Hong Kong hedge fund managers should consider litigating against the city’s Inland Revenue Department's challenge to their policies on taxation of remuneration, said some industry players.

This comes as at least a dozen Hong Kong-based hedge funds have begun to make settlements with the government tax department on the issue. Industry observers hope this will result in the end of a wave of tax-related audits by the IRD that is now in its third year.

Tax specialists estimate that since 2011 there have been 50 audit assessments targeting alternative investment firms, of which some 60% involve hedge funds (and the rest private equity firms, as reported).

This represents nearly 10% of the 348 hedge fund managers that operate in the city, managing $87.1 billion in AUM between them, according to the latest 2012 figures from the Securities and Futures Commission.

And there could be further notices issued before the end of the 2014 fiscal year in March 31, 2015, noted Paul Ho, tax partner at consultancy EY.

At issue is how the advisory fees paid to Hong Kong-based fund houses by their offshore peers are sometimes calculated. The IRD said some of these transactions do not conform to the arm’s-length principle that requires transacting subsidiary parties to price their services on an independent footing equal to what a third-party provider would charge. The calculation comprises business costs plus a mark-up, which the IRD has argued is sometimes too low.

In private, some consultants have said the IRD is right to target the small number of fund managers that have drawn unwanted attention to the industry by aggressively calculating management fees with cost-plus pricing of less than 5%, which is increasingly being viewed as below the typical industry minimum.

They also pointed out that some are not holding board meetings offshore and not even having a listing of their shell companies in Cayman Islands directories.

But not all blame should be pinned on the fund managers, argued one hedge fund insider, who declined to be named. He argued that many of the structures, including transfer-pricing policies, were based on professional advice coming from the large accountancy firms – the very advisory groups that have generally been in favour of settlements with the IRD.

Increasingly hedge funds are seeking tax advice from sources other than accountants, in light of what they see as potential conflicts of interest, given that they also may be acting as consultants or advisers to the IRD. “They have no interest whatsoever to shake the tree,” he added.

Grounds for litigation
Ultimately, however, the IRD’s focus on transfer-pricing policies is “technically irrelevant” in the eyes of the law and therefore the industry could consider litigating, said Travis Benjamin, tax partner at Deacons.

As there are no comprehensive tax treaties between Hong Kong and either the Caymans or the British Virgin Islands, arm’s-length pricing should not apply to fund firms in the city when dealing with managers in those two offshore locations, he argued.

Broadly, there are two ways that management fees earned by an offshore fund manager can be taxed in Hong Kong.

The first is if the fund manager conducts business in Hong Kong and earns Hong Kong-sourced profits from the performance of its activities in city. The second is if the offshore asset manager/onshore adviser structure intends to deceive authorities with the purpose of avoiding Hong Kong tax.

“The inconvenient truth of the matter is that there is no legal basis for the IRD’s approach or for its assessment position,” Benjamin said.

After spending time and resources over a number of years on such cases, the IRD wants a return on its investment, said Benjamin. “This has resulted in a rather aggressive IRD position, where the underlying message to asset managers is 'settle the audit by paying tax or take your chances in litigation'.”

The insider, agreeing the industry could consider litigation, agreed that the rising number of hedge fund settlements risks putting pressure on other firms to ultimately settle.

While litigation may create clarity for the industry, he added, the time and cost it would take is a big disincentive for the industry. He suggested that perhaps like-minded lawyers could consider coming together to litigate for free for the industry’s benefit.

“No individual manager would want to pick up the fