their tax audits.
The Benchmarking Report indicates that hedge funds rely on a number of different sources to raise capital/perform marketing activities. As Figure 1 shows, most hedge funds will have an internal marketing/capital raising function, albeit sometimes used in conjunction with third parties.
Figure 1: Who Provides Marketing/Capital Raising Activities?
Marketers perform a range of different activities; some, such as guiding investors through the due diligence and subscription process, are considered more routine in nature and often take place as much for the benefit of the marketer as for that of the potential investor. Essentially the value of the marketer is the network of investors that they are able to introduce to the hedge fund manager, and convince to contribute to the hedge fund. Although they do perform an ongoing relationship management role, this is usually particularly for the marketer's own benefit. Figure 2 illustrates the activities most often performed by the marketers.
Figure 2: Activities Performed by Respondents ( Third-party Marketers)
The Benchmarking Report also shows that most marketers receive evergreen payments, ie for as long as the investors, which they introduced to the fund, continue to invest. If payments were to discontinue after a number of years, the marketers would no longer have an incentive to encourage "their" network of investors to remain with the fund and may encourage the investors to rather invest in an alternative opportunity which would provide the marketer with an income stream.
Implication of the Report for Hedge Fund Transfer Pricing
Most significantly, the results illustrate, as is commonly found with transfer pricing comparability analysis, that a range of possible compensation levels for the distribution function could be supported, centring on the industry standard of 20% . While the actual compensation rewarded would ultimately depend on the exact functions and/or profiles of a particular distributor (for example, where marketers distribute a new fund for a new manager, fees could exceed 20% of management and performance fee), it can be said that that a price within the industry standard range can be viewed as being more or less appropriate.
While historically it may have been difficult to defend against the relative percentage of management and performance fees hedge fund managers reward their distributors, recently this challenge has become easier with the completion of The Hedge Fund Distribution Benchmarking Report. PricewaterhouseCoopers believes this benchmark is unique in the marketplace and provides a robust basis upon which to either support existing arrangements or to plan new structures.
Despite growing scrutiny from the tax authorities, hedge fund managers are still able to make the most of transfer pricing to manage their effective tax rate. The key value drivers (or to borrow an OECD2 phrase, the key entrepreneurial risk taking (KERT) functions) are the activities of a small number of people performing core portfolio management or distribution functions (in addition to the capital that is put at risk by the fund). As these value drivers are so concentrated in a few personnel it is arguably easier to legitimately tax-optimise a hedge fund business than businesses in a lot of the other financial (and non-financial) sectors. Many hedge funds have already done exactly this by locating a significant portion of their overall functions in more tax-efficient locations such as Cayman, Channel Islands, Ireland, Switzerland or Hong Kong. Although the benefits are obvious, to be successful arrangements of this type must be robustly evidenced and documented, and real value driver functions, assets or risks must be located in the more tax-efficient jurisdictions. The Hedge Fund Benchmarking Report can also be valuable in supporting tax-efficient structuring.
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1Transfer pricing deals with the pricing of goods and services transferred between different parts of an organisation and generally relates to the pricing of transactions between different parts of an organisation based in different countries.
2 The OECD (Organisation for Economic Cooperation and Development) is the source of the arm’s length principle, the central tenet of transfer pricing, which requires that parts of a multinational enterprise set their internal prices with each other as if they were completely unrelated. The OECD is also the source of ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’, which has been adopted by many tax authorities and is considered by many as the most authoritative publication on transfer pricing.