Taxation guidance.

Structures and key tax considerations for a new venture.

By Peter Witton, UK Hedge Funds Tax Leader, PwC. 

When setting up a new hedge fund business there are typically two key areas of tax focus: the fund structure and the management group structure.

 

Peter Witton, UK Hedge Funds Tax Leader, PwC

Basic hedge fund structures

On the fund side, it will be important to establish an efficient structure for making investments and generating returns for potentially multi-jurisdictional investors, together
with considering the investors’ tax reporting needs. It will also be important to consider how the fund remunerates the management group and its key people for management and performance and the tax implications.

On the management group side, the structure will need to be designed to accommodate the tax profiles of the founders and key people, wherever  they may be based, and to also ensure future business flexibility where possible. Crucially, it is important that the structures are created to meet the ongoing commercial objectives and operational needs of the business. It should be noted that as the business grows and strategies evolve, the structures may need to evolve with it. For example, in recent years many hedge fund managers have broadened their strategies into less liquid asset classes which may bring additional complexities and structuring requirements, such as platform and other financing structures.

For example, in recent years many hedge fund managers have broadened their strategies into less liquid asset classes, which may bring additional complexities and structuring requirements, such as platform and other financing structures.

At a high level, we have sought to address the typical structures and

Key takeaway:

Although it may appear that the appropriate structure and location for the Hedge Fund and management group is reasonably industry standard, both evolving tax legislation (and the interpretation of that tax legislation by authorities) and the evolving global tax climate should be considered in advance of setting up the chosen structure to ensure it will suit the founder and the businesses commercial objectives and operational requirements in practice.  It is also worth ensuring there is flexibility for the management group structure to evolve as the immediate objectives of the business and the key individuals may be different to the medium and longer term objectives.  Finally, the location and requirements of investors and the nature of the strategy will be key when thinking about the fund structure and jurisdiction of establishment.

some of the main tax considerations for a new venture in key jurisdictions including the U.K., U.S., Hong Kong, 

 

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Singapore and Ireland, but focusing primarily on the U.K. and assuming a typical “liquid” hedge fund strategy.

1. Hedge fund structures

Most hedge funds broadly follow one of three main structural forms:

• Master/feeder
• Parallel
• Stand-alone

Depending on the strategy, variations of these main structures may exist, and each structure may also establish "side pockets" for particular investments.

Many hedge fund managers also operate managed accounts on behalf of investors. These accounts may reside with the hedge fund’s prime broker (rather than in the legal vehicle of the fund) but will be invested by the hedge fund manager similar to the fund’s assets.

vehicle of the fund) but will be invested by the hedge fund manager similar to the fund’s assets.

Funds are established for their own particular purpose based on the strategy, track record and reputation of the manager and the makeup of the investor group. These factors will all influence the final considered structure of a fund range. Depending on the strategy, an investment platform may be set up below the Fund.

Where it is constituted as a corporate entity, the fund will have a board of directors to make certain decisions on behalf of the fund. Offshore corporate funds are typically used to serve the needs of non-U.S. investors and U.S. tax-exempt investors who typically prefer an opaque entry into the fund to manage the tax exposure and reduce U.S. tax filings.
 

Transparent vehicles such as limited partnerships are principally used to structure hedge funds aimed at U.S. taxable investors, as the investors typically want a tax-transparent treatment from such a design. The general partner of the limited partnership may be the investment manager or a standalone entity. Due to the ability to elect tax treatment for US purposes, a corporate entity may be used as the fund entity but with elected partnership treatment for US purposes.

Funds will typically have no or few direct employees and no assets other than its investment portfolio and cash. The directors of the corporate fund or the GP of the partnership fund employ a number of service providers to deliver the activities of the fund, although proper fund governance and Director oversight remains necessary and is an increasing area of focus. 

These service providers typically include the auditor, legal counsel, an administrator, a prime broker and the investment manager. The investment portfolio is managed by the investment manager.

Typically, hedge funds are set up in low-tax jurisdictions to ensure that the product itself isn’t taxable, maximizing investor returns. Although regulatory considerations, registration and oversight has increased there in recent years, the Cayman Islands remains a key fund jurisdiction with multiple vehicle types available, including the exempted company, exempted limited partnership, limited liability company, trust and the segregated portfolio company.

 

However, more hedge fund managers are considering alternative domiciles for their funds, e.g., Ireland and the Irish ICAV vehicle, discussed further below, often driven by investor demand for onshore, locally regulated structures. Further, certain onshore products may be able to access a greater range of double tax treaties or fund exemptions than offshore products, while still being subject to minimal, if any, taxation.

