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Hedge Fund Monthly
 
New Tax Developments Affecting Management Fees in Hong Kong
Timothy Loh, Henri Arslanian and Zhao Shuyu
Timothy Loh Solicitors, Hong Kong
July 2010
 

The Hong Kong Inland Revenue Department (IRD) recently issued Departmental Interpretation and Practice Note No. 46 (DIPN 46), which may affect the arrangements used by fund management groups to minimise tax on management fees and performance fees. In this article, we examine the current taxation position and set out defensive steps which fund management groups may take to minimise the risk of tax enforcement.

Background

Hong Kong-based hedge funds are often managed by a fund management group comprising an offshore manager and a Hong Kong sub-manager. Under these arrangements, the fund delegates investment management authority to the offshore manager which, in turn, delegates certain management functions to the Hong Kong manager. The fund will pay management fees and performance fees to the offshore manager and the offshore manager will pay a service fee to the Hong Kong manager. In many cases, the service fee is calculated as the operating costs of the Hong Kong manager plus a mark-up of between 5% and 10%.

The Law

The Inland Revenue Ordinance (IRO) includes both transfer pricing provisions and anti-avoidance provisions.

Transfer Pricing

The IRO, section 20(2) provides that a non-resident person, such as an offshore manager, is deemed to carry on a business in Hong Kong and thus, may be subject to profits tax, if (i) the non-resident person carries on business with a resident person, such as the Hong Kong manager, (ii) the non-resident person and the resident person are closely connected, and (iii) the course of such business is so arranged that it produces to the resident person either no profits which arise in or derive from Hong Kong or less than the ordinary profits which might be expected to arise in or derive from Hong Kong.

Anti-Avoidance

The IRO sets out a number of anti-avoidance provisions. A key anti-avoidance provision is section 61A, which permits the IRD to assess the tax liability of a person in such manner as it considers appropriate to counteract a tax benefit from a transaction (including a scheme or operation) where the sole or dominant purpose of the transaction is to enable the person to obtain such a tax benefit.

Under this anti-avoidance provision, the IRD may seek to tax the Hong Kong manager as if it were the recipient of the management and performance fees instead of the offshore manager.

DIPN 46

Issued on 4 December 2009, DIPN 46 seeks to apply the OECD's Transfer Pricing Guidelines for Multinational Enterprises in Hong Kong, except where they are incompatible with the express provisions of the IRO. DIPN 46 is general in nature and does not specifically discuss the fund management industry. Like all guidance issued by the IRD, it has no force of law and a court may disregard it. Nevertheless, it clarifies the IRD's position on the law relating to transfer pricing and failure to adhere to the IRD's position may increase the risk of tax enforcement action.

Broadly, DIPN 46 requires associated enterprises to operate on an arm's length basis. It requires associated enterprises to charge the same price, royalty and other fee in relation to a controlled transaction as that which would be charged by independent enterprises in an uncontrolled transaction in comparable circumstances. It thus requires the Hong Kong manager to charge the offshore manager the same fee that it would charge an unrelated enterprise.

Tax Enforcement Risk

It is possible that DIPN 46 increases the tax enforcement risk of fund management groups on the basis that the arrangements do not satisfy the arm's length test. To the extent that the sole or dominant purpose of the interposition of the offshore manager is to minimise the profits tax of the fund management group, such tax enforcement action may succeed.

In this regard, the Hong Kong government has historically favoured the development of the fund management industry in Hong Kong and has set out a framework for exempting funds themselves from profits tax to foster the development of the industry. Enforcement action against the fund managers would seem to run counter to this policy. At the same time, DIPN 46 does not specifically focus on the fund management industry and there has not been any apparent and concerted recent tax enforcement activity against fund management groups in particular.

Enforcement policy, however, can change at any time and it is possible that DIPN 46 signals such a change. If found to have engaged in tax avoidance, even in the absence of fraud or wilful intent to evade tax, fund managers may be subject to a fine up to three times the tax that should have been payable.

Defensive Steps

Fund management groups concerned about Hong Kong profits tax liability in respect of their management and performance fees should consider seeking tax advice.

In this regard, the anti-avoidance provisions of the IRO depend upon proof of the sole or dominant purpose of a transaction. While legitimate tax advice would not advise any taxpayer to engage in an illegal course of conduct to the extent that the disclosure to the IRD of any legitimate tax advice may facilitate a finding that the sole or dominant purpose of a transaction is to obtain a tax benefit, it may be beneficial to obtain tax advice from legal counsel.

Communications between legal counsel and client are subject to legal professional privilege and hence, the IRD cannot compel disclosure.

Transfer Pricing Documentation

Fund management groups should consider engaging a tax adviser to prepare transfer pricing documentation. Such documentation provides a basis for determining whether arrangements between an offshore manager and a Hong Kong manager are on arm's length terms and for identifying the purpose of the arrangements.

Among other things, such documentation provides written evidence of services rendered by each of the offshore manager and the Hong Kong manager, the terms and conditions of the arrangements between the offshore manager and the Hong Kong manager, a survey of comparable arrangements and the factors that led to the adoption of a particular pricing methodology. Such documentation must, of course, not only recognise tax concerns but also regulatory concerns.

Pricing Methodology

Fund management groups should carefully consider the method by which the fees between the offshore manager and the Hong Kong manager are determined.

The method should best reflect the fees which would be payable in an arm's length arrangement. Possible methods include the comparable uncontrolled price method, the cost plus method or the profit split method.

Activities of Offshore Manager

Fund management groups should consider carefully the role to be played by the offshore manager and transfer pricing documentation should fully support the role played by the offshore manager. Where the offshore manager does not carry out substantial activity, the Hong Kong manager performs all the activities in Hong Kong which, in substance, give rise to profits and the commercial justification for the offshore manager is not apparent, there is a greater risk not only of tax enforcement but also of a finding that the sole or dominant purpose of the interposition of the offshore manager is to obtain a tax benefit.

Conclusion

In light of DIPN 46, fund management groups which comprise managers in Hong Kong and an offshore tax haven jurisdiction may wish to consider whether the arrangements between the Hong Kong manager and the offshore manager are likely to be the subject of scrutiny by the IRD and if so, whether they would survive such scrutiny.

 

 

 

This article first appeared in AIMA Journal (Pg 17, Q2 2010 issue). For more details, please visit www.aima.org.

 

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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