The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

UK: do I need to rely on the IME? Am I trading?

Stephen Rabel and Michael Beart

Kinetic Partners LLP

Q1 2007

Given the recently issued HMRC guidance on the Investment Manager Exemption (IME) on 20 July 2007, it is a good opportunity to take a step back and revisit the IME issue from a first principles basis. Is it necessary to rely on the IME given the activity performed by an investment manager on behalf of a fund?

By way of background, if a non-resident carries on a trade in the UK through a permanent establishment or branch or agency, the profits arising from that trade are prima facie subject to tax in the UK. Investment managers based in the UK avail themselves of the IME if the funds they manage are considered to be trading to gain protection from this general charging position. Before we need to consider the specific requirements of the IME, it is necessary to determine whether the fund is trading.

Relevant Badges of Trade

There is no clear definition in statute as to what actually constitutes trading activity. The 1955 Royal Commission on the taxation of profits and income collated the case law at that time and identified six badges of trade, a concept that has been developed further over the past half century. Applying these badges of trade is highly subjective, as each case must be judged on its individual characteristics. The arrival of UCITS III products and their ability to invest in a broader range of financial instruments will further bring into focus HMRC treatment of what they consider to be trading or investing activity.

No one badge or indicator is conclusive and commonly some will point one way and some the other way, while others will not be applicable. The five badges which tend to have the most resonance in an investment management context are:

Subject matter

There is a prima facie assumption that an individual engaged in speculative dealing of shares is not carrying out a trade. How this assertion is applied in a final context is not without doubt, although HMRC have recently taken steps to provide clarity here. The focus will be on whether the asset is income producing or not. For instance, an investment in physical commodities would point to trading. This is doubly difficult as such trading would have difficulty in coming within the IME.

Frequency of transactions and length of ownership

These tend to be perhaps the most easily understood indicators, as direct comparisons between portfolios can be made and indicators such as portfolio turnover can be easily calculated. Generally, fewer transactions and a longer length of ownership are more akin to investment. Where transactions are driven by poor performance, market conditions or redemption, these indicators can be easily skewed.

Supplementary work carried out on the assets

Conceptually, this is usually applied to the manufacturing industry, though this could plausibly be extended to activities undertaken by more ‘activist’ orientated funds who seek to effect a change in the asset to realise a gain on disposal, which is more indicative of trading activity. However, the frequency of transactions in this strategy tends to be much lower than otherwise.

Profit motive

This is perhaps the most important of the concepts in relation to the investment management industry but also potentially one of the more subjective. Two investment managers could enter into what, on the surface, would appear to be identical transactions but their intention could be vastly different, i.e., one may be looking for long term growth/income whilst the other could be covering a short position held. The strategy adopted by the manager, as evidenced in marketing documentation, provides an indicator of profit motive.

Sold as purchased or broken down

The period of time over which a position is built up or disposed of could infer trading or investing activity. The approach adopted by a manager may depend largely on the price elasticity of the position rather than the intention behind the investment, so the reliability of using this as an indicator is questionable.

Each case where the meaning of “trade” is an issue must be decided on its own facts. These general principles need to be considered and applied to each fund or indeed to each transaction made by the fund.

Industry and HMRC Comments

The lack of certainty is a concern for the investment management industry both onshore and offshore. UK based “retail” funds, including investment trusts and OEICs, are not subject to tax on capital gains. They would, however, be subject to tax on trading income. If they were to be considered to be trading their gains, they would be subject to tax.

In contrast, for the offshore hedge/alternative funds industry, there is almost a presumption of trading, (unlike UK based funds which start from a position that they would not be trading). The Investment Management Association (IMA) has been asking for HMRC to do away with the trading and investing distinction based on the activity of the fund manager. Their sensible view is that the distinguishing feature of funds is that they are there to earn returns for investors and the transactions they undertake to earn those returns should not determine the tax treatment. Such an approach would provide certainty and place the UK on an equal footing with other fund domiciles where this issue does not arise. HMRC are not prepared yet to give such certainty but it is hoped they keep the issue under consideration.

Thankfully HMRC are not completely silent on the point and have given guidance on the investing trading distinction. This includes comments in the IME statement of practice, that the active management of an investment portfolio does not constitute a trade. More recently the supplementary notes in the pre-Budget Report have offered further clarity. They have built upon their comments in the revised statement and provided guidance on financial derivatives transactions. They state that taking short positions or using derivatives is no more or less likely to constitute trading than more “traditional” investments. It is useful to have such guidance but does it really take the trading investing debate much further? There is still a requirement to establish whether the transaction is trading or investing but it confirms there should be no prejudice based on the nature of the transaction.

Am I Trading?

Where does that leave the manager of an offshore hedge/alternative fund? Given the risk of potential taxation of the fund’s income (including “gains”), should a fund manager assume that their fund is trading? If they do so, they accept that they will need to comply with the IME. If commercially such compliance is not an issue, that would be a likely course; however, the IME requirements can be restrictive, inflexible and require behaviour led by tax rules rather than commercial or market imperatives.
Given the recent indications from HMRC as to their current attitude, managers more than ever should pause to consider whether they will need the protection of the IME at all.

The first step in considering the trading issue should be to look at the strategy followed by the fund. Although each case should be viewed independently, certain strategies, such as long/short equity or fund of funds tend, to be indicative of investing. A convertible arbitrage strategy is, generally, more likely to be considered trading. Unfortunately, there is no hard and fast rule than can be applied.

A next step could be to drill down into the investment process to try to determine the intention behind transactions. Most investment managers can easily explain their intention behind a trade at the time of execution but may find it more difficult 12-18 months after the event. It may not merely be a case of remembering. Is there any documented evidence to substantiate their claim, especially if the transactions could be interpreted in different ways? Often, the story behind the numbers is lost.

Turnover of the portfolio is an important factor. Typically strategies with a high turnover, say over 100 percent/200 percent per annum, are more likely to be viewed as trading. Industry standards vary widely but even long bias strategies can exceed this, in certain circumstances.

If a fund manager were to disagree with HMRC’s view on whether a fund is trading, then it would ultimately be down to the courts.

What will be important is evidence. Financial statements and the wording in the prospectus or offering memorandum of a fund can act as high level indicators but tend not to give sufficient weighting one way or the other. Internal systems and procedures documenting trades can give more detail to the picture but these require careful implementation to provide a body of evidence to support a case.

In practical terms, a balance has to be struck in how best to manage the risk compared to the value added in not having to comply with the IME. The current environment seems to be heading much more down the investing path which provides managers greater opportunity to review their position.
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