In addition to its role as investment manager, the investment manager or an affiliate will often hold additional control rights in its managed fund through either the general partner (where the fund is structured as a limited partnership) or through what are referred to as "founder" or "management shares" (in a corporate fund). Founder shares typically have no economic rights but rather hold exclusive voting rights over a range of issues, such as appointment of 

directors. As a result, although the board of directors has the right to control a corporate fund as a matter of company law, the investment manager often retains the right to appoint and remove the directors.

Board members of corporate funds can be employees of the investment manager (although note the comments on tax residence included later in this section), independent persons or a combination of the two.

Master/feeder fund

A master/feeder fund is a structure that is capable of attracting capital investment from U.S. taxable and tax-exempt investors as well as other global non-U.S. investors through the use of “feeder” entities, allowing all parties to access the master fund through their own preferred entity choice. As this structure caters to a 

wide range of investors, the master/feeder structure has been very popular in the industry for many years. There are typically two feeder vehicles from which investors acquire their interest.

One feeder is established for the U.S. taxable investors and is commonly a Delaware or other U.S. limited partnership or limited liability company (LLC). It is also common to see feeders as limited partnerships established in no/low tax jurisdictions. Generally a transparent vehicle is used to manage certain potential U.S. tax issues that may arise from US shareholders holding interests in a corporation. For example, to ensure that offshore entities are not subject to the US Controlled Foreign Corporation (CFC) rules or that the entity (onshore or offshore) is not a Passive Foreign Investment Company (PFIC).

Transparent vehicles are also used to provide investors access to benefit from losses of the fund and for returns to retain the underlying characteristics for U.S. investors, which is often preferable from a U.S. tax perspective. The partnership feeder will have a general partner that often provides little service to the fund other than oversight of the feeder vehicle and the collection of any incentive allocation. As mentioned above, the general partner typically contributes some capital to the Fund to ensure they are treated as a partner in the partnership for tax purposes.

The second feeder — often referred to as the offshore feeder (due to its location) — can be a corporate vehicle (or a partnership that elects to be treated as a corporation for U.S. tax purposes) through which US tax-exempt and non-U.S. investors generally acquire their interest. This 

entity is generally established in a no/low tax jurisdiction, commonly the Cayman Islands; however, there are many low tax jurisdictions that are used to achieve the same result. Non-U.S. investors and U.S. tax exempt investors may prefer to invest through an offshore entity that is treated as, or is elected to be treated as, a corporation for tax purposes, in order to block any returns that would otherwise lead to reporting requirements or unfavorable tax positions for those investors, such as U.S. effectively connected income (ECI) or Unrelated Business Taxable Income (UBTI).

Both feeder vehicles will invest their deployable capital into the master fund; this is done through the feeders’ acquisition of interests/equity in the master fund. The master fund can take the legal form of either a limited partnership, unit trust or a corporate vehicle (in a

low tax jurisdiction) that has "checked the box" for U.S. tax purposes to ensure it is treated as a transparent entity for U.S. taxable investors. The fund complex will contract with an investment manager to manage its portfolio of investments in return for payment of a management and performance/incentive fee or allocation.

Although typically the Cayman Islands remain the domicile of choice for hedge funds, some countries offer specialized fund regimes that may be used as master funds. Luxembourg’s Reserved Alternative Investment Fund (RAIF), created in 2016 with the potential of taking different legal forms, is a flexible, multipurpose alternative investment fund that can be marketed quickly as it is not subject to regulation by the Financial Sector Supervisory Authority (CSSF). Singapore’s Variable Capital Company (VCC) launched January 

2020, offers improved operational and tax efficiency and can be used for all types of investment funds in Singapore, including hedge funds. Many of these vehicles can also be established as a stand-alone fund or as an umbrella entity with multiple sub-funds.

The Irish Qualified Investor Alternative Investment Fund (“QIAIF”), typically structured as an Irish Collective Asset-management Vehicle (ICAV) has also become a vehicle of choice for alternative fund promoters seeking an onshore regulated vehicle. The ICAV is typically established as an umbrella structure with a number of sub-funds and share classes. Irish-regulated funds are exempt from Irish tax on income and gains derived from their investments and are not subject to any Irish tax on their net asset value. There are additionally no net asset, transfer or capital taxes on the issue, transfer or 

redemption of units owned by non-Irish resident investors. An ICAV can also make a check-the-box election to be treated as tax transparent for U.S. federal income tax purposes.

