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Tuesday, December 10, 2019

Opportunity to bring hedge funds onshore

Date: Monday, July 13, 2009
Author: Ratan Engineer, Financial Times

Europeans intent on blasting offshore hedge funds, manifested in the somewhat misguided proposal for a European Union draft directive [on alternative investment fund managers], should focus instead on a great opportunity thrown up by the financial crisis: to bring hedge funds onshore.

The potential benefits are enormous: governments would gain fiscally; considerable employment would be generated; enhanced governance and transparency would follow; and it would remove the need for funds to domicile in the perceived shadowy havens offshore for the benefit of their investors.

There are three principal reasons why hedge fund managers use offshore locations. First, complete fiscal neutrality for the fund so it suffers no tax on income or capital gains and allows easy structuring of feeder funds in jurisdictions that suit investors.

Second, a lack of restriction on the nature, type and extent of investments held. For example, the fund is not subject to rules forcing a diversification of holdings or restricting short positions or the use of leverage or exotic instruments.

Third, domiciling offshore is a tried and tested approach that gives managers and investors certainty.

On the fiscal neutrality point, while it is true that a fund domiciled in the Cayman Islands can be exempt from tax on its income and capital gains, that principle is well established in a number of EU jurisdictions as well. Both Ireland and Luxembourg allow for such a structure. Why not the UK, where the bulk of managers, but not their funds, are established?

UK authorised funds are exempt from capital gains (although issues remain for funds of funds). The fund pays tax on its income and is effectively forced to distribute its income to its investors. This is only to embed a principle of avoiding double taxation and taxing income as it arises. In many hedge funds, net income, as opposed to capital gains, may be negligible given financing costs and management fees.

There was also concern that the use of certain instruments and strategies could be attacked as “trading” and hence make the fund subject to tax as a trading entity rather than being treated as an investment vehicle.

The UK Budget earlier this year clarified matters and set out a so-called “white list” of instruments that would be regarded as qualifying for the tax exemption enjoyed by authorised funds on their capital gains.

Two other concerns remain: the Stamp Duty Reserve Tax regime in the UK, whereby redemptions may be subject to a 0.5 per cent charge; and the fact that a UK manager supplying an investment management service to a Cayman fund can recover VAT on his own costs but may not when supplying a similar service directly to a UK fund.

Seeking to surmount these barriers would be a more productive, and potentially fiscally lucrative, path for European governments to follow than the muddled proposals put forward.

It would not be difficult to eradicate the fiscal disadvantage and avoid the current facade that the industry needs to maintain its offshore status.

The investment freedom issue could be dealt with through normal investor protection regulation, specifically, the existing rules governing qualifying or professional investors, and the distribution of such products could be extended where appropriate.

Assuming these objections to coming onshore could be dealt with, the prize is worth capturing.

The benefits are considerable: the industry would flourish onshore and the ancillary service providers would be domiciled onshore.

Governance would be strengthened: funds could have more effective boards with directors capable of challenging managers and looking after investor interests.

Regulators and fiscal authorities would have better access to hedge funds, and there would be greater public transparency and scrutiny.

Fiscally-strapped governments could stop worrying about tax leakage, with less reason to complain about tax-advantaged and unsavoury offshore centres. Above all, investors would be significant beneficiaries.

These must be prizes worth having even for the most sceptical politicians.


Ratan Engineer is Ernst & Young’s Global Asset Management sector leader. He writes here in a personal capacity and the views expressed are his own.