New Tax Developments Affecting Management Fees: What Hong Kong Fund Managers Should Know
February 22, 2010
By Timothy Loh, Henri Arslanian and Rose Zhao
The Hong Kong tax authorities have
issued new guidance which may affect the arrangements used by fund management
groups to minimize tax on management fees and performance fees. In this article, we examine the
current taxation position and set out defensive steps which fund management
groups may take to minimize the risk of an increased tax burden.
TIMOTHY LOH | Financial Services & Law Review
Vol. 4 (2010) at p. 1
On December 4, 2009, the Hong
Kong Inland Revenue Department ("IRD") issued Departmental
Interpretation and Practice Note No. 46 ("DIPN 46"). Whilst DIPN 46 is not specifically
aimed at the funds industry, it may substantially affect the tax liabilities of
fund management groups operating in Hong Kong.
BACKGROUND
Hong Kong based hedge funds are
often managed by a fund management group comprising an offshore manager ("Offshore Manager") and a
Hong Kong sub-manager ("Hong Kong Manager"). Under these arrangements, the fund delegates investment management authority to the Offshore Manager which,
in turn, delegates certain management functions to the Hong Kong Manager. At the same time, the fund will pay
management fees and performance fees to the Offshore Manager and the Offshore Manager
will pay a service fee to the Hong Kong Manager.
In many cases, the service fee is
calculated as the operating costs of the Hong Kong Manager plus a mark-up of
between 5 to 10 per cent. However, other methods of calculating the service fee may be used.
The transfer pricing and anti-avoidance provisions of the Inland Revenue Ordinance ("IRO")
enable the IRD to challenge the arrangements between the Offshore Manager and
the Hong Kong Manager in certain circumstances where the arrangements provide a
disproportionate tax savings to the fund management group.
DIPN 46 may signal that the IRD
intends to more closely scrutinize these types of arrangements and in this
case, provides guidance as to the IRD's approach.
THE LAW
The IRO includes both transfer pricing provisions and anti-avoidance provisions. At the same time, it empowers the Hong Kong government to
enter into double taxation agreements which may over-ride these provisions. At present, Hong Kong
has entered into double taxation treaties with Luxembourg and Belgium, amongst others, but has not entered into double taxation treaties with the Cayman
Islands or the British Virgin Islands. Fund management groups with an Offshore Manager in a jurisdiction which has signed a double taxation treaty should be aware that the transfer pricing
arrangements may differ from those set out in this article.
Transfer Pricing
The IRO, s. 20(2) provides that a
non-resident person, such as an Offshore Manager, is deemed to carry on a
business in Hong Kong and thus, may be subject to profits tax, if the following
conditions are satisfied:
the non-resident person carries on business with a resident person, such as the
Hong Kong Manager, the non-resident person and the resident person are closely connected, and the course of such business is so arranged that it produces to the resident person
either no profits which arise in or derive from Hong Kong or less than the
ordinary profits which might be expected to arise in or derive from Hong Kong.
Anti-Avoidance
Broadly, a taxpayer is engaged in
tax avoidance when he reduces his tax liability without incurring the economic
consequences that the legislature intended to be suffered by a taxpayer
qualifying for such reduction in his tax liability. In contrast, a taxpayer is engaged in tax mitigation where
he takes advantage of a fiscally attractive option afforded to him by tax
legislation and genuinely suffers the economic consequences that the
legislature intended to be suffered by those taking advantage of the option.
In this regard, the IRO sets out a
number of anti-avoidance provisions. A key anti-avoidance provision is s. 61A, which permits the IRD to
assess the tax liability of a person in such manner as it considers appropriate
to counteract a tax benefit from a transaction (including a scheme or
operation) where the sole or dominant purpose of the transaction is to enable
the person to obtain such a tax benefit. In determining whether the sole or dominant purpose of a transaction is
to enable a person to obtain a tax benefit, the IRD must have regard to
prescribed statutory criteria.
Under this anti-avoidance provision, the IRD may seek to tax the Hong Kong Manager as if it were the
recipient of the management and performance fees instead of the Offshore Manager.
