What Should Hedge Fund Managers Understand About Transfer Pricing and How to Manage the Related Risks?

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1 hedge LAW REPORT fund law and regulation Transfer Pricing What Should Managers Understand About Transfer Pricing and How to Manage the Related Risks? By Jessica Joy, Stefanie Perrella and Matt Rappaport, Duff & Phelps Hedge fund firms with multinational operations should understand the implications of transfer pricing for their operations. Transfer pricing establishes the price charged between controlled parties involved in cross-border transfers of goods, intangibles and services, as well as financial transactions (e.g., loans). While transfer pricing is most often applicable to international transactions involving distinct legal entities within a global group, the concept of controlled parties can extend to entities involved in domestic transactions, as well as partnerships and individuals. [1] Taxing authorities around the world have enacted transfer pricing rules to ensure that income is not arbitrarily shifted to other taxpayers or jurisdictions, and that reported profits are aligned with functions, assets and risks. The arm s length standard is the fundamental basis of most transfer pricing law, and seeks to price a transaction between controlled parties as if it occurred between two unrelated parties. Many countries require taxpayers to maintain documentation to demonstrate that intercompany transactions comply with the arm s length standard and can impose significant penalties absent this documentation. As a matter of course, many taxing authorities (including the Internal Revenue Service (IRS) in the U.S.) request this documentation at the outset of an audit. This article presents an overview of transfer pricing and the relevant U.S. laws. Further, it discusses current events that may be indicative of how lawmakers and regulators will approach transfer pricing for hedge fund firms going forward, and presents illustrative transfer pricing issues of particular relevance to hedge fund firms. Growing Importance of Transfer Pricing While transfer pricing is a legal construct governing intercompany transactions, one misconception is that it is an elaborate tax avoidance strategy. Fueling this, in part, is the recent scrutiny by lawmakers and non-governmental organizations on the potential misuse of transfer pricing to reduce global tax liabilities. A prominent example is the May 2013 U.S. Congressional hearings of Apple Inc. s international tax practices, during which it was asserted that $22 billion in U.S. taxable income was shifted to Ireland through transfer pricing. [2] Further, in July 2013, at the request of the Group of 20 (G20), [3] the Organization for Economic Cooperation and Development released an action plan to address the erosion of national tax bases, in which transfer pricing is viewed as a contributing factor. A primary objective driving transfer pricing regimes has been the elimination of double taxation (i.e., the same income derived from an intercompany transaction taxed in two jurisdictions); however, there is growing concern that double non-taxation can also occur. While transfer pricing disputes involving hedge fund firms are not yet prevalent, there are indications that tax and transfer pricing issues surrounding these entities are gaining attention. Notably, the U.K. s taxing authority, HM Revenue & Customs (HMRC), issued a consultation document in May 2013 to address potential misuse of limited partnership structures (commonly used by hedge

2 fund firms) that may (1) disguise employment of an individual as a partner to avoid employment taxes, or (2) manipulate profit/loss allocations among members (including corporations) to realize tax benefits. Moreover, in September 2013, the HMRC released proposals to amend transfer pricing law by eliminating individual partners ability to claim an adjustment for payments made to service companies employed by the partnership, such as a fund management company, when such payments are determined to be less than an arm s length amount. [4] U.S. Transfer Pricing Law The U.S. tax law governing transfer pricing is found under Internal Revenue Code (IRC) section 482, which authorizes the IRS to adjust taxable income to reflect an arm s length result, and associated regulations. The regulations provide economic theory, specific methods of analysis and examples to assist taxpayers in determining arm s length prices. To this end, the regulations provide for the application of the best method rule, or the method that produces the most reliable measure of an arm s length result. [5] Certain methods rely on a comparison of prices paid or margins earned in comparable uncontrolled transactions, while other methods compare the profitability of one of the parties involved in the controlled transaction to the profitability achieved by comparable, independent companies. U.S. transfer pricing law also includes section 6662 of the IRC, which dictates the circumstances under which penalties for non-compliance with section 482 apply, and defines ten principal documents that a taxpayer is required to prepare prior to the filing of the U.S. tax return in order to avoid penalties. These principal documents are: 1. An overview of the taxpayer s business, including an analysis of the economic and legal factors that affect the pricing of its property or services; 2. A description of the taxpayer s organizational structure (including an organization chart) covering all controlled parties engaged in transactions relevant under section 482; 3. Any documentation explicitly required by the section 482 regulations, such as for substantiation of a market share strategy or for cost sharing arrangements; 4. A discussion of the method selected and why that method was selected; 5. A discussion of alternative methods that were considered, including why they were not selected; 6. A description of the controlled transactions (including the terms of sale) and any internal data used to analyze the transactions; 7. A description of the comparables that were used, how comparability was evaluated and what (if any) adjustments were made; 8. An explanation of the economic analysis and any projections relied upon; 9. A description or summary of any relevant data that the taxpayer obtains after the end of the tax year and before filing the tax return, which would help determine if a specified method was selected and applied in a reasonable manner; and 10. An index of the principal and background documents and a description of the recordkeeping system used for accessing those documents.

