AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Transfer pricing: Application in an evolving market

By Michael Beart, Director, Kinetic Partners LLP

 

Q4 2012 edition


Be it through design or necessity, international structuring and the ability to ‘control’ the recognition of profits across a structure underpins the effective tax rate suffered by every multinational organisation. Put simply, transfer pricing legislation seeks to regulate that control, enabling competing tax authorities to get their fair share of tax. Unsurprisingly, the potential for transfer pricing disputes is for most businesses their single largest tax risk. The investment management industry is no different, with perhaps the exception of tax risk embedded at the investment level.

Globally, tax authorities tend to adopt, either implicitly or explicitly, the transfer pricing guidelines developed by the Organisation for Economic Co-operation and Development (OECD) into their local legislation allowing taxpayers, in theory, to apply a consistent pricing methodology across their business. Typically when submitting their tax return a taxpayer has by default declared that they have undertaken a transfer pricing analysis to determine an arm’s length rate, as set out in the OECD guidelines. Most managers will consider their transfer pricing position when they first launch and then perhaps only next when they open an office in a new jurisdiction, but technically the test is annual and documentation should be maintained to reflect this.

To determine an arm’s length price, the OECD guidelines (last updated in 2010) provide a best practice ‘stepped’ approach setting out a prescribed script for taxpayers to follow, one which would seem unwise to deviate from should the conclusion ever be in dispute. In brief, it requires a background analysis of both the taxpayer and industry they operate in – setting the scene and context for the analysis. This is followed by the identification of inter group services through a functional analysis and a review of any internal or external comparable benchmarks for the services. Based on the review, one of five transfer pricing methodologies is then adopted and applied, making adjustments in reaching a final conclusion. Useful as this may be, it is still vital that the taxpayer remains focused on the commercial reality and bargaining power across the group. Famously, the taxpayer in the UK’s largest ever transfer pricing case lost not because they hadn’t undertaken significant analysis but because the conclusion drawn did not reflect the commercial reality.

In recent years the industry, in common with many, has witnessed a contraction and a flight to quality. Asset-raising has served to be a powerful barrier to entry, testing the resolve of any manager who has launched in the past five years. Increasingly intrusive and complex regulation paired with the need for evermore robust operational infrastructure play to the relative strengths of the large players who have the economies of scale to deal with these changes. Managers should consider how the evolving commercial environment should be reflected in their transfer pricing policies and where they are in their business life cycle before arriving at a conclusion. For some it will be a cost, whilst for others an opportunity.

Almost universally, investment managers have remuneration structures founded upon the fees charged as a percentage of AUM of the investment portfolio they manage and a performance fee. A strong argument exists that when seeking to determine an arm’s length price for profit generating activities within a firm a fee split method (an extension of the profit split method) could be used. The adoption of a fee split methodology based on assets, risks and functions performed has evolved as a common transfer pricing methodology by advisors and tax authorities alike in relation to the investment management function.

In choosing the appropriate split of fees, it is important to consider the investment management supply chain provided to the end investor and the business model adopted. From inception, investment managers are typically structured as owner-managed businesses, unless integrated within institutions or listed organisations. This business model is critical to a service based industry that is heavily reliant on key personnel within the investment manager as the equity share acts as a powerful retention mechanism. However, when it comes to compensation, attention is first given to the crucial role of asset raising and marketing as without any investors no business will exist. Then the core operational costs of regulation, administration, finance, legal, etc will be compensated. Finally the remaining pot tends to be allocated amongst investment professionals. This three-tiered approach to compensation provides a possible framework for a fee split methodology to be applied.

Taking each tier in turn, the first tier of asset raising and marketing is probably the single area that managers are most likely to outsource to a third party. Third party marketing agents do provide invaluable comparable pricing data as a benchmark, however this should be adjusted based on the relative positioning of a manager in the market. Clearly a fund with a strong 10-year track record and $10bn of AUM is going to be an easier sell to investors than a new entry to the market, so the fee charged by a marketing agent would understandably reflect this. Moreover, the established manager in such a scenario would hold far more bargaining power when negotiating contracts. This type of nuance would be reflected in the contractual relationships between independent parties so should be incorporated in determining an arm’s length price.

The second tier of fees to be distributed is more difficult to apportion. The base running costs of operating an investment manager can vary wildly depending on location, strategy and complexity of the business. Although sometimes assigned as a low value as it neither directly drives assets nor performance, these functions are essential to the smooth operation of a business. For example, a regulatory breach or legal action against a manager can be enough to bring trading to a halt. For new entrants to the market, established operational platforms provided by a few niche outfits can give some kind of indicative range, but whether this can be accurately scaled up for larger managers is debatable and tax authorities are likely to question whether they are indeed comparable.

The final tier can, by a process of elimination, provide the remainder to be apportioned to the investment management function. If this is located in a single jurisdiction then this should be a relatively simple result. However it is increasingly the case established managers will look to open new offices to base traders in financial centres across the world. Apportionment based on the precise functions undertaken or the portfolio managed can be useful, but a reliable split really depends on how the investment teams operate together across the organisation. Pragmatically, staff remuneration often gives the best indication of value added.

To insert yet more intricacy, managers also have to consider how intangibles embedded in their business are captured in their transfer pricing policies. In June 2012 the OECD released a draft update to the transfer pricing guidelines addressing the pricing of intangible assets in a business. The existing guidance in this area was generally regarded as inadequate, leading some to assume that any intangible value in the business attaches to the investment management process. This could be true to a greater or lesser extent as typically in the industry a brand is synonymous with key individuals in the business who lead the investment management function. However, as personnel come and go the value of that brand starts to develop in its own right as the business matures.

Similarly the value of intellectual property developed within a business may also have a value in its own right, but establishing a valuation can again be difficult. Where managers develop trading models, extensive databases or integrated trading systems in-house they are obviously reluctant to offer it on the open market. Indeed a huge amount of time and effort is often dedicated to ensuring it cannot leave the business, retaining the competitive edge it creates. Nonetheless, managers will need to recognise this value in their pricing policies.

In conclusion, managers should take the time to understand what drives their transfer pricing methodology and the various factors that can influence it. Not only is ongoing monitoring prudent management of the tax risk, but with a little forethought and careful planning substantial benefits can be realised.

 

michael.beart@kinetic-partners.com

www.kinetic-partners.com

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