DIPN 46
DIPN 46 seeks to apply the
Organisation for Economic Co-operation and Development's Transfer Pricing
Guidelines for Multinational Enterprises in Hong Kong except where they are
incompatible with the express provisions of the IRO. DIPN 46 reinforces Departmental Interpretation and Practice
Note No. 11A ("DIPN 11A") in which the IRD indicated that it would seek to apply the
anti-avoidance provisions of the IRO to taxpayers carrying on a business in
Hong Kong seeking to book Hong Kong profits to an offshore affiliate.
DIPN 46 is general in nature and does not specifically discuss the fund management industry. Like all guidance issued by the IRD, it
has no force of law and a court may disregard it. Nevertheless, it clarifies the IRD's position on the law
relating to transfer pricing and failure to adhere to the IRD's position may increase the risk of tax enforcement action. In that respect, DIPN 46 provides indications as to the
degree of tax enforcement risk which fund management groups may face.
Arm's Length Principle
Broadly, DIPN 46 requires associated
enterprises to operate on an arm's length basis. It requires associated enterprises to charge the same price,
royalty and other fee in relation to a controlled transaction as that which
would be charged by independent enterprises in an uncontrolled transaction in
comparable circumstances. It thus requires the Hong Kong Manager to charge the Offshore Manager the same fee that
it would charge an unrelated enterprise.
If this requirement is not met,
the IRD has indicated in DIPN 46 that it will make adjustments to transactions
under the provisions of the IRO.
Limitations in Transfer Pricing Law
Interestingly, whilst DIPN 46
references IRO, s. 20(2), it neither discusses to what extent the IRD may use
this section nor how the IRD may interpret this section. It is unclear why the IRD has elected
not to rely on this section.
One possible reason is that the
IRD recognizes that the current drafting of the section does not give it
sufficient powers to combat intra-group tax plans. Although s. 20(2) would appear to give the IRD specific
powers to combat non-arm's length arrangements which limit profits tax, Hong
Kong profits tax is payable only where a person not only carries on a business
in Hong Kong but also where the person has profits which arise in or derive
from Hong Kong. The section deems the non-resident person to carry on a business in Hong Kong but does not deem
the non-resident person's profits from course of its business with the resident
person to arise in or derive from Hong Kong. Thus, to the extent that the non-resident person has no
profits which arise in or derive from (or are deemed to arise in or derive
from) Hong Kong, the non-resident person may nevertheless not be subject to
profits tax even though he may be deemed to carry on a business in Hong Kong.
Limitations in Anti-Avoidance Law
Whilst the anti-avoidance
provisions in IRO, s. 61A are broad, judicial precedent suggests that the
section applies not because the arrangements are made otherwise than on an
arm's lengths terms (as suggested in DIPN 46) but because the arrangements are
made for the sole or dominant purpose of obtaining a tax benefit. This suggests that in some cases,
arrangements which fall short of satisfying the arm's length test may, nevertheless, survive an
attack by the IRD on the basis that such arrangements were not solely or
predominantly motivated by a tax benefit.
TAX ENFORCEMENT RISK
It is possible that DIPN 46
increases the tax enforcement risk of fund management groups on the basis that
the arrangements do not satisfy the arm's length test. To the extent that the sole or dominant
purpose of the interposition of the Offshore Manager is to minimize the profits
tax of the fund management group, such tax enforcement action may succeed.
In this regard, the Hong Kong
government has historically favoured the development of the fund management
industry in Hong Kong and has set out a framework for exempting funds
themselves from profits tax to foster the development of the industry. Enforcement action against the fund
managers would seem to run counter to this policy. In this regard, it is significant to note that:
DIPN 11A earlier established IRD intolerance to the use of offshore affiliates to
book profits in circumstances where the offshore affiliate does not carry out
substantial activity and at the time of its issuance, there was no change in
enforcement policy against fund managers; DIPN 46 does not specifically focus on the fund management industry; and there has not been any apparent and concerted recent tax enforcement activity against
fund management groups in particular.
Enforcement policy however, can
change at any time and it is possible that DIPN 46 signals such a change. Hong Kong based fund managers may
therefore wish to consider if their tax structure, if challenged, would
withstand scrutiny. If found to have engaged in tax avoidance, even in the absence of fraud or wilful intent to
evade tax, fund managers may be subject to a fine up to 3 times the tax that
should have been payable.