3 Taxpayers are offered protection against penalties; provided that documentation requirements are met. Absent the maintenance of contemporaneous documentation, penalties of either 20 percent (for a substantial misstatement of income) or 40 percent (for a gross misstatement) are applied to the underpayment of tax (i.e., the difference between the adjusted taxable income determined by the IRS and the income reported by the taxpayer). [6] An ever-growing number of other countries have largely similar expectations for taxpayers [7] to prepare transfer pricing documentation, with analogous penalties in the event an adjustment is proposed and such documentation is not prepared. It is important to note that the existence of documentation does not preclude an adjustment, nor does the absence of documentation automatically trigger an adjustment. Transfer Pricing Issues for Firms Any hedge fund firm with multinational operations is subject to transfer pricing rules. In addition, as the concept of controlled parties is very broad, section 482 in theory can also extend to U.S.-only transactions, including transactions between the fund s management company and the general partner, or compensation programs of individuals that may be both an employee of the management company and a member of the general partner (as is the subject of current scrutiny in the U.K.). This article focuses on traditional, cross-border transfer pricing issues that may be of particular relevance to hedge fund firms, and provides simplified examples of how the U.S. rules are applied. Hedge fund firms are capital intensive, requiring both financial capital and human capital. The U.S. regulations provide detailed guidance for transfers of tangibles, intangibles and services, but there is little guidance specific to financial institutions. [8] Thus the focus is placed on transactions which are most likely to arise from hedge fund firms human capital namely services. While specific intercompany transactions are unique to each hedge fund firm and are driven by facts and circumstances, typical services transactions may include (1) the provision of corporate services to global affiliates; and (2) the provision of services in support of fund management, including investment research, trading, capital sourcing, marketing and advisory services. (See Examples 1 and 2, detailed in the figures to follow.) Though each fund will have distinctive intercompany arrangements, some common pricing policies for these types of services include cost reimbursement or cost-plus; a share of revenue or profit; or an asset-based charge (e.g., 50 basis points). Example 1: Routine Services Figure 1: Intercompany Provision of Corporate Services

4 The U.S. regulations provide guidance for controlled services transactions, defined as any activity performed by one member of a controlled group that may result in a benefit to one or more members of the group (even if never realized). An activity is considered to provide a benefit if it provides incremental economic or commercial value to the recipient and is not duplicative, ancillary or stewardship in nature. A functional analysis, part of transfer pricing documentation, assists in determining whether the services are beneficial in nature and warrant an arm s length charge. In Example 1, U.S.Co provides certain corporate services, which may include IT, accounting, finance and HR, to subsidiaries. In the absence of these services, each subsidiary would have to perform these functions internally (e.g., hire additional staff) or contract with a third party. In either scenario, the subsidiary would choose to incur the associated costs. Therefore, the services performed benefit the subsidiaries and U.S.Co should receive arm s length remuneration for providing these services. Under the U.S. rules, remuneration can be determined using the Services Cost Method (SCM), which is elective and allows for services to be charged at cost if certain criteria are met. [9] As a threshold matter, services that contribute to the key competitive advantages, core capabilities, or fundamental risks or successes of the business are not eligible. If transactions are not eligible for cost-based treatment, or the taxpayer elects not to apply the SCM, an arm s-length charge must be administered using another methodology. For example, the Comparable Profits Method is commonly employed for services transactions, including routine services (e.g., administrative services), to determine an appropriate markup on costs. Rather than testing the transfer price directly, the arm s length nature of the transaction is inferred through an examination of the overall profitability of the service provider. This method requires the identification of third-party comparable companies [10] (i.e., companies that perform similar functions to the intercompany