Hedge Funds – Are They Investment Banks of the Future?

Convergence of activity between hedge funds and investment banks poses a challenge for tax authorities. The authorities are seeking to prevent investment bank-type activities from moving outside the tax net without discouraging the asset management industry.

The last few years have seen an increasing convergence of activity between Europe’s hedge funds and investment banks, or put another way hedge funds are moving into the banking arena. Faced with a shortage of suitable investment opportunities in the more conventional investment strategies, they have moved into areas such as debt factoring, primary lending, derivatives trading and M&A activity, traditionally the realm of the investment banks.

This has served to highlight key tax differences between investment banks and hedge funds. Investment banks are normally located in high tax jurisdictions paying tax on their “capital” profits. Conversely hedge funds are usually located in tax havens and benefit from policy decisions in the jurisdictions where the investment advisors are located, exempting the funds from tax on gains that may be attributable to their advisors’ activities, or in other words accepting the non-taxation of offshore unrelated capital.

Distinguishing between asset managers and financial traders in this way was relatively straight forward while hedge funds were pursuing strategies which could be viewed as more passive than the active trading undertaken by an investment bank. However, the increasing convergence of strategies makes this distinction ever more difficult for tax authorities, particularly given the recent large breakouts from investment banks involving large groups of individuals, setting up in multiple countries, with substantial assets under management from day one.

The challenge for tax authorities is how they deal with the threat of profits moving out of the tax net without discouraging the asset management industry. One way they already have in mind is to use transfer pricing to ensure that if funds remain outside the tax net, the profits which relate to the onshore management activity are maximised. The current proposition that profit follows the key entrepreneurial risk takers ensures that going forward the tax authorities will police this aggressively.

Convergence of activities between hedge funds and investment banks is also giving rise to difficulties for the Inland Revenue and fund managers in terms of the policy of not taxing, through the safe harbour of the UK’s investment manager exemption, offshore unrelated capital. Europe’s hedge fund managers have chosen to locate themselves in the UK partly because of this exemption, yet many new more exotic strategies do not easily fit within the tax definition of investment transactions that goes back to the 1980s. If an offshore fund undertakes transactions which do not qualify as investment transactions then it risks bringing all of the fund’s profits into charge to UK tax.

Such uncertainty offers the UK government an opportunity to review its policy in the light of hedge fund managers’ new strategies. While historically the investment manager exemption has been seen as a set of safe harbour rules designed to protect the UK fund management industry, going forward it is likely to be used by the UK Revenue to police the dividing line between investment banks and hedge funds if, as everyone expects, their activities continue to converge.