 

Parallel funds, Stand-alone funds and Hedge funds with side pockets

At a high level, the parallel fund structure is a master/feeder structure with no master fund, such that the feeder vehicles become the direct investment holding entities. The fund vehicles are chosen for U.S. taxable investors and U.S. tax-exempt or non-U.S. investors, and these sister funds will directly invest together in the same financial instruments.

Stand-alone funds are typically used where the investor profile base is relatively fixed, meaning that a single entity will accommodate all the investor tax profiles removing the need for bespoke feeder entities.

The use of side pockets to structure certain investments of a fund is a way for hedge funds to separate illiquid or speculative investments from its main

liquid portfolio and to limit the investors partaking in such an investment.

Funds of funds (multi-manager funds)

There are many investors who would like access to more than one hedge fund or hedge fund manager. The difficulty with such a desire for a single investor is finding the time for research and/or the excessive capital commitment to be able to hold an interest in several differing funds. Because of this market demand, the fund of funds was established.

A fund of funds is a structure that invests in other hedge funds. The fund of funds typically has a widely diversified portfolio of unrelated hedge funds, or equally can invest in a number of hedge funds with a similar focus such as by sector or geographical location.

A fund of funds will typically take the legal form of a limited partnership or a parallel fund structure.

Tax elections and reporting

Whatever fund structure is selected, consideration will need to be given to the tax profiles of the investors (both external and internal). It is likely that tax reporting will be required by the fund to provide adequate information to investors for them to prepare their own tax returns and filings. Additionally, certain elections may need to be made by the fund entities to ensure preferential investor tax treatment and applications may need to be made by the fund to access certain tax reporting regimes.

For example, it should be determined whether “check the box,” Section 475(f) and QEF elections need to be made to confirm the treatment of fund entities for the U.S. purposes.

As a further example, U.K. investors may ask whether the fund may access the U.K. Reporting Fund Regime, which can provide preferential tax treatment for U.K. investors by allowing them access to capital gains treatment on certain returns as opposed to income treatment. If the fund is eligible, this regime needs to be accessed through application, and there are annual reporting and compliance requirements.

2. Co-investment and Carry

Structures and considerations

Hedge fund managers often elect to invest or are required to invest a specified minimum amount of their own money into the funds they manage ("co-investment"), typically as a result of commitments given to external investors during the fundraising process to align interests. 

There are several ways in which the co-investment may be structured, often involving the use of a separate co-investment vehicle or a separate class of interest, which may hold differing characteristics to third-party investor shares.

Carry structures may also be established to allocate performance compensation to key individuals, potentially in a tax-efficient manner. However, rules regarding the taxation of carried interest are regularly being reviewed, and it should be considered whether such a performance structure will afford any benefit, usually with reference to the investment strategy and the mechanism and timing of paying performance compensation and asset holding period. For U.K. considerations, please see further details in the remuneration section.

 

3. Management of Hedge Funds

A global hedge fund management structure will typically vary depending on whether the hedge fund manager is a U.S., U.K./European or Asian headquartered operation.

Hedge fund management from the U.K. - common structures

The U.K., and London, in particular, continues to serve as the centre of the European hedge fund industry. Despite uncertainty around the U.K.’s exit from the European Union at the time of writing (discussed below), there remains a thriving hedge fund industry in London, due to the presence of a number of major global financial markets and service providers as well as the wide-ranging multi-discipline talent pool and relatively close proximity to the U.S. 

In addition, the established tax framework in the U.K. has also contributed to the success of the hedge fund industry in London. The long-standing "trading safe harbour," the Investment Manager Exemption (IME), provides a framework for delivering a degree of certainty of tax treatment for the non UK resident funds, often demanded by investors and sponsors.

treatment for the non-U.K. resident funds, often demanded by investors and sponsors.

Typical U.K. management group structure

Historically, U.K. - headquartered operations have often based its lead manager or holding company structure in a no/low tax jurisdiction, such as the Cayman Islands or the Channel Islands, with operating subsidiaries/sub-advisers established below the lead manager/holding company structure in appropriate jurisdictions. Such a structure allowed for the flexible future expansion and growth of the investment manager to locations outside of the U.K. and may have also suited the personal tax planning of the senior executives of the hedge fund manager if they are U.K. nonresident or non-domiciled individuals.

 

 

 

While this structure still remains popular in the industry, due to a number of tax changes (e.g., transfer pricing rules, economic substance rules, deemed domicile rules and the disguised investment management fee rules, discussed further below) the suitability of this structure is less clear for all businesses and start-up managers should assess whether any benefit may be obtained from such a structure, based upon their business, commercial and personal needs. Even if the business is still set up with this structure, it is likely that the role of the offshore entities will be limited in practice, typically being a passive holding structure or a procurement agent of investment management services (provided by the operating subsidiaries) only.

