UK Hedge Funds Electrnic Newsletter

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INVESTMENT MANAGEMENT AND REAL ESTATE

Rain or shine?UK Hedge Funds Electronic Newsletter*

MARCH 2007

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UK Hedge Funds Electronic Newsletter // March 2007

ContentsClick on the links below to navigate through the document

Click on the links below to navigate directly to each article

3 Accounting for uncertain tax positions – How prepared are you?

6 Residence – Gaines-Cooper v HMRC (Spc 568)

8 Limited Liability Partnerships – HMRC are now activelyreviewing LLP conversions in the hedge fund sector

10 Proposed revisions to Statement of Practice 1/01 (“SoP 1/01”)

13 Offshore funds update

15 Hedge Fund Transfer Pricing – How robust is your policy?

18 PwC Bespoke Equity Research

21 The Indofood decision – Do your overseas operationshave enough local presence?

by Debbie Payne 7213 5443, Richard Cox 7213 5564, Rebecca McGerty 7804 2272

Click on each authors’ name to contact them directly via email Nex

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Accounting for uncertain tax positionsHow prepared are you?

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Accounting for uncertain tax positionsHow prepared are you?

FIN 48 is amongst the most significant accounting for taxdevelopments in a number of years and has importantimplications for many companies. It is a new US accountingrule that affects all companies reporting under US GAAPincluding subsidiaries of US companies, UK companies with a US listing or US listed debt, and UK subsidiaries of non-UKcompanies with a US listing or US listed debt.

It is effective for accounting periods beginning after 15December 2006 therefore in most cases it first applies toaccounts for the year to December 2007. Historically hedgefunds were structured to attract US investors which includeda corporate fund for US tax exempt investors. Consequentlymany hedge fund managers will be managing funds whichproduce accounts under US GAAP and will therefore have tocomply with the accounting standard.

Many hedge funds implement tax efficient investmentstructures via offshore jurisdictions. Under FIN 48 companiesmust assess their view of the likely outcome of any taxpositions which have been taken around the world. Taxposition denotes any position taken or expected to be takenin a tax return and includes the decision not to file a tax returnin a particular jurisdiction. It may include consideration of theimpact of tax-advantaged transactions/structures, financingarrangements and incentive compensation.

Where there is a tax position the basis for this position mustbe considered to be “more likely than not” to be sustainedbased on technical merits for it not to be recognised in theaccounts. For these purposes is must be assumed that therelevant tax authority has full knowledge of all relevantinformation, there is no scope for considering the probabilityof being audited/investigated as part of the assessment ofwhether or not a tax liability will arise.

Click on each authors’ name to contact them directly via email





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Where there is a tax position the basis for this position must be considered to be “more likely than not” to be sustained based on technical merits.

If this test is not satisfied then the benefit of the tax positioncan not be reflected in the accounts and the variousdisclosure requirements contained within FIN 48 must befollowed. This will mean that the tax position of the companyis far more transparent to tax authorities, regulators andinvestors. Whilst companies will need to identify and assessall material positions existing at the date of implementation itis essential to undertake an assessment of any new positionsas part of the structuring/implementation process for futuretransactions or fund launches to determine whetherdisclosure will be required under the accounting standard.





by Richard Hutchinson 7212 8403, Mark Waddilove 7213 5786


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Residence: Gaines-Cooper v HMRC (Spc 568)The Special Commissioners’ decision has raised questions about HMRC’s practice in determining a taxpayer’s status

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by Richard Hutchinson 7212 8403, Mark Waddilove 7213 5786

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Residence: Gaines-Cooper v HMRC (Spc 568)The Special Commissioners’ decision has raised questions about HMRC’s practice in determining a taxpayer’s status

The recent Special Commissioners’ decision against Mr Robert Gaines-Cooper (“Gaines-Cooper”) has raisedquestions about HMRC’s practice in determining a taxpayer’sUK taxation status in relation to the calculation of the numberof days spent in the UK. HMRC’s practice in this respect isexplained in more detail in the guidance booklet IR 20. This practice allows a taxpayer to ignore, for the purposes of calculating whether he has spent 91 days on average in the UK, both days of arrival in and departure from the UK, and any days spent in the UK for circumstances beyond his control.

The case concerned Mr Gaines-Cooper, a Commonwealthcitizen who had been both resident and ordinarily resident inthe UK, and who claimed that he had subsequently ceased tobe UK resident and had abandoned his domicile of origin inthe UK. The Commissioners found as a matter of fact that hehad not, in the light of all his circumstances.

The case sounds anote of caution on UK residence.The decision is not a binding precedent, and Mr Gaines-Cooper may be considering a judicial review of HMRC decision not to follow IR20, so it is not clear how far-reaching the Commissioners’ decision will be in practice. It is also worth noting that the decision did not suggest, assome press comment has, that days of arrival and departurewill always need to be considered in the 91 day calculation,as the appropriate method will always depend to some extent on the taxpayer’s circumstances.




by Richard Clarke 7213 5778, Debbie Payne 7213 5443, Mark Waddilove 7213 5786, Joanne Klaentschi 7804 3869


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Limited Liability PartnershipsHMRC are now actively reviewing LLP conversions in the hedge fund sector

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by Richard Clarke 7213 5778, Debbie Payne 7213 5443, Mark Waddilove 7213 5786, Joanne Klaentschi 7804 3869

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Limited Liability PartnershipsHMRC are now actively reviewing LLP conversions in the hedge fund sector

Hedge fund managers have, for some time, been receivingparticularly close attention from an HMRC specialist team ofdomestic and international specialists for tax and accountingenquiries. An emerging area of interest is the process ofconverting to an LLP structure via the transfer of the business of an existing UK corporate manager to an LLP.

With many LLP conversions now bedding down, ourexperience indicates that HMRC want to understand thedrivers behind the conversion and to check thedocumentation and procedures both at the time of conversionand going forward. HMRC’s Serious Civil Investigation officehas led many such enquiries and they look at both thepersonal tax positions of the members (partners) and the LLP structures used.

HMRC are likely to show interest in the following areas inchecking whether the business is correctly transferred and run through a “mature” LLP.

• The structure of your business and the implementationsteps from Limited company to Limited Liability Partnership – they may even ask for copies of the implementation papers.

• Self-employed status of the members – HMRC are concerned that many members may have retained theiremployment status.

• Capital gains treatment of the transfer if the business –particularly where the shareholders of the original companyare also members of the LLP.

• Methodology of valuations and the commercial background of the profit sharing arrangements.

A review of your filing position may identify any possible riskareas and provide valuable time to manage these risks beforethe next HMRC enquiry notice arrives.






by Robert Mellor 7804 1385, Debbie Payne 7213 5443, Elizabeth Stone 7804 9678


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Proposed revisions to Statement of Practice 1/01 (“SoP 1/01”)The updated statement makes it clear that HMRC are seeking to accommodate the newer investment strategies

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Proposed revisions to Statement of Practice 1/01 (“SoP 1/01”)The updated statement makes it clear that HMRC are seeking to accommodate the newer investment strategies

The Investment Manager Exemption (“IME”) is a set of safeharbour rules which exempt from UK taxation the profits of anon-resident entity, such as an offshore hedge fund, derivedfrom assets managed by a UK based investment advisor.HMRC have been in discussion with industry bodies forsometime regarding updating SoP 1/01 which sets-out theirinterpretation of certain aspects of the IME. This culminated inthe publication of an open letter and revised draft of SP1/01for consultation in October 2006.

The draft of SP 1/01 makes it clear that HMRC are seeking toaccommodate newer investment strategies being employedby UK managers whilst at the same time maintaining abalance between the hedge fund industry and other sectorssuch as banking and commodity trading.

Whilst there has been considerable speculation in recentpress articles our understanding is that HMRC’s positionremains largely unchanged namely that it is not seeking todrive the UK hedge fund industry offshore simply to ensurethat profits generated by hedge fund managers from UKbased activities are calculated in accordance with UK taxlegislation and subject to UK tax.

Clearly we need to await the outcome of the consultationprocess which is expected to be released later this month butit is hoped that a number of the concerns raised by theindustry during the consultation process particularly aroundthe “independence test” will, at least in part, have beenaddressed. However, there are a number of issues, such asthe so called “cliff edge” nature of the safe harbour rules,which strictly means the whole of the profits of the fund areexposed to UK tax in the event of the fund entering into asingle tainted transaction which does not fall to be treated asan investment transaction within the safe harbour, which






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HMRC have been in discussion with industrybodies for sometime regarding updating SoP1/01 which sets-out their interpretation ofcertain aspects of the IME.

will require amending legislation and hence will take time toamend. It would be useful if HMRC could be persuaded toadopt some form of interim solution to cover the period up totime when revised legislation can be introduced.