services, assume similar risks and employ similar resources) and then compares the overall profitability of the controlled service provider to the profitability of the comparables. In selecting comparables, the focus is on identifying companies that perform similar functions as the intercompany service under analysis, not necessarily identifying hedge fund firms or asset management companies. For a cost-based charge (whether at cost or with a mark-up), a process must be undertaken to identify all relevant costs incurred in performing the beneficial activities, including both direct (e.g., compensation) and indirect (e.g., overhead) costs. [11] Where beneficial services are provided for multiple controlled parties, the applicable total costs (plus an arm s length mark-up, if appropriate) must be allocated among the recipients (i.e., U.K.Co and SingaporeCo in Example 1) using a reasonable method that reflects each recipient s anticipated benefits (e.g., sales, assets, time spent). [12] In instances where beneficial services are provided for just one party, the applicable total services costs (plus a mark-up, if appropriate) should be directly paid to the service provider. In Example 1, the services likely qualify for the SCM, whereby the total services costs are allocated to U.K.Co and SingaporeCo. Alternatively, U.S.Co may elect to apply a mark-up. In this case, under the CPM, a set of U.S.-based companies that perform services comparable to the corporate services provided by U.S.Co is identified, and an arm s-length range of returns achieved by the comparables on their total expenses is determined. [13] As per the U.S. regulations, an interquartile range of results is calculated to remove outliers and approximate the middle 50 percent of observations. The transfer price is considered to be arm s length if the return achieved by U.S.Co is within the interquartile range.

5 A similar approach may be useful for other routine functions provided on an intercompany basis, such as marketing/ investor liaison and research (if the functions are routine for the hedge fund firm). Whereas cost-based charges, with or without a markup, are acceptable for a variety of intercompany services, more direct transactional benchmarks can be used in other circumstances. The ability to apply certain transactional-based methods to directly compare the transfer price [14] is often predicated on data availability. For example, comparable uncontrolled transactions may exist whereby the service provider (recipient) may perform (receive) the same services for (from) an uncontrolled party. Similarly, there may be market data available on remuneration for such services between two unrelated parties. One example of a transaction for which such market benchmarks may be available is the provision of fund management services among related hedge fund entities, illustrated in Figure 2. Example 2: Non-Routine Services Figure 2: Intercompany Provision of Fund Management Services For fund-related services that are non-routine in nature, such as the provision of sub-advisory services, a cost-plus approach may not be appropriate as it does not adequately reflect the level of risk (and reward) inuring to the service provider. Suppose U.S.Co engages U.K.Co to manage certain assets within the fund (e.g., European equities). In this scenario, a revenue split, by which management fees are shared between U.S.Co and U.K.Co based on the relative split of managed assets, may be appropriate. To test the arm s length nature of this arrangement a transactional method, namely the Comparable Uncontrolled Services Price method, can be employed, by examining how an advisor compensates a thirdparty sub-advisor for the provision of comparable services. Uncontrolled funds are typically compensated based on a percentage of the assets they are managing, and data on such fees is available from a number of sources. Again, each circumstance is fact-specific and the best method for pricing a transaction should be based on a detailed analysis of the functions, assets and risks of the parties involved. Adjustments and Penalties If U.S.Co did not charge U.K.Co or SingaporeCo for corporate services in Example 1, the IRS could propose an adjustment to U.S. income under audit. If the arm s length charge is determined to be $10 million, an adjustment to taxable income in the amount of $3.5 million (35 percent tax rate) would trigger a transactional penalty of 40 percent ($1.4 million). [15] Moreover, adjustments (and potentially penalties) can also be triggered if the cost base or the mark-up is determined to be non-arm s length for other routine services (e.g., research), or if U.K.Co overcharged U.S.Co for fund management services in Example 2. If U.S.Co maintained adequate transfer pricing documentation, penalties may be avoided, but income adjustments may still stand.