The U.K. operating entity itself will usually take one of two legal forms, irrespective of whether it is a stand-alone manager or part of a

European, Asian or U.S.- headquartered management group. A U.K. hedge fund manager will generally be structured as either a U.K. limited company (U.K. Ltd) or a U.K. limited liability partnership (LLP) or a combination of both.

The U.K. entity will typically hold a sub-investment management or advisory agreement with the lead manager to perform designated management services and should be FCA regulated. However, it could also be appointed directly as investment manager by the funds or the funds' GP.

The U.K. Limited Company as U.K. manager

The U.K. Ltd is a “tax opaque” entity, meaning that the U.K. Ltd itself should be subject to U.K. corporation tax on its taxable income. The main rate of corporation tax in the U.K. is currently 

19 percent, although this is due to rise to 25 percent in April 2023.

For inbound structures, it is typical that 100 percent of the equity of the U.K. Ltd would be owned by the holding structure or lead manager. For U.K.- headquartered businesses, all or the majority equity may still be owned by a holding structure or offshore lead manager, but there could also be minority direct or indirect ownership awarded to key executives either upfront or through share incentivisation.

The U.K. Limited Liability Partnership as UK manager

An LLP is typically treated as fiscally transparent in the U.K., meaning that it should be the members (partners) of the LLP who will be taxable on the profits of the LLP, based on their allocation of the LLP’s profit, rather than the entity being taxable itself.

In the case of an inbound manager, the lead (overseas) manager will typically establish and acquire all the equity of a U.K. limited company, which may act as a service company ("U.K. ServiceCo") or simply a “blocker” entity so that the non-U.K. manager does not need to file U.K. tax returns on the taxable trading profit of the LLP allocated to it through this ownership chain. As well as U.K. ServiceCo being a corporate member of the LLP, individuals (typically key U.K. executives and potentially lead portfolio managers) will likely become individual members (or partners) of the LLP. Typically, for an inbound structure, U.K. ServiceCo will be the managing member of the LLP, although it is best practice for all LLP members to be part of the management committee of the LLP.

U.K.-headquartered businesses may choose to use this same setup; however, as discussed further on, it is

likely that the vast majority of LLP profits will need to be paid directly to the individual members rather than through the corporate member.

Changes to the taxation of LLP profits

In 2014, targeted anti-avoidance legislation was introduced to prevent what the U.K. government deemed to be an abuse of the tax advantages obtained by using an LLP structure. The perceived mischief was, firstly, that any LLP profit share allocated to individual members would not attract the 13.8 percent employer national insurance charge otherwise payable on ordinary employee salary and, secondly that it was possible to indirectly stream LLP profits to individuals via the corporate member in the LLP, thereby potentially avoiding a charge to both income tax and national insurance altogether. 

The anti-avoidance legislation designed to catch this type of tax planning is referred to as "the Salaried Member rules" and "the Mixed Member rules" respectively.

At the time of writing, both of these areas are a key focus of HMRC enquiries and market practice for the operation of these structures is evolving quickly.

Over the last decade, the LLP structure has generally been the structure of choice for the U.K. investment manager or sub-adviser. However, rule changes including the Salaried Member and Mixed Member rules discussed above reflect the increase in HMRC scrutiny on LLPs, and added to this are the potentially complex income tax implications, for example "dry" tax charges on individual members that could arise

and added to this are the potentially complex income tax implications, for example "dry" tax charges on individual members that could arise from deferred remuneration or book to tax differences. These considerations can make certain commercial objectives difficult, such as incentivising staff, aligning pay with individual performance and 

1. The Salaried Member rules:
These rules are designed to consider whether an LLP member should be treated as an employee for tax purposes, rather than self-employed, based on, broadly, a ‘substance over form’ approach. If a member is treated as an employee for tax purposes there will be additional payroll and social security obligations that should not otherwise be needed for self-employed individuals. The rules set out three conditions regarding remuneration, influence over the LLP and capital contributed to the LLP and if all three conditions are met an individual should be considered akin to an employee for tax purposes. As such, to ensure true self employed member status for tax purposes, it is necessary for each individual member to fail at least one of these three conditions.

2. The Mixed Member rules:
These rules seek to combat perceived abuse whereby profits of an LLP are allocated to nonindividual members of the LLP (i.e., a company, another partnership or individuals acting in the capacity as trustees), while earmarking those profits as, in substance, for the benefit of the individual members. Broadly, where the rules apply, those profits may be treated as if they were allocated directly to the relevant individual members by the LLP and taxed accordingly.

