Michael Beart, Director within the Duff & Phelps' Regulatory Tax Advisory team, contributed to this article for The Hedge Fund Law Report.
The transfer pricing policies adopted by multinationals has been subject to increased scrutiny for a number of years, a trend that promises greater tax transparency and revisions to the international tax framework. However, U.K.-based investment managers are subject to additional layers of regulation that pose a significantly greater risk, not only at a corporate level but also at an investor and personal level.
Since April 2015, U.K.-based hedge fund managers have fallen within the scope of the Diverted Profits Tax (DPT) and the Disguised Investment Management Fee (DIMF) regimes, two pieces of anti-avoidance legislation that pose their own unique set of challenges but also have themes in common with transfer pricing. In a guest article, Michael Beart, a director at Duff & Phelps, focuses on the legislation and its practical implications for hedge fund managers operating in the U.K.
Transfer Pricing
Under the U.K.’s self-assessment tax regime, upon submission of its tax return to HM Revenue & Customs (HMRC), an entity undertakes that where appropriate it has followed the Organization for Economic Co-operation and Development (OECD) transfer pricing guidelines. In short, this means that intragroup pricing represents an arm’s length rate of remuneration equal to the price that two independent parties would have arrived at had they entered into the relationship.
To arrive at an arm’s length rate, the taxpayer is required to establish a comparable benchmark price following prescribed transfer pricing methodologies taking into account the functions performed. Failure to do so could result in an adjustment to the taxable income of the entity with an associated tax liability.
In October 2015, the final recommendations of the OECD/G20 Base Erosion and Profit Shifting (BEPS) project were released. Starting in April 2016, the U.K. has begun adopting a number of these recommendations into legislation. See “Steps That Alternative Investment Fund Managers Need to Take Today to Comply With the Global Trend Toward Tax Transparency (Part One of Two)” (Apr. 7, 2016).
The existing transfer pricing guidelines have been in existence since 2010. The recommendations implement a number of changes focused on aligning transfer pricing outcomes with value creation. These changes ultimately seek to remove the arbitrage opportunities that existed in the old regime, particularly around the use of intangibles, low value-adding services and cost contribution arrangements.
Additionally, investment managers in the U.K. managing an offshore trading fund typically need to adhere to the conditions of the investment manager exemption (IME), a longstanding piece of tax legislation designed for the asset management industry that prevents the fund from being taxed in the U.K. One of the conditions of the IME is that the remuneration that the U.K. investment manager receives in respect of the transaction is not less than customary for that class of business – which requires investment managers via HMRC guidance to apply the OECD transfer pricing guidelines. Therefore, it is of paramount importance that a U.K. investment manager apply transfer pricing guidelines when determining the remuneration it recognizes. Ultimately, failure to do so could bring the fund that it manages within the U.K. tax net.
Diverted Profits Tax
Known in the media as the “Google Tax,” DPT legislation is intended to prevent the diversion of profits by multinational groups using contrived arrangements that either lack economic substance or avoid creating a U.K. permanent establishment. Whilst household-name and technology-based industries were clearly the initial target for the legislation, hedge fund managers could quite easily fall within its scope.
Effective since April 2015, the Google Tax imposes a 25% charge on “diverted profits.” Although the legislation is complex, to determine whether they are within the scope of the DPT regime, taxpayers could be required to consider hypothetical alternatives to the cross-border controlled transactions they have actually undertaken and whether profits have in effect been diverted. For example, a U.K.-based manager accepting a mandate as a sub-manager to its offshore parent may need to consider an alternative structure if it has contracted with the fund directly.
Taxpayers within the scope of the DPT regime are required to notify HMRC within three months of the end of the accounting period. In theory, the disclosure threshold is lower than the charging threshold requiring businesses to exercise considerable judgment whether to approach HMRC or not. This is brought into sharp focus when the tax-geared penalties for failure to notify are considered, along with the fact that HMRC – not the taxpayer – calculates the DPT charge.
Once HMRC raises a tax charge, it must be paid within 30 days and cannot be postponed on any grounds irrespective of any ongoing review or appeal in respect of the notice. This essentially reverses the cash flow advantage taxpayers have traditionally held in dispute scenarios with HMRC. It may be assumed that simply adopting OECD-compliant transfer pricing policies will avoid a DPT charge arising, but there are two key challenges to this. First, it is important to recognize that the DPT legislation was enacted to counter perceived weaknesses in the transfer pricing regime, and there is no suggestion that the recent BEPS updates to the transfer pricing guidelines will lead to a withdrawal of the regime. Second, DPT is fundamentally different. Transfer pricing seeks to tax the arrangements undertaken at a price determined by the taxpayer, whereas DPT seeks to tax hypothetical alternative arrangements.
Disguised Investment Management Fee
The DIMF is a specific piece of anti-avoidance legislation and part of a package of legislative changes the sole focus of which is U.K.-based investment managers. In common with transfer pricing and DPT, DIMF focuses on how and where fees arise. However, whilst income recognized outside the U.K. is one of the targets of this legislation, it could extend as far as the receipt of dividends from a U.K. company.
