Hedge fund managers: why transfer pricing matters in Hong Kong

April 20, 2011

In the past few years, Hong Kong has cemented its position as one of the largest hedge-fund centers in the world. As hedge fund managers set up or expand into Hong Kong, one of the tax issues faced is transfer pricing.

Transfer pricing refers to the price assigned to products or services transferred between group companies.

It is common for hedge fund managers to engage related parties to provide investment advisory services, capital raising functions and/or support services on behalf of the group’s main manager(s).

Under Hong Kong’s transfer pricing rules, related party payments or receipts should be consistent with market rates to avoid tax and regulatory challenges.

Why transfer pricing matters in Hong Kong?

Hong Kong has had one of the world’s more relaxed transfer pricing regimes in terms of level of enforcement by the tax authorities, especially when compared to other financial centers such as the US, the UK or Japan.

However, in December 2009, the Hong Kong Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Note No. 46 (DIPN 46) (1) (2).

This clarified that Hong Kong‘s TP requirements were in line with those prescribed by the Organisation for Economic Development and Co-operation (OECD) and reaffirmed that businesses operating in Hong Kong should transact with their affiliates in a manner consistent with the arm’s length standard.

Failure to adhere to Hong Kong’s transfer pricing regulations could result in challenges to the methods used to price services, additional income being subject to Hong Kong tax plus penalties of up to 300% of any tax adjustment imposed by the IRD.

A further, and often overlooked, implication for hedge funds of a transfer pricing adjustment is that it would need to be disclosed and explained to the Hong Kong financial regulator. Hong Kong hedge fund managers are required, under the Securities and Futures Ordinance (SFO), to obtain a number of licenses from the Securities and Futures Commission (SFC) (3).

As part of the license application a hedge fund manager will need to furnish the SFC (both initially and on an ongoing basis) details on the group’s business plan and compliance manual. This is intended to demonstrate that the firm has the necessary capabilities to undertake its business and importantly that it will be able to comply with its regulatory requirements – this includes tax and transfer pricing.

Key considerations for transfer pricing

The following outlines several common transfer pricing questions asked by hedge fund managers with operations in Hong Kong.

Can a Hong Kong investment advisor be compensated on a cost plus basis?

It depends. The cost plus method is a common approach for compensating a Hong Kong-based investment advisor.

The method is practical and provides a steady level of compensation. As the Hong Kong cost base will include the salaries and bonus costs of the local individuals it is arguable that the method links the compensation of the Hong Kong advisor with the overall performance of the group.

This is so because compensation of the individuals and particularly their bonuses is often directly tied to overall performance.

Despite the practical merits of this approach, the cost plus method4 is most commonly applicable to the pricing of support services. This would not appear appropriate therefore for investment advisory services that are one of the core activities of the group.

Furthermore, if all employees (or partners) are based in Hong Kong, the cost plus method may result in revenues being left in the offshore fund manager. If there are no functions performed by people offshore, this would not be supportable from a transfer pricing perspective.

The method may, however, be appropriate if it can be argued that the group’s key functions are performed offshore.

In this regard this method may be more acceptable for US or Europe-based hedge fund groups, which are expanding into the region and are providing significant support to their fledgling Hong Kong-based advisor.

Equally if the business is in start up and assets under management are beneath a certain threshold, the cost plus method may provide a reasonable result for transfer pricing.

Our capital raising takes place offshore, what does this mean for transfer pricing?

Capital raising, as distinct from ongoing investor relations, is often seen as a key function of the group. The ability to raise assets is critical in enabling a group to earn revenues.

Therefore comprehensive capital raising functions could be compensated, for transfer pricing purposes, with fees, based on a percentage of assets under management (AUM) earned from investors.

If part of this function takes place outside of Hong Kong, under Hong Kong’s source profits tax regulations it may be possible to structure operations so that the income attributable to the offshore component of this function is not subject to Hong Kong corporate income taxation.

However, caution is advised to ensure that any group seeking to separate Hong Kong and non-Hong Kong source income maintain sufficient documentation to support the income being classified as non-Hong Kong sourced.

The group must also separate its cost base between onshore and offshore functions and group must be ready to demonstrate that the functions in question were performed 100% offshore. A related issue is whether the offshore functions create a taxable presence in the location of service.

Do I need to prepare transfer pricing documentation and what should it include?

DIPN 46 emphasized the TP documentation requirements. It notes that “they [taxpayers] are required to draw up their accounts truly and fairly and may be called upon to justify their transfer prices and the amount of profits or losses returned for tax purposes in the event of an enquiry, audit or investigation.”(5)

Therefore hedge fund managers should prepare documentation commensurate with the size of their local operations.

This should include details of the group’s legal and operating structure, details on all applicable investment management functions performed including those performed outside of Hong Kong to the extent they relate to Asia focused investments, and critical details of the transfer pricing methods used and why they are considered appropriate.

A pdf version of this article is available using the link below:

1. See: www.ird.gov.hk/eng/pdf/e_dipn46.pdf

2. Separately the IRD has entered into a number of double tax agreements with other tax administrations around the world. These agreements link to transfer pricing and are examples of the IRD’s recent increased focus on general tax risk management.

3. Typically this includes Type 9 (asset management), Type 4 (advising on securities) and/or Type 5 (advising on futures contracts).

4. Although often referred to as the cost plus method as the method often applied is a full-cost mark up, it would technically be a transactional net margin method under OECD principles.

5. See: www.ird.gov.hk/eng/pdf/e_dipn46.pdf

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