Comparing a U.K. LLP vs a U.K. Ltd company

 

Hedge fund management from the U.K. - other key U.K. tax considerations

The Investment Management Exemption (IME)

The IME is a trading safe harbour designed specifically for U.K. investment managers managing non-UK "trading" funds to provide comfort that the investment manager’s U.K. activities on behalf of the non-U.K. fund will not lead to the fund becoming taxable in the U.K. The IME sets out five conditions that need to be met in relation to specific "investment transactions" to ensure protection for the U.K. investment manager.

 

building retained earnings in the business. Operating through a U.K. Ltd may reduce complexity and allow more clear access to other U.K. tax incentives, such as the U.K. R&D regime and the Annual Investment Allowance for certain capital assets. There may also be wider benefits to individuals being employees as compared to members of an LLP, and it may also be more tax efficient to build retained earnings in the business, depending on the nature of the business and the profiles of the owners. 

As a result, the choice of an LLP as the investment manager vehicle is no longer necessarily the natural one for a newly launched hedge fund, and start-up managers are spending more time considering the pros and cons of each structure in the context of their short-, medium- and long-term commercial objectives and the need 

to access profits. That being said, the recently announced change to the headline corporation tax rate from 19 percent to 25 percent on 1 April 2023, as set out in the 2021 Spring Budget, and the proposed NIC increase/social care levy and dividend tax increase of an additional 1.25% on current rates will add further complexity to this decision.

Regulatory platforms and hosting structures

U.K. start-ups or inbound subsidiaries may prefer not to become regulated in their own right (should they need to perform regulated activities), at least initially, potentially to save costs and/or set-up time. The U.K. structure of the business and the U.K. based people may therefore interact with and utilise a regulatory platform or host provider, so that certain regulated functions are actually provided 

provided by U.K. individuals under the regulatory umbrella of that regulatory provider. U.K. individuals may be seconded to the regulatory host to perform these services, or the U.K. firm may become an appointed representative of the regulatory platform.

While these structures are common, it is important to consider whether the operating model and service contracting bring any further tax considerations to the U.K. structure and its people and also whether these positions change should the U.K. business roll off the platform to become regulated in its own right at a later point in time.

Whilst the U.K. tax authorities have updated IME guidance and the "investment transactions" list over the years, at the time of writing there remains some uncertainty surrounding new and emerging strategies and assets, specifically crypto and digital asset strategies, meaning extra care should be taken when considering the IME in this context. 

Remuneration

Remuneration received by individuals either as employment income or trading profits is expected to be subject to income tax on those individuals at up to 45 percent plus national insurance. Where returns arise to an individual as other than employment income or U.K. trading income, it will be necessary to consider whether the Disguised Investment Management Fee (‘DIMF’) rules apply.

The DIMF rules, introduced in 2015 (and since tightened) have added a further layer of anti-avoidance legislation to the remuneration of investment professionals. The rules are intended to stop fund managers converting what HMRC considers to be trading income into capital receipts, which may potentially be taxed at a lower rate. The rules are extremely widely drafted and apply to receipts as they "arise," which could precede the physical receipt by an individual of such amounts.

While there are certain exemptions for the return of capital and narrowly defined co-investment and carried interest returns, it should also be noted that even where an amount meets the carried interest exemption there are further rules to consider, namely the Income Based Carried Interest (IBCI) rules, which seek to determine whether that amount should still be subject to income tax rates as opposed to capital gains tax 

should still be subject to income tax rates as opposed to capital gains tax rates. The test is largely based on the holding period of the underlying assets that generated the return. As such, it is necessary to closely consider all returns that arise or are deemed to arise to individuals, in or outside of the U.K., to determine their tax treatment.

Individual residence and domicile

The taxation of investment professionals will also depend on their tax residence and domicile status. A U.K. resident and domiciled individual is taxable on worldwide income on an arising basis. However, a U.K. tax resident individual who is considered non-U.K. domiciled and claiming the remittance basis should only be taxed on non-U.K. source income if it is remitted to the U.K. Individuals may be deemed U.K.

domiciled after a significant period residing in the U.K. When establishing the structure of a new hedge fund business, the tax domicile or deemed domicile status of the founding members should be considered up-front to assess whether there are opportunities for efficient tax structuring.