One of the key differentiators is that the DIMF legislation applies at an individual level rather than at a corporate level. Thus, there is a potential personal liability, requiring individuals to exercise judgment as to whether the legislation applies when completing their own personal tax returns.
A DIMF charge requires an individual to provide investment management services directly or indirectly to a collective investment scheme or certain managed accounts. The legislation operates by re-characterizing untaxed income (essentially anything not taxed as trading or employment income in the U.K.) arising to an individual as U.K. trading income, subjecting it to income tax and national insurance contribution.
Amounts that arise directly are caught, but the legislation is armed with a number of automatic deeming provisions attributing income to individuals where amounts arise to connected parties and also unconnected parties where certain “enjoyment conditions” are met. As with most of the U.K.’s anti-avoidance legislation, the scope of the DIMF legislation is drawn sufficiently wide as to catch virtually all commercial arrangements, an approach that tends to have unexpected consequences in practice.
The regime has been in force since April 2015, and it has targeted management fees and other amounts not linked to the profitability of the fund. From April 2016, it will be extended to performance fees. Although not clearly articulated in the legislation, there appears to be a requirement that sums arising to an individual be linked to the services they provide.
The current published HMRC guidance – which has lagged behind the rapid legislative development (noting the rules have been amended on a number of occasions in the past 12 months and were tweaked again in the 2016 Budget) – suggests that where entities are remunerated on a commercial basis and individuals receive arm’s length remuneration, no DIMF liability should arise. This in effect suggests that the rules impose a quasi-transfer pricing regime, not only on the corporate structure but also for individuals.
However, representatives of HMRC have advised the author that the current guidance does not take account of the revised automatic deeming provisions, so taxpayers should not rely on it in this area. The legislation could have a material impact on certain owner-managed businesses where individuals take limited remuneration in favor of a return on equity.
For discussion of disguised management fees (although the DIMF legislation has since been amended), see our two-part series: “Tax Regulators Attack Efforts” (Aug. 27, 2015); and “How Hedge Fund Managers Should Respond” (Sep. 3, 2015); as well as our two-part series “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated With Hedge Fund Managers”: Part One (Apr. 16, 2015); and Part Two (Apr. 23, 2015).
Common Themes
Both transfer pricing and DPT have small and medium sized enterprise (SME) exemptions, but DIMF does not have an equivalent protection. Nor for that matter does the IME.
On first reading, the SME exemptions appear straightforward, but, to arrive at the correct tested figures for the turnover and balance sheet tests, a thorough analysis of the group structure is required. Definitions of “linked” and “partner enterprises” could inadvertently lead to fund structures falling within the definition of the group, thus removing the potential to rely on the exemption. Furthermore, there are slight variations in the legislative detail, meaning the SME exemption may apply for one piece of legislation but not the other.
The requirement to exercise judgment is also common to both the DPT and DIMF regimes. Whilst transfer pricing has mandatory requirements with regard to maintaining appropriate documentation on an annual basis, for DPT and DIMF the path to evidence this judgment is not as clear.
Notifications under the DPT regime can be avoided where it is reasonable to assume that no charge to DPT would arise for the current period. In reaching this conclusion, hedge fund managers will be expected to have satisfied themselves how the legislation applies to their business – raising questions as to how this should be evidenced.
Under DIMF, each individual to whom untaxed income may arise will need to consider what, if anything, should be disclosed on their personal tax returns and to the extent it isn’t, what steps have they taken to evidence that due care has been undertaken in arriving at that decision. An extra complication comes from ensuring consistency across all such individuals with respect to what is disclosed to HMRC. Underpinning all three regimes is the entirely reasonable proposition that activities undertaken in the U.K. are to be taxed in the U.K. However DPT and DIMF both can focus on the commercial decisions taken by taxpayers which, until now, HMRC would quite rightly struggle to influence. DPT raises the question of whether offshore operations should instead be undertaken in the U.K., whilst the DIMF legislation questions whether a business should be paying remuneration over a dividend.
All take the consistent position that there is an expectation that intragroup pricing should be based on substance over form. The tangible functions undertaken by individuals should be a dominant factor in attributing value in the pricing policies adopted. Red flags to watch out for include profit margins that do not correlate to where functions are performed or owner-managers not participating in staff bonus pools.
Action to Be Taken
Hedge fund managers with a potential exposure should act now (although those with an HMRC client relationship manager will no doubt have already entered into a dialogue on these matters).
The first step should be to get up to speed with the legislation to determine how it could apply and whether any of the exemptions or other exclusions are available. For transfer pricing, existing policies should be reviewed to determine if they are sustainable and whether the current structure is still fit for purpose. For DPT, it is important to determine the applicable HMRC notification date and make the critical decision whether to make a notification or not, documenting it accordingly. For those required to notify HMRC, it will be crucial to understand both the process and the potential consequences. For DIMF, hedge fund managers should seek to identify potential issues particularly with regard to remuneration structures and fee flows. A plan of action should be developed at both the corporate level and with the individuals impacted, as consultation may be vital for achieving a consensus. Where the legislation has a material impact and is inadequately covered in the guidance, taxpayers may consider approaching HMRC to confirm the position.
All of the above should be reviewed annually, but ongoing legislative changes and updated guidance unfortunately make managing this area a watching brief.
