Alternative Investment Management Association
KPMG LLP (UK)
This article looks at some common problems that could bring into question the tax residence of an offshore entity.
Most UK hedge fund managers will have sought tax advice and will be fully aware of the need to ensure that the offshore funds in question are managed and controlled outside the UK. This advice applies equally to any other offshore entity within the fund or management structure (including offshore management, employment or marketing companies). Based on this advice, the funds will have a majority of non-UK resident directors, the board meetings will be held outside the UK and these meetings will be documented. Assuming that this advice has been followed, could HM Revenue & Customs (HMRC) still argue that the funds (or any other offshore entity) are managed and controlled in the UK?
Unfortunately, the answer may be yes. Based on our experience of HMRC enquiries and case law discussion on tax residence, there are a number of practical actions that can strengthen or weaken a company’s tax residence.
What is the issue?
A company that is not incorporated in the UK can still be resident for tax purposes if it is managed and controlled from the UK. The company will then be subject to corporation tax on the whole of its profits. Managing and controlling an offshore fund from the UK would therefore be disastrous for the fund and the fund manager. So ensuring that HMRC has no scope to argue that the fund is UK managed and controlled should be a priority of the UK fund manager and the directors of the offshore fund.
Management and control
The concept of management and control has been developed by the English courts with the result that there is no definitive legislative definition.
In determining where management and control is exercised, the courts have looked at the highest level of control over the company’s business. On the basis that decisions at the highest level are made by the Board of Directors, the place where the directors meet has been held to be indicative of the place that management and control is exercised. However, if control is in fact exercised by a single individual, the location of that individual may be held to be the place where management and control is exercised. This is an important consideration when assessing the level of control that any UK director has over the fund.
At the time of writing, a significant Court of Appeal decision (Wood v Holden) was handed down on the topic of company tax residence. The Court of Appeal upheld the High Court decision, in favour of the taxpayer, confirming that the company was managed and controlled offshore. The case is of interest because it specifically looked at whether the actions of the offshore company’s directors amounted to the management and control of the company. The facts held as compelling evidence included that:
• The directors made their decisions in the Netherlands, as evidenced by the board resolutions made and the documents signed in the Netherlands
• The directors were not dictated to and were seen to have a high enough standing that it was thought improbable that they would allow their actions to be dictated
• The directors had the right to refuse a decision and had the power to do so.
The Court of Appeal noted that the case was decided on its specific facts, which may limit its wider application. The offshore company in the case was a special purpose vehicle that undertook only one transaction. In the case of an active entity, such as a hedge fund, the directors may have more day-to-day involvement, increasing the risk of breaching management and control procedures. We also understand that it is likely that HMRC will petition the Lords for permission to appeal.
Are all directors aware?
Having a majority of non-UK resident directors is important in maintaining a fund’s offshore residence. A common concern when assessing whether a non-UK resident majority exists is whether there is a true majority of non-resident directors actively involved in the management and control of the company. For example, a fund may have one UK resident director and three non-UK resident directors, only one of whom is fully informed on matters. The other non-UK resident directors may simply follow the views of the active non-resident director, or worse, follow the views of the UK resident. In this scenario there may be some concern as to whether there is a true non-UK resident majority.
The High Court commented in the judgement of Wood v Holden (and repeated in the Court of Appeal decision) that “if directors of an overseas subsidiary sign documents mindlessly, without even thinking what the documents are, I accept that it would be difficult to say that the national jurisdiction in which the directors do that is the jurisdiction of residence of the company. But if they apply their minds to whether or not to sign the documents, the authorities…indicate that it is a very different matter.”
The non-UK resident directors need to be fully informed, they need to review information provided to them, engage in any discussions and form their own view on fund matters to ensure that it is clear that they make the decisions on behalf of the fund – in other words, the directors must be able to show that they have applied their minds in making decisions.
When are the directors briefed?
Another important factor is the directors’ involvement in any evaluation or planning process leading up to a decision. If evaluation and planning is conducted in the UK, the involvement of the directors at an early stage in the process may strengthen the argument that the directors are fully informed in making any decision.
Conversely, if the directors are presented with a proposal at the end of a long planning process without any earlier involvement, it may weaken the argument that the management and control of the fund is offshore. Additionally, the involvement of a UK resident director in the planning process without the non-UK resident directors may weaken the argument further. And if the UK director is seen to have increased authority, control may be argued to be held by this individual and exercised in the UK.
Is the documentation a true representation?
Documentation should exist to support the non-resident status of a fund. It is important that this documentation is a true representation of the affairs of the fund and the actions of the directors, and that the validity and accuracy of the documentation is not brought into question.
The documentation should include complete board minutes, documentation of decisions, a record of discussions, and reasons why the decisions were made (where appropriate).
Common errors that could bring into question the validity or accuracy of documentation include:
• Pre-prepared board minutes are common where formalities are actioned by the directors and the board meeting is expected to involve little discussion. Pre-prepared minutes will not record any discussion held during the meetings and may not correctly reflect any decisions that were not made as planned.
• E-mails (or other documents) that indicate that amendments have been made to board minutes to include items that were not actually discussed at the meeting or evidence exists that documents have been back-dated.
• Simple errors such as typos in the board minutes that result in the minutes not making sense.
What does the documentation say?
Where planning is performed by individuals who are not the directors, any briefing documents for the directors should include all relevant information necessary for the directors to make fully informed decisions. Documentation can include statements as to the thoughts of the preparers, but should not dictate a decision, nor should it infer that agreement should be given without a full and independent review of all relevant information. The documentation should also not refer to what the Board of Directors would think or are likely to agree, for example, “the directors will approve…”, as it is solely the directors’ decision as to whether they give their approval or not.
In summary, all written correspondence should be worded with care to support the fact that decisions are made by the directors outside the UK.
The importance of maintaining non-resident status should not be forgotten after a fund (or other offshore entity) is established. Given the now co-ordinated approach by HMRC’s special civil investigations group (which appears so far to have resulted in an increased number of HMRC enquiries into hedge fund groups) and the catastrophic effects of getting it wrong, there is a real need to manage risk areas.
I strongly suggest that periodic reviews are undertaken of the procedures and documentation of all offshore entities, either by the fund manager or by engaging a professional advisor to perform a health-check. The review should take account of the issues outlined above and any matters specific to the offshore entities, to ensure that management and control continues to be undertaken outside the UK.
Note: the views and opinions expressed are those of the author and do not necessarily represent the views and opinions of KPMG LLP (UK).