In a previous Fried Frank memorandum (October 26th, 2006) we described how the UK tax authorities ("HMRC") had issued revised draft guidance by way of a draft Statement of Practice on the application of the investment manager exemption. To recap, this sets out HMRC's views on the UK legislation that can exempt the trading profits of non-UK residents that are made through independent UK investment managers from being taxed in the UK.
This exemption is of particular relevance to offshore hedge funds who, in many cases, would be treated as trading for UK tax purposes and who, in the absence of this exemption, would be subject to UK tax on their profits generated through the activities of a UK manager.
The draft revised guidance issued in October caused some disquiet amongst UK commentators, as it seemed to add unwelcome uncertainty as to the way in which HMRC would interpret some of the relevant tests. Following substantial industry lobbying and consultation with HMRC, a final revised Statement of Practice was issued on 20 July 2007 (the “New Guidance”). This is being given a tentative welcome by the industry and advisers, since it removes much of the uncertainty caused by the draft guidance in October, and also addresses some of the particular detail of the way in which modern hedge funds are structured which had not been covered in the original 2001 guidance.
The New Guidance replaces the original SP 1/01 with immediate effect, except to the extent that it requires a non-resident or its investment manager to make changes to current circumstances or contractual arrangements in order to comply with the terms of this statement, in which case the original SP 1/01 may be applied until 31 December 2009.
1. A detailed examination of all of the elements of the New Guidance is beyond the scope of this brief news update, but a summary of some of the main points is set out below. As a reminder, the underlying legislation remains unchanged. There are three tests that need to be satisfied in order for the exemption to apply to a UK investment manager, being the independent capacity test, the 20% test and the customary rate test. Independent Capacity
2. HMRC will now consider a relationship between a UK manager and a non-resident as independent if the non-resident is either a widely held collective fund or the non-resident is being actively marketed with the intention that it becomes a widely held collective fund (or is being wound-up or dissolved). A fund is to be regarded as widely held if either no majority interest in the fund is ultimately held by five or fewer persons and persons connected with them, or no interest of more than 20% is held by a single person and persons connected with that person.
The fund will have 18 months from the commencement of trading in the UK to meet the widely held test. In order to meet the actively marketed test, there must be evidence of ongoing genuine attempts to obtain third party investment.
3. In other cases, the independent capacity test will be met where the provision of services to the non-resident and persons connected with it is not a substantial (70%) part of the investment management business. Again, there is an 18-month test from the start of a new investment management business during which the proportion needs to be brought down below 70%. There is a further exception where the proportion remains above 70% after 18 months from the start of a new business but the manager had taken all reasonable steps to bring it below 70% and this state of affairs was for reasons outside the manager's control.
4. Finally, if none of those tests are satisfied, HMRC will have regard to the overall circumstances of the relationship between the non-resident and the investment manager in determining whether they are carrying on independent businesses that deal with each other on arm's length terms.
5. The New Guidance in this area provides welcome clarity and some "bright line" tests as to the circumstances in which typical hedge fund structures will fall within the exemption. 20% Test
6. As a reminder, the 20% test requires that the investment manager and persons connected with it do not have a beneficial entitlement to more than 20% of the non-resident's chargeable profits arising from transactions carried out through the investment manager. A welcome clarification in the New Guidance provides that management fees paid to the investment manager and persons connected with it are not included in that chargeable profit provided they would be allowable in computing the profits of the non-resident were it chargeable to UK tax. This applies equally to incentive fees, performance fees or incentive allocations that are calculated by reference to any increase in the net asset value or profits of the relevant non-resident. This test is computed over a five-year period, as was the case under the previous guidance. The recognition by HMRC that UK investment managers are regularly remunerated with profit or incentive allocations, and that these should be treated as performance fees in substance, is a major step forward and a helpful clarification in the light of current industry practice. Customary Remuneration
7. The final test states that the UK investment manager must receive remuneration at a rate that is not less than customary for its services. As mentioned in our October memorandum, HMRC will be guided by the OECD transfer pricing guidelines to determine whether a pricing structure applies a customary rate, and will take into account all relevant circumstances, including whether that remuneration has been reduced below the arm's length rate in any way either before or after payment to the investment manager. In certain circumstances, reduced or rebated fees for unconnected investors in the non-resident fund can be taken into account in considering whether the investment manager is remunerated at arm's length. In determining whether the customary rate test has been met, fees payable to the UK investment manager need to be recognised for UK tax purposes when earned. Any cash payment deferred or reinvested in the fund should not affect the recognition of fee income.
8. In some circumstances, the UK investment manager, or partners, directors or employees of the manager are awarded securities or interests in the offshore hedge fund or other connected entity in return for services provided by the manager. In order for that awarded security to form part of the customary rate remuneration for the purposes of the relevant test, the security or other interest needs to be brought into charge to UK tax at its full market value.
9. As ever, with arm's length tests, it is vital that the offshore fund and the UK manager keep documentation and evidence of the methodology used for pricing in order to support the UK tax filing position. Importantly, the New Guidance suggests that where appropriate documentation, including a factual functional analysis and an acceptable transfer pricing methodology, is in place to support a tax return, the investment manager will have an opportunity to agree an adjustment to the return to meet the customary rate test or for any other reason, or to have adjustments determined through litigation where such an agreement has not been reached, without the nonresident having thereby failed the customary rate test.
10. Where HMRC does not consider that appropriate steps were taken to determine arm’s length pricing, the IME may be lost in respect of the relevant periods. In many cases this is something that offshore funds will need to examine urgently, so as to ensure that documentation is on place to justify the pricing used. The New Guidance (as noted above) will come into full force on 31 December 2009, so any changes to contractual arrangements need to be in place in good time before then.
The full revised Statement of Practice (SP1/01) is fairly detailed and includes several changes and extensions to current practice not referred to in this note.