Shed A Tear For Those Poor Hedge-Fund Managers

by Jeremy Hetherington-Gore, Tax-News.com, London

01 June 2006

Fed up with reading about hedge-fund managers' astronomical earnings and second yachts while you struggle along on 5,000 euros a month? Well, you can indulge in a little schadenfreude - May has been a miserable month for hedge funds and their managers according to market gossip, and the tax authorities are in hot pursuit of those Cayman Island properties.

The unexpected collapse in commodity prices in May and the resulting falls in emerging market stocks are said to have cost many hedge funds up to 5% of their value during the month. Most commodities funds seem to have stayed in their holdings far too long: some of them may have lost up to 25% or even more.

Meanwhile, in London, hedge fund managers who have been using offshore destinations to park their giant bonuses are facing an attack from the Inland Revenue. UK-based hedge funds are not taxed on gains on their holdings under an investment management exemption which applies to all UK-managed funds, providing that management fees, which are taxable, are reasonable. It is usual for UK-managed funds to have themselves administered in offshore jurisdictions - Ireland, the Cayman Islands and Luxembourg are the favourites - and for management fees to be split between the London and offshore offices. This split should be made according to the best transfer-pricing arm's length principles, and it is this split that the Revenue is said to be examining.

John Neighbour of KPMG, told the Financial Times this week that HMRC is stepping up its scrutiny in a move likely to lead to litigation in some cases. "There is potentially a lot of tax at stake. This is a big area of tax risk." Funds which allocate too little in the way of fees to the UK could lose their funds' tax-free status, says Mr Neighbour, an ex-Revenue officer.

This situation will not be news to New York hedge fund managers, who were similarly targeted by the IRS in 2003. One of the techniques used in New York was to exchange fee entitlements for shares in offshore subsidiaries; this is not illegal as long as the funds use 'cash' rather than 'accrual' accounting for their income, but the IRS accused many firms of being erratic in their accounting techniques.

Also keeping London hedge-fund managers awake at nights is the growing risk they are facing of legislative attack from the US. Foreign hedge fund managers have to register with the Securities and Exchange Commission if they have US clients under new and highly controversial hedge-fund registration rules introduced earlier this year. More than 150 London-based funds are said to have registered - and their managers are highly vulnerable to transatlantic attack.

Robert Kelly, of hedge fund insurer Baronsmead, told the Daily Telegraph that managers who are heavily involved with US markets were at greatest risk. Mr Kelly said that as these managers have US investors, operate under US regulators and trade in US markets, they couldn't be more at risk unless they moved there. And as appeared recently, UK courts seem unable and unwilling to resist extradition requests from the US authorities under the new mutual assistance treaty between the US and the UK.

So relax with your cup of tea and count your blessings. That young man with the flashy Ferraris may end up doing a perp walk at Kennedy while his yacht rusts away in Tortola Bay. Or are they made of titanium nowadays?

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