For asset managers including managers of Alternative Investment Funds ("AIFs") the Base Erosion and Profit Shifting project ("BEPS") is a particular issue. Many outcomes will likely affect this industry, but those regarding permanent establishments ("PE"), tax treaty shopping and transfer pricing deserve immediate attention.
The Multilateral Instrument ("MLI"), designed to affect many of the tax treaty based BEPS changes, was adopted on 24 November 2016 and signed by representatives of approximately 70 governments in June 2017. The operation of the MLI is rather complex, due to two key factors: it is to achieve its objective by forming a layer over existing bilateral tax treaties and allows broad optionality for governments. Upon signature of the MLI, each signatory government was requested to submit its ‘MLI Positions’ inter alia listing Covered Tax Agreements (existing bilateral tax treaties to be modified by the MLI), choices of options and reservations. These MLI Positions may be changed during the ratification processes. Once the MLI takes effect, the interpretation of bilateral tax treaties will become an elaborate exercise: MLI Positions, options and reservations taken by respective treaty partners will have to be analysed to assess how the MLI modifies (or not) a single bilateral tax treaty. For example, the MLI will only apply to modify a bilateral tax treaty if both treaty partners have listed that specific tax treaty in their respective MLI Positions document; a relevant MLI provision will not apply if any of those two partners has made a respective reservation. It is expected HMRC will publish consolidated versions of UK bilateral tax treaties, as modified by the MLI, while other countries (eg Australia) are not proposing to do this. The first modifications by the MLI are expected to become operative in the course of 2018; the timeline is dependent on the ratification processes of the signatory governments.
The 2017 update of the OECD model tax treaty, along with updated commentary, was released in July 2017. This will bring to life the balance of tax treaty based BEPS changes.
Key issues arising for asset managers
PE is the threshold for the chargeability of a business to tax overseas. To avoid overseas PEs and tax exposure arising from overseas business activities, management staff of AIFs and asset managers have long relied on what is termed the dependent agent exemption. Under this exemption, no overseas PE arose unless an agent was concluding contracts in an overseas jurisdiction for the home enterprise. The new threshold is an agent who, while overseas, ‘habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification’. This ‘agent’ could be a fund manager working on finding, negotiating or closing an overseas deal; or the client relationship manager of a bank visiting clients and developing overseas business. Various examples given by the OECD materials explain that mere active promotion is not harmful, but active overseas business development where new clients subsequently agree to standard or pre-agreed contracts/pricing etc with head office will result in an overseas PE.
Importantly, many European and other tax regimes do not distinguish between revenue and capital (trading and investing). Therefore, an overseas PE can arise even if overseas activities are related to investment (rather than trading) by an AIF.
Asset managers will need to consider making changes to how they employ staff and agents overseas. The relevant action items are:
- In light of new PE risks, review existing operations and protocols and consider how those now require modification. Particular focus is required for guidelines regarding overseas negotiation and authorisation of contracts and decision-making protocols, and their implementation by operating staff.
- Review and map out existing overseas marketing, fund raising, deal sourcing etc activities and related staff to identify new PE risks.
- If a new PE risk materialises, appropriate profit allocation to that new PE is required along updated transfer pricing principles, inter alia to avoid any potential double taxation.
Several countries, such as the UK, have decided not to implement this new PE standard by way of including a reservation in their MLI Positions document. Therefore, the MLI Positions and local rules of various overseas jurisdictions will have to be carefully considered as part of the above PE risk assessment exercise.
Access to treaty benefits
Access to tax treaty benefits for investment structures is now more difficult. Benefits will only be available if relevant new treaty tests are satisfied by a taxpayer: the principal purpose test ("PPT") and/or limitation on benefits test ("LOB"). The relevant test for most of Europe is the PPT; treaty benefits (for example exemption from, or reduction of, withholding tax) will not be available if the obtaining of that benefit was one of the principal purposes of a structure or arrangement.
The OECD materials offer various options to governments to address treaty entitlement of regulated (non-alternative) fund structures, ranging from listing in bilateral tax treaties those fund forms that should have treaty eligibility, to requiring funds to due diligence their investor base quarterly.
For the alternative fund sector, the above PPT rules apply, and three examples are given. The theme emerging from the various examples appears to be that taking into account the existence of a favourable tax treaty when creating a structure is not harmful, as long as there are other non-tax drivers for choosing a location, such as legal and regulatory framework, skilled workforce, investor familiarity, substantive activities at an eg regional platform etc. A new way of thinking will be required when drawing up structures!
The last of the three examples reflects a classic real estate fund structure involving a fund, master holding platform and individual investment holding companies. Helpfully the commentary suggests these structures may be able to pass the newly elevated treaty access hurdle, but the devil will be in the detail.
Asset managers must now:
- Review the substance of any entities in their existing structures availing themselves of tax treaty benefits, to assess whether any additional substance is required for continued benefit from tax treaties. Reviewing existing financing arrangements (at fund investor and asset level) will be part of this work, as many countries have now introduced rules along the BEPS interest relief restriction and hybrid mismatch recommendations.
- Consider, in light of the new guidance and examples given, if any previously employed structures can be recycled or sufficiently improved for new investments.
- Review alternative options when devising new investment structures. For example, consider whether reliance on domestic, rather than tax treaty based, exemptions is an option, or whether there are any structures available with government-blessed preferential tax treatment, such as securitisation vehicles or REITs.
- A cost benefit analysis will be mandatory in each case.
Mounting pressure for transparency is the relevant theme arising from transfer pricing BEPS initiatives for the asset management sector.
Management companies and in some cases funds will be required to provide detailed information enabling tax authorities to conduct transfer pricing risk assessments and enquiries. The threshold for this sort of country-by-country ("CbC") reporting and filing requirement is annual consolidated group revenue of €750m or more. The UK rules on CbC reporting capture multinational groups whose ultimate parent entities are partnerships governed under laws in the UK, including LLPs. The regulations will require the reporting partner of such partnerships to ensure compliance.
Seperatetly from CbC requirements, the format of required transfer pricing documentation is also changing. The filing of a ‘local’ and a ‘master’ file is now required for taxpayers with cross-border controlled transactions, in each jurisdiction where a multinational operates. This is likely to be required for most AIFs. The local file will look similar to current transfer pricing documentation, although some new and more detailed information will be required, such as expanded financial information. The master file will require an overview approach and detailed description of global operations. For example, the master file will require detail on group structure, mapping of group intangible property (including items such as customer lists and internally developed software), intercompany financial transactions, the group’s financial and tax positions and certain tax rulings.
Impacted asset managers will have to:
- Identify, for disclosure purposes, intangibles and key value drivers. Review what could be classed as intangibles.
- Put systems in place that can track data in respect of revenue, pre-tax profit and taxes paid in each country in which they operate.
- Review the data collated and consider if there are any particular transfer pricing risks within the wider group.
- The first CbC reports in respect of years ending 31 December 2016 are due by 31 December 2017. Asset managers will have to be mindful of local requirements, as these will vary from country to country.