Corporate tax residence 

Individuals who are Directors of any fund entities (or any other non UK entities) should monitor their activities in the UK to ensure that those entities do not become UK tax resident. Entities that are considered to be “centrally managed and controlled” in the UK should be considered UK tax resident and therefore subject to UK taxation.

Regulatory position following the U.K.’s exit from the European Union and tax

The EU-U.K. Trade and Cooperation Agreement (TCA) was agreed on 24th December 2020 and provided no new arrangements for financial services to replace the existing "EU passports," making the U.K. a third country for EU regulatory purposes. While discussions are ongoing at the time of writing and agreements may be reached, hedge fund managers 

who do not currently have an EU management company may have to use alternative means to market to new EU investors and manage EU funds. For hedge fund start-ups, it is crucial that regulatory and operational considerations are carefully thought about alongside tax when structuring the business and managing the risks associated with delivering tax and regulatory substance in relevant jurisdictions.

 

Hedge fund management from the U.S.

A U.S. headquartered operation will typically use a U.S. domiciled entity such as a limited partnership or a limited liability company as its lead management and/or group holding entity.

For a non-U.S. headquartered business, to the extent the fund manager has employees based or working from the U.S., it is common for a U.S. subsidiary sub-advisor to be formed. The sub-advisers are commonly structured as corporations for U.S. federal income tax purposes to block any effectively connected income (ECI) from flowing up to any non-U.S. structure owners, although there may be opportunity to also utilise a partnership structure as well. Any income derived by the corporate U.S. sub-adviser would be subject to U.S. corporate taxes (federal, state and local taxes).

U.S. sub-adviser would be subject to U.S. corporate taxes (federal, state and local taxes).

U.S. trade or business considerations

To the extent that the fund is managed from the U.S., consideration should be given as to whether the fund (specifically the non-U.S. investors in the fund) may be considered to be engaged in a U.S. trade or business (“USTB”) for U.S. federal tax purposes (and therefore subject to U.S. tax / filing obligations) as a result of the activities of the fund. The U.S. has a fairly broad trading safe harbour (U.S. TSH) with respect to trading in stocks or securities. Non-U.S. investors (e.g., those who hold their interest in a fund through offshore foreign entities) are not likely to be viewed as being engaged in a 

USTB if the activities of the fund in the U.S. are limited to those covered by the U.S. TSH. Please note that this exception is not available for dealers.

However, certain types of activities could give rise to USTB. Among others, such activities include loan origination activities and investing in certain transparent entities such as master limited partnerships (MLPs) or publicly traded partnerships (PTPs), as to the ongoing maintenance of offshore substance in the entity or entities receiving the UK manager’s services such interests may be treated as interests in a partnership for U.S. tax purposes.

Additionally, given that many MLPs are engaged in energy infrastructure, such MLPs are likely to be treated as having ECI. Accordingly, MLP investments could result in ECI for any non resident who owns any 

 

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VAT

Where a UK manager provides its services to a typical Hedge Fund structure involving a GP/Fund or Lead Manager established in an offshore jurisdiction, such as the Cayman Islands, the services should be outside the scope of UK VAT, provided that the recipient of the services has sufficient economic substance in the offshore jurisdiction. 

Similarly, in the case of an EU fund, such as an Irish ICAV, services provided by the UK manager to the EU manager should also be outside the scope of UK VAT, again subject to the EU manager having sufficient substance in its EU jurisdiction. The provision of these services should also entitle the UK manager to recover input VAT incurred in the UK on its costs, which would require it to register for VAT. VAT registration may be on a voluntary basis, unless the UK manager has other activities triggering a compulsory registration requirement (such as the receipt of services from outside the UK subject to the “reverse charge” mechanism with a value above the VAT registration threshold, which is currently £85k per annum). VAT registration is generally desirable, even if not compulsory, due to the potential for VAT recovery. Grouping for VAT purposes may also be

possible if the U.K. structure utilises more than one UK entity. The VAT profile of a typical UK manager, whereby no VAT is due on its output transactions but it is entitled to input VAT recovery on its costs, such that it is in a consistent VAT repayment position can lead to heightened scrutiny from tax authorities. Robust processes and controls are recommended in relation to both the UK manager’s VAT accounting and in relation to the ongoing maintenance of offshore substance in the entity or entities receiving the UK manager’s services.

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interest in a partnership that is engaged in USTB.

Additionally, to the extent that that non-U.S. investors come into the structure via an offshore entity which is treated as a corporation for U.S. tax purposes, further consideration needs to be given to any withholding taxes on dividends, and where arise gains on sale of U.S. property, Foreign Investment in Real Property Tax Act (FIRPTA) considerations must be taken into account.

