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In most jurisdictions around the world, and particularly in Europe, governments and regulators are examining a number of options to rein in compensation for financial industry professionals. In the UK, the government there imposed substantial taxes on high income earners, and, not surprisingly, hedge funds have worked to develop structures in order to pay their professionals in a manner which minimized the tax burden.

Complex Structure Seems to be Designed to Avoid Taxes

A considerable number of hedge funds in the UK utilize a complex structure that seems designed to pay staffers their compensation at lower tax rates. As most hedge fund managed firms are structured as partnerships, tax authorities are beginning to see an increasing number of partners in many firms. In some cases, these partners are corporations, which pay substantially less tax (approximately 20 percent versus 45 percent for individual taxpayers). This practice in and of itself would be acceptable, however tax authorities are concerned that many of these “partners” are likely just employees, not having contributed any capital and not exposed to much risk due to fixed salaries.

In addition the partnership structure allows for some manipulation of profit and loss allocations for tax purposes, again adding to the amount of tax avoided. Finally, a third source of avoidance is using corporate partners in order to pay dividends out to spouses and children, reducing the amount of income taxed at the highest tax brackets. All of these measures help shield the industry and employees from $20 billion in taxes each year.

And the use of these structures is very widespread. “It affects virtually everybody. Out of 400 odd firms in London, more than 80 percent of them have these [corporate member] structures,” Joe Seet, a senior partner at London based hedge fund consultancy Sigma Partnership told the Financial Times. Seet also suggested that performance bonuses were a particular form of compensation channeled through these structures, with many of the corporations being based in much lower taxed Ireland.

Clearly, British tax authorities,  HM Revenue and Customs, are not a big fan of the arrangement and are looking to recover lost revenues. With $20 billion potentially at play, one can be assured no effort will be spared in going after these structures.

Taxation Approach is Inconsistent with Objectives to Grow Financial Industry

Unfortunately for British policy makers, these attacks on the industry are counterproductive to the goal of establishing a stronger financial industry and associated high income jobs. On one hand they want wealthy financial professionals to establish themselves in London but on the other, they want an increasingly large piece of their income. The overall approach of the government may encourage firms to look elsewhere in terms of where they want to locate their business; however, London will likely be a major player regardless of any tax crackdown.

In the end, hedge funds will develop new and innovative ways to create as much tax efficiency as possible for themselves and their employees, as they have done for decades. Many funds are considering corporate structures rather than partnerships to avoid tax issues, though this may also limit their flexibility in avoiding European Union caps on bonus payments. In the end, when a number of highly talented financial minds are put in one place, innovative solutions will be developed in terms of tax efficiency, which should ensure hedge funds remain a big part of London finance for some time.

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The growing pressure that the hedge fund industry is facing from regulators and the few individuals that have been willing to stand against the political tide were featured in a recent piece by the Financial News. Syed Kamall is a member of the European Parliament, representing London, one of the hedge fund centers of the world. While most politicians have demanded hedge funds face increased regulation, pay higher taxes or simply cease to exist, Kamall is advocating for the positives that hedge funds bring to both the local and broader economy.

While the hedge fund and private equity models have some recognition in the English speaking world, in much of continental Europe, they are known primarily as excessive risk takers that create systemic concerns for regulators and lawmakers alike. Leading European countries such as France and Germany have been unsuccessful in establishing innovative financial centers like London and New York and therefore seem eager to stem the risk taking where they see no local benefit. Unfortunately for hedge funds, few politicians are willing to put their own reputations on the line in order to defend the industry against the interests of the major continental powers.

London Remains the European Center for Alternative Investment

The hedge fund industry is particularly critical to London, who Kamall represents. Up to 80 percent of the hedge fund industry in Europe calls London home, while 60 percent of private equity firms operate out of the city. Clearly, London and the United Kingdom as a whole have the most to lose as a consequence of increasing regulation of the hedge fund industry. The recent Alternative Investment Fund Managers Directive is one such attempt at regulation that will have real impacts on individuals working in London’s hedge fund industry. The increased regulation, rules and limitations on leverage may create an uncompetitive environment for hedge funds to operate global from Europe, and they may shift their geographic locations to more favorable jurisdictions. Thousands of jobs may be at risk in London as a result, while potentially opening the door for new opportunities in foreign jurisdictions.

What Does This Mean for Job Seekers in the Hedge Fund Industry?

There is certainly a trend developing in many countries with established investment management industries towards increased regulation and oversight for alternative investment managers. Unfortunately for these countries, investment capital is now fairly mobile around the world. There are a number of countries that have taken an open minded approach, such as Singapore and Malaysia, and have cautiously welcomed the benefits that alternative investment managers bring to their economy. Not only have heavily regulated economies lost hedge fund jobs, but they also have less oversight of the industry than before heavy handed rules were imposed.

As a result, those looking for employment in the hedge fund industry need to cast a wide net geographically when searching for opportunities. Researching the regulatory regime of a country where a prospective job is located is important for understanding whether the position may be shipped offshore in light of changing regulation in the near future. While there will always be hedge funds operating in London or New York despite increased regulation, many of the most attractive opportunities in the future will likely be positioned overseas in jurisdictions that look favorably upon the industry.

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