Hedge Funds Faced with Tax Uncertainty in UK

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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