State tax considerations

A state’s right to tax interstate commerce is supported by the Commerce Clause and the Due Process Clause in the U.S. Constitution. Under both clauses, a state has a right of taxation only when there is sufficient connection, or “nexus,” to the state. Generally, states 

impose an individual or corporate income tax or business activity tax on every corporation having nexus or doing business within the state, or require an informational return on behalf of a partnership conducting a business within a state. Many states no longer require a physical presence and impose corporate income tax or non-resident withholding on partnerships based on their economic presence in the state. States may also assert nexus if an entity satisfies a certain threshold of in-state sales, commonly referred to as factor presence, i.e., an asset manager (including non-U.S. advisers) could have a nexus in California if it generates more than $610K (at the time of writing) in management fees from California-managed accounts.

As states continually adopt new economic nexus standards, hedge fund managers will need to 

understand the impact of sourcing management fees to other states based on the location of their onshore investors and how this may impact their state and local filing footprint.

Additionally, indirect taxes, commercial rent tax, sales and use taxes and employment mobility issues arising from employees working from different states are likely to be relevant for a U.S. sub-advisor. For example, if U.S. employees of a New York sub-adviser start working from a different state, considerations would potentially need to be given to whether the company now has nexus in these states and is required to file and pay corporate taxes and comply with withholding tax requirements on behalf of its employees.

 

Hedge fund management from Hong Kong

Management and performance fees derived by a Hong Kong (HK) investment manager/sub-adviser are generally subject to HK profits tax of 16.5 percent if the services are performed in HK (note however a two-tiered profits tax rates system may apply upon election, whereby the first HK$2 million of assessable profits of corporations should be taxed at a reduced rate of 8.25 percent and the remaining should be taxed at 16.5 percent). Where all or 

part of the services are performed outside HK, the HK investment manager/sub-advisor may lodge a non-taxable offshore income claim on the fees attributable to non-HK performing services.

Further, the HK government has released a tax bill to introduce a “zero” rate tax concession to both the HK investment manager/sub-adviser and its employees on carried interest, provided certain conditions are met.

Offshore/onshore funds managed from HK may be eligible for the Unified Offshore Fund Tax Exemption Regime (Trading Safe Harbour). Under the Unified Fund Tax Exemption Regime, the profits of an offshore/onshore fund should be exempt from HK profits tax provided that certain requirements are met.

Hedge fund management from Singapore

Assuming that certain requirements are met, under the Financial Sector Incentive — Fund Management scheme, fund managers managing a qualifying fund may be eligible for a concessionary tax rate of 10 percent on income arising from such management.

Two key tax incentive schemes are also available to funds managed in Singapore: the Offshore Fund Tax Incentive Scheme (Offshore Fund Scheme, or S13CA scheme) and the Enhanced-Tier Fund Tax Incentive Scheme (S13X scheme).

The main distinction between the two regimes is that the S13CA scheme is a self-administered regime and no formal approval from the Monetary Authority of Singapore (MAS) is

required, whereas approval is required from the MAS under the S13X scheme, and several other requirements as discussed below need to be satisfied.

Among other items, the S13CA scheme has annual reporting obligations to the tax authorities/MAS where there are non-qualifying investors in the fund entity and a requirement to file annual statements containing certain standard information to investors. However, this regime does not otherwise impose Singapore income tax filing obligations on the funds (or their partners in the case of limited partnerships) unless the funds or their respective partners derive any taxable income.

Under the S13X scheme, an approved fund is granted a tax exemption on “specified income” derived from “designated investments” managed by a “fund manager” in Singapore, for the life of the fund, and subject to meeting the ongoing conditions of the scheme.

 

 

 

Other general international tax considerations for Hedge Fund Managers

Transfer pricing & BEPS

The globalization of hedge fund managers has brought with it new tax risks and compliance obligations. Transfer pricing is a key tax consideration for hedge fund 

managers, particularly those with an international presence leading to a multi-jurisdictional provision of services within the group and to the funds. One key aspect from a transfer pricing perspective is ensuring that the group’s transfer pricing policy should accurately reflect the way their business operates and takes into account any changes as the business evolves, to ensure the inter-group pricing of services remains correct.

The closely integrated nature of high-value, cross-border activities within the hedge fund industry means a revenue or profit split transfer pricing policy may often be most appropriate. In applying a revenue/profit split, routine business functions are typically rewarded with a mark-up on their costs first, before the remaining residual is split across the high-value-adding activities of the business (based on a reasonable allocation key). However, it is also common for managers in their start-up phase to apply a different transfer pricing methodology, such as a "cost plus," to ensure any initial losses are borne by the appropriate entity/entities, considering the allocation of functions, assets and risks across the wider value chain.