In summary whilst we do not expect the updated SP1/01 toaddress all the issues which commentators have raised it isanticipated that there will be an ongoing dialogue to ensurethat the remaining issues which can only be addressed byeither primary or secondary legislation are dealt with.However, managers will need to review fund structures, and inparticular their transfer pricing documentation, once the newguidance is published to ensure that that the IME can still berelied on for future periods.





by Elizabeth Stone 7804 9678, Gauri Devidayal 7804 2171


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Offshore funds update2006 pre-budget report, alternatives, IFRS and loan relationships

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by Elizabeth Stone 7804 9678, Gauri Devidayal 7804 2171

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Offshore funds update2006 pre-budget report, alternatives, IFRS and loan relationships

2006 Pre-Budget Report

A key announcement in the Chancellor's 2006 Pre-BudgetReport was the Government's statement that it will consultwith the investment management industry to ensure tax rulesin the offshore funds regime do not act as a barrier tocommercial development of multi-tiered funds, and tolegislate in this respect in the Finance Bill 2007. Favourableamendments to the investment restriction limits within theserules would certainly be welcomed by the investmentmanagement industry and promoters of offshore funds.

Alternatives

As a result of the Finance Act 2004 changes which allowedoffshore funds to apply for UK distributor status on a shareclass basis, we are seeing an increasing number of funds(including private equity funds, and certain funds adopting“hedge fund” type strategies) seeking UK distributor status(with the attendant UK tax benefits for investors).

The increased ability of UCITS III funds to invest in derivatives(and therefore pursue “hedge fund” type strategies) and the2004 changes which allow all funds to follow the accountingtreatment of income and capital of such derivatives wherecertain conditions are met, has also resulted in thedevelopment of new “hedge fund” like products. In somecases this has enabled investors to access wider assetclasses and strategies (ie. alternatives) and has facilitated the distribution of these funds within the UK.

IFRS and loan relationships

The UK SORP has converted to IFRS effective for accountingperiods beginning 1 January 2007 in relation to loan relationships.Fund managers that rely on the comparability of local fundGAAP and UK GAAP to prepare their UK distributor statusapplications will need to consider how the accounting policiesof the offshore fund will be affected by this change, as thefund is unlikely to be applying IFRS. This is particularlyrelevant to bond funds established in Luxembourg.




by Aamer Rafiq 7212 8830, David McDonald 7212 3736


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Hedge Fund Transfer PricingHow robust is your policy?

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Hedge Fund Transfer PricingHow robust is your policy?

As taxing authorities have focused more and more on transferpricing in the financial sector their specialist skills andexperience in these fields have grown. Some, including theUK, now have specialist teams focusing on the tax affairs ofhedge fund managers. HMRC has been especially vigilant inassessing and imposing penalties for incorrect selfassessment due to their perception of egregious transferpricing arrangements. However, a potentially more hazardousconsequence is that the transfer pricing failure can lead to abreach of the customary rate test within the investmentmanager exemption (“IME”), potentially exposing the offshorefund to UK tax.

Despite the growing scrutiny from the tax authorities, hedgefund managers continue to be in a good position to takeadvantage of transfer pricing to manage their effective taxrate. The key value drivers (or to borrow an OECD phrase, thekey entrepreneurial risk taking (“KERT”) functions) are oftenthe activities of a small number of people performing coreportfolio management or distribution functions. As these valuedrivers are concentrated in a few personnel it is arguablyeasier to legitimately tax optimise a hedge fund business thanbusinesses in a lot of the other financial sectors. Many hedgefunds have already done exactly this by locating a significantportion of their overall functions in more tax efficient locationssuch as Cayman, Channel Islands, Ireland, Switzerland orHong Kong. Although the benefits are obvious, to besuccessful arrangements of this type must be robustlyevidenced and documented, and real value driver functions,assets or risks must be located in the more tax-efficient jurisdictions.





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...it is arguably easier to legitimately tax optimise a hedge fund business than businesses in a lot of the other financial sectors.

Given the context above the transfer pricing policies in thehedge fund sector often focus on ways of allocatingrevenues/profits to the key value driver functions of:

• Portfolio Management, covering asset allocation, investmentresearch, investment decisions, position risk managementand performance related brand/reputation); and

• Distribution/Capital Raising, covering targeting investors and selling the fund.