DEFENSIVE STEPS
Fund management groups concerned
about Hong Kong profits tax liability in respect of their management and
performance fees should consider seeking tax advice.
In this regard, the anti-avoidance
provisions of the IRO depend upon proof of the sole or dominant purpose of a
transaction. Whilst legitimate tax advice would not advise any taxpayer to engage in an illegal course of conduct,
to the extent that the disclosure to the IRD of any legitimate tax advice may
facilitate a finding that the sole or dominant purpose of a transaction is to
obtain a tax benefit, it may be beneficial to obtain tax advice from legal
counsel. Communications between legal counsel and client are subject to legal professional privilege and hence,
enjoy a degree of confidentiality that advice received from other tax advisers
do not enjoy.
Transfer Pricing Documentation
Fund management groups should
consider engaging a tax adviser to prepare transfer pricing documentation. Such documentation provides a basis for
determining whether arrangements between an Offshore Manager and a Hong Kong
Manager are on arm's length terms and for identifying the purpose of the
arrangements. Amongst other things, such documentation provides written evidence of services rendered by
each of the Offshore Manager and the Hong Kong Manager, the terms and
conditions of the arrangements between the Offshore Manager and the Hong Kong
Manager, a survey of comparable arrangements and the factors that led to the
adoption of a particular pricing methodology. Such documentation must, of course, not only recognize tax
concerns but also regulatory concerns.
Pricing Methodology
Fund management groups should carefully consider the method by which the fees between the Offshore Manager
and the Hong Kong Manager is determined. The method should best reflect the fees which would be payable in an
arm's length arrangement. Possible methods include:
Comparable uncontrolled price method – the fee is based on a comparable transaction
between a manager and a sub-manager which are unrelated; Cost plus method – the fee is based on the costs incurred by the Hong Kong
manager in providing the services to the Offshore Manager plus a mark-up; or Profit split method – the fee is based on a split of the actual or projected
aggregate profits of the Offshore Manager and the Hong Kong Manager which reflects their respective economic contribution to those profits.
Whilst the cost plus method may be regarded as inconsistent with the arm's length principle given that many asset
management arrangements on an arm's length basis are priced on the basis of a
percentage of assets under management, this is not necessarily so. In the context of service company
providing services for an unincorporated firm, the IRD itself recognizes that a
commercially realistic figure for the firm to pay for qualifying services can
reflect not only the costs of the service company which are directly
attributable to providing the relevant services to the firm but also an
appropriate margin or mark-up to covert he overheads and profits of the service
company.
Activities of Offshore Manager
Fund management groups should
consider carefully the role to be played by the Offshore Manager. Where the Offshore Manager does not
carry out substantial activity, the Hong Kong Manager performs all the
activities in Hong Kong which in substance give rise to profits and the
commercial justification for the Offshore Manager is not apparent, there is a
greater risk not only of tax enforcement but also of a finding that the sole or
dominant purpose of the interposition of the Offshore Manager is to obtain a
tax benefit.
In this regard, it is significant
to note that under the laws of the place of incorporation of many Offshore
Managers, the Offshore Manager is required to mainly carry on its business
outside of that place to qualify for tax exemption. At the same time, the Offshore Manager may not be in a
position to carry on its business in Hong Kong without becoming liable to Hong
Kong profits tax and becoming subject to licensing requirements of the
Securities and Futures Commission in Hong Kong.
Transfer pricing documentation
should fully support the role played by the Offshore Manager.
Advance Ruling
Fund management groups, particularly those who have yet to formalize their corporate structure, may
consider obtaining an advance ruling from the IRD as to how the provisions of
the IRO would be applied in their specific proposed circumstances.
CONCLUSION
In light of DIPN 46, fund management groups which comprise managers in Hong Kong and an offshore tax
haven jurisdiction may wish to consider whether the arrangements between the
Hong Kong Manager and the Offshore Manager are likely to be the subject of
scrutiny by the IRD and if so, whether they would survive such scrutiny.
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