One of the key changes to come out of the 2015 BEPS Project was increased scrutiny around the 

alignment of transfer pricing arrangements with the substance of the activities performed (i.e., placing an emphasis on the underlying substance or activities, not necessarily on the description of the arrangements from a contractual perspective). Tax authorities, including HMRC, are becoming increasingly focused on the transfer pricing arrangements for hedge fund managers, and there is an expectation that taxpayers maintain robust evidence to support the transfer pricing policies applied.

The BEPS Project also introduced new transfer pricing documentation requirements, and these have been introduced into legislation in many jurisdictions (and in others, considered to be "best before the remaining residual is split across the high-value-adding activities of the business" (based on a reasonable 

allocation key). However, it is also common for managers in their start-up phase to apply a different transfer pricing methodology, such as a "cost plus," to ensure any initial losses are borne by the appropriate entity/entities, considering the allocation of functions, assets and risks across the wider value chain.

One of the key changes to come out of the 2015 BEPS Project was increased scrutiny around the alignment of transfer pricing arrangements with the substance of the activities performed (i.e., placing an emphasis on the underlying substance or activities, not necessarily on the description of the arrangements from a contractual perspective). Tax authorities, including HMRC, are becoming increasingly focused on the transfer pricing arrangements for hedge fund managers, and there is an 

expectation that taxpayers maintain robust evidence to support the transfer pricing policies applied.

The BEPS Project also introduced new transfer pricing documentation requirements, and these have been introduced into legislation in many jurisdictions (and in others, considered to be "best practice"). Hedge fund managers should ensure they have appropriate processes in place to keep up to date with the preparation of compliance documentation and any filing deadlines, as well as required content in each jurisdiction (noting this can change on an annual basis). "Country by Country Reporting" is also required for larger multinational groups (consolidated group revenue exceeding EUR 750m or local equivalent), and this applies to both management and fund structures.

 

Permanent establishment and travel risks

A permanent establishment (PE) test features in many countries’ domestic tax laws and double tax treaties, and it considers whether a business or entity has sufficient activity in another territory to create a taxable presence in that other territory from a tax perspective.

Where certain activities are performed in a jurisdiction on behalf of a non-resident fund, determining whether those activities create a PE of the fund or whether a "trading safe harbour" applies can require detailed analysis. Regulatory and PE risks of this nature often go hand in hand; where a PE risk exists for a fund through the activities performed in a jurisdiction, it is also important to confirm the regulatory position of those activities in that local jurisdiction.

As well as the PE risk of the fund, a key focus is often on the PE risk to the management group as a result of increasing global mobility of staff and remote working. This can be of particular concern where tax-transparent entities, such as U.K. LLPs, are used in the management group structure, resulting in potential tax reporting risks of the individual partners overseas.

The COVID-19 pandemic has accelerated the trend towards remote and mobile working. To the extent hedge fund managers are considering a longer-term home-working model for their employees, a "work from anywhere" global workforce, or even have regular travel for business needs, consideration will need to be given as to how to manage the permanent establishment, employment tax, VAT and social security tax risks together with non-tax aspects such as visa and regulatory implications.

 

Economic substance

In recent years, several offshore jurisdictions have introduced new rules regarding "economic substance," which centre around the principle that any entity must demonstrate compliance with certain tests where the entity undertakes an activity in a relevant sector and wants to be respected for tax purposes in the jurisdiction. Relevant sector is defined in each jurisdiction but can include fund management entities and holding companies. These jurisdictions include Jersey, Guernsey, Isle of Man, UAE, BVI, Cayman, Bermuda and Bahamas.

Investment funds are often specifically excluded from the laws. For example typical Cayman Islands limited partnership funds, the Cayman resident general partners (GPs) of those funds and any Cayman 

investment SPVs established by the funds should fall outside the scope of these specific rules. It should be noted though that there may be other general local regulatory substance rules that still need to be met; for example, Cayman funds are likely to need a local registered office.

However, fund management activities remain in scope, which means that fund managers located in jurisdictions implementing these types of rules are often required to meet the minimum substance requirements.

 

 

 

 

 

 

 

 

 

 

 

 

About the contributor

Peter Witton is a Director in the PwC Alternative Investment Funds team. He has 10 years’ experience advising start-up Hedge Fund clients on the setup of their fund and management group and also assisting established Hedge Fund clients across a range of tax advisory and compliance matters.