Traditionally, benchmarking the distribution function directly inthe hedge fund context has been difficult due to theunavailability of third party benchmarks or lack on internalcomparables. Given these problems of comparability betweenindustries and recognising that there can be significant taxand/or penalties at stake for most hedge fund managers PwCundertook research and analyses to develop a benchmark forthis function (known as the “The Hedge Fund Survey”).

The Hedge Fund Survey took almost a year to complete andis drawn together from detailed interviews with more than 100hedge fund managers and independent distribution agents. Inaddition, the Survey also incorporates reviews of industrypublications and publicly available filings of US hedge fundmanagers. We believe that this benchmark is unique in themarketplace and provides a robust basis upon which to eitherto support existing arrangements or to plan new structures.




by Louise von Blixen 7213 8981


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PwC bespoke equity researchBy outsourcing parts of the Equity Research to PwC it enables you to free up time for you and your team to focus on investment decisions.

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PwC bespoke equity researchBy outsourcing parts of the Equity Research to PwC it enables you to free up time for you and your team to focus on investment decisions.

The PwC Global Equity Research Team is part of the Advisorypractice of PricewaterhouseCoopers LLP. The team includes12 Equity Research Analysts with extensive sector experiencefrom working in the City at Investment banks and 4Economists with a broad set of micro and macro economic expertise.

Based on its experience and depth of resources the team is dedicated to providing insightful bespoke analysis of globalstock markets, countries, regions, industries and specific companies.

The analysis is:

• High quality

• Objective and independent

• Industry focused

• Tailored

• Idea generating

By outsourcing parts of the Equity Research to PwC itenables you to free up time for you and your team to focus oninvestment decisions.

Our work is independent and is based on information in thepublic domain. All research is bespoke and tailored to meeteach client's specific needs so none of our deliverables lookthe same. However our research can for example include:




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Our work is independent and is based oninformation in the public domain. All research isbespoke and tailored to meet each client'sspecific needs so none of our deliverables lookthe same.

• In-depth company research - initiating coverage style

• Industry research – key trends and issues

• Country specific economic reports

• Forecast models - P&L, B/S and cash flow with forecastsand key drivers

• Briefing notes ahead of meetings with the companymanagement (highlighting key issues and questions to ask)

• Analyst meetings/Investor day attendance and write-ups.

If you would like to get more information around PwC’sBespoke Equity Research please let us know.



by Robert Mellor 7804 1385, Lachlan Roos 7213 1309


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The Indofood decisionDo your overseas operations have enough local presence?

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by Robert Mellor 7804 1385, Lachlan Roos 7213 1309

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The Indofood decisionDo your overseas operations have enough local presence?

Following the Court of Appeal’s decision in the Indofood casein March 2006, there was considerable uncertainty andconcern as to how HMRC might seek to apply the case totransactions in which a double taxation treaty is relied on toclaim relief from UK withholding tax.

The case concerned an international financing structure inwhich a Dutch company was interposed between a principalcompany and a bond issuing company with a view toclaiming the benefit of a double taxation treaty to reducewithholding tax on interest. It was held that the Dutchcompany did not beneficially own the interest it received from the principal company so the treaty in question wouldnot apply.

HMRC published their draft guidance on the case inNovember 2006. Although the case was predominantlyconcerned with matters of contract law HMRC's view is thatthis decision, as far as it relates to double taxation treaties,

is now part of UK law and also likely to be of persuasive forcewhere related issues for UK double taxation treaties are beingconsidered. In other words, HMRC will seek to use the caseto deny treaty relief where they perceive there to be someform of abuse such as treaty shopping.

Helpfully HMRC go on to give examples of certaintransactions that they consider will not be abusive, includingcertain securitisations, issues of Quoted Eurobonds,syndication and sub-participations.

However, when considering options for structuringinvestments care should be taken to ensure that the companyhas operational substance in the country where is it residentfor tax purposes which would include giving consideration torenting offices and employing staff. Clearly the lower the levelof operational substance the greater the risk of a successfulchallenge by the relevant fiscal authority.




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This publication has been prepared for general guidance on matters of interest only, and does not constitute professionaladvice. You should not act upon the information contained in this publication without obtaining specific professional advice. Norepresentation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in thispublication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents accept noliability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on theinformation contained in this publication or for any decision based on it.

©2007 PricewaterhouseCoopers LLP. All rights reserved. ‘PricewaterhouseCoopers’ refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, the PricewaterhouseCoopers global network orother member firms of the network, each of which is a separate and independent legal entity.

UK Hedge Funds Electrnic Newsletter

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