6 Conclusion Given the heightened attention by tax authorities to perceived abuses using transfer pricing, it is important for all companies with intercompany transactions, including hedge fund firms, to adhere to relevant transfer pricing regulations, and to establish and document transfer pricing policies that are consistent with the arm s length standard, in order to avoid disputes. Jessica Joy is a Managing Director in Duff & Phelps New York office with considerable experience assisting multinational companies with their global transfer pricing needs including documentation and planning studies, cost allocation analyses for the charge-out of centralized services, arrangements involving the use of intangible property, FIN48 reviews, audit defense, and financial modeling to examine the impact of intercompany pricing adjustments. Jessica serves clients in a variety of industries, with a particular focus on the financial services industry including investment management, insurance and reinsurance, brokerage, commodities trading and banking. Her experience ranges from global income and expense allocations for trading, investment banking and investment advisory services, to the pricing of intercompany loans and guarantees. Stefanie Perrella is a Vice President in Duff & Phelps New York office who provides global transfer pricing advice to organizations that range from Fortune 500 companies to start-up businesses. Her expertise is focused on the pharmaceutical and medical device industries, but she also has experience providing services to clients in the software, industrial goods, financial services, and specialty chemicals industries. Specifically, Stefanie has experience in litigation support, cost sharing arrangements, intangibles transfers and buy-in payments and global services allocations. She has assisted clients with all aspects of transfer pricing from planning, documentation, and implementation to controversy and advanced pricing agreements. Matt Rappaport is an Analyst in Duff & Phelps Boston office and is in the firm s transfer pricing practice. Since joining Duff & Phelps in 2012, he has assisted clients with global transfer pricing services including U.S. and global documentation, planning analyses, valuation of intercompany rent, intangible valuation, audit defense, and global management services fee benchmarking and cost allocation. He has conducted economic and comparable company analyses for a broad range of industries including financial services, REIT, software, medical device, life science and professional services. The authors would like to thank Sherif Assef and Chris Franzek, Managing Directors in Duff & Phelps New York office, for their contributions. [1] Treas. Reg (i)(4). [2] Testimony of J. Richard (Dick) Harvey, Jr. before the U.S. Senate Permanent Subcommittee on Investigations, May 21, [3] The G20 consists of finance ministers and central bank governors from 19 countries, plus the EU. [4] See technical discussion. [5] Treas. Reg (c). [6] Treas. Reg [7] Including affiliates of U.S. companies. [8] The Department of Treasury has listed guidance on financial services as a priority, but there has been no action since issuance of the proposed global dealing regulations in March 1998 ( , 63 Fed. Reg ). [9] Treas. Reg (b). [10] There are a number of databases that contain descriptive and financial information of independent companies. [11] Treas. Reg (j). [12] Treas.Reg (k)(2)(i). [13] Treas. Reg (f). [14] See the Comparable Uncontrolled Services Price (Treas. Reg (c)), the Gross Services Margin (Treas. Reg (d)), and the Cost of Services Plus Method (Treas. Reg (e)). [15] Treas. Reg (b). A gross valuation misstatement is triggered when taxable income recorded is less than 25 percent of the arm s length amount.