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?
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