As the hedge fund industry visibly grows and becomes more global, it is becoming increasingly subject to the scrutiny of the forces that affect mature industries. The new Securities and Exchange Commission registration requirement is probably the most visible evidence. Regulatory developments are sure to be followed on the taxing front. With transfer pricing a top concern among tax authorities and taxpayers alike, it is a critical time to consider its impact on the hedge fund industry. Hedge fund managers should also be made aware of the tax planning opportunities that are available to them and the role transfer pricing plays in determining their effective tax rate. Through careful consideration of transfer-pricing principles and international structuring, hedge fund managers may be able to appropriately reduce the effective tax rate of their companies and their partners.
Transfer Pricing and Hedge Funds
Marketing and portfolio management are the two most common intercompany flows. U.S.-based hedge funds may look to expand their investor base outside the U.S. and add a marketing force in, for example, the United Kingdom to reach investors there. Similarly, a hedge fund may place portfolio managers in the U.K. to identify and manage investment opportunities in Europe. Both U.S. and U.K. tax authorities will expect that the activities carried out on their soil will be compensated in a way that two parties acting at arm's length would compensate them.
Transfer Pricing Basics
For many industries, finding evidence of arm's-length pricing for a transaction sufficiently comparable to the intercompany transaction at hand is, at best, difficult. In the absence of suitable comparables, two approaches are warranted. IRS regulations--proposed and final--and Organisation for Economic Co-operation and Development (OECD) guidance propose that getting transfer prices right means finding the link between the profit or loss taxable entity and the underlying activities performed, accompanying risks and assets employed.
Under the guidance, routine functions, such as back office or administrative functions, are distinguished from non-routine functions, such as marketing and portfolio management. Routine functions generally earn a return commensurate with independent firms carrying out the same routine functions. Non-routine functions take a share of the profit or loss, commensurate with their contribution to the profit or loss.
Suppose a U.S. hedge fund manager establishes a U.K. subsidiary to follow developments in Europe and carry out basic research on financial markets. The research is supplied to the hedge fund managers in the United States who act on the information, buying, selling or holding European securities. Because the services rendered by the U.K. firm are routine in nature and are not inherently risky, compensation on a cost-plus basis is most likely appropriate, and should be compensated out of the management fee, not the incentive fee.
Example: Non-routine Services
Suppose instead that the U.K. subsidiary is responsible for managing a portion of the hedge fund's assets. In this instance, the U.K. subsidiary is placing the fund's assets at risk, carrying out not just research but also deciding which assets to hold. Thus, the U.K. subsidiary should partake not only in the management fee--to cover routine costs; e.g., any back-office activities--but also the incentive fee--to compensate it for the high value-adding services and the risks it bears.
One could argue that in years where both sides of the ocean perform well, they could share the incentive fee in proportion to: (a) the portion of assets they manage, (b) the portion of the gain they produce or (c) headcount or relative (base) compensation. The best approach will depend heavily on the particular facts and circumstances at hand.
Of course, if both perform poorly in a given year and the fund shows losses, the hedge fund managers see no incentive fee, and only the management fee is divided among the routine service providers.
The greatest challenge arises when the hedge fund manager in one jurisdiction performs very well, and the manager in the other jurisdiction experiences a loss. If the loss is great enough to wipe out the gains, the fund receives no incentive fee. What is the appropriate compensation for the jurisdiction realizing gains? For the jurisdiction showing losses?
A meaningful answer depends in large part on the facts and circumstances driving the gains and losses. It will be necessary to gain an understanding of where value was created and risks undertaken. For instance, what are the source of the losses and the gains? Did the gainer or the loser outperform the market?
What Can You Do?
U.S. hedge fund managers with significant non-U.S. operations should be prepared to defend their transfer prices.
First, arm's-length pricing is needed. As the examples above illustrate, a thorough functional analysis is central to arriving at arm's-length prices.
The next critical element is an agreement, spelling out the division of responsibilities and risks among the participating locations. When non-routine functions occur in more than one jurisdiction, giving rise to the possibilities of gains or losses in each jurisdiction, the agreement should be very clear on the division of the gains and losses. Under the proposed regulations relating to intercompany services, such contingent-payment contracts are permitted. However, they must meet three main criteria:
1.The arrangement is set forth in a written contract prior to commencement of the services being rendered;
2.The contract states contingencies and the fees associated with the contingencies; and
3.The contract provides for payment that reflects the recipient's benefit.
Under the same proposed regulations, if the taxpayer does not set out an agreement, the IRS may impute one based on its understanding of the economic substance of the transaction. Thus, failing to set out an agreement places the taxpayer in a vulnerable position.
How Does Transfer Pricing Play A Role In A Hedge Fund's Management Company Structure?
Once a manager has established an arm's-length price for its overseas activities, it can then begin to explore alternatives for distributing its profits to its owners in a tax-efficient manner. Opportunities applicable to local country employees and partners are necessarily fact- and jurisdiction-specific, but planning for a U.S. partner's share of a management company's overseas profits may involve deferring the recognition of these profits or reducing the rate at which they are taxed in the U.S.
For example, a U.S. manager that is interested in entering into a deferred compensation plan will want to set a transfer price that appropriately reflects the value of the services performed in the United States. In so doing, the adviser will avoid deferring income that may already have been subjected to foreign taxes. In addition, managers operating in low tax jurisdictions may consider taking advantage of preferential tax rates for certain qualifying dividend income by ensuring that the transfer price for activities performed in those jurisdictions correctly reflects their value.
Finally, U.S. managers that begin operating in foreign jurisdictions should be certain to consider whether a permanent establishment exists and, if so, whether foreign tax credit will be available for any foreign tax burden incurred in those jurisdictions. Critical to this planning will be the filing of a "check the box" election with regard to the foreign management entities to treat them as transparent for U.S. federal income tax purposes. U.S. managers should also be aware that there are many nuances to the U.S. foreign tax credit mechanism, and pitfalls can arise in the context of structuring intercompany transactions.
In summary, documenting a manager's transfer pricing policy is a necessary and important first step in determining its global footprint. With proper planning, a prudent hedge fund manager can then marry that global footprint to its ownership structure in order to reduce the tax burden of its companies and, ultimately, its owners.
Howard Leventhal, co-national Director of Ernst & Young's Asset Management Tax Practice, is a partner in Ernst & Young's Global Hedge Fund Practice and is based in the New York Financial Services Office. Julie Hunt, is a senior manager in Ernst & Young's Transfer Pricing Practice and is based in the New York Financial Services Office. Daniel Farrell, is a senior manager in Ernst & Young's Global Hedge Fund Practice and is currently operating the U.S. Tax desk for the London Financial Services Office.
Contact Bob Keane with questions or comments at firstname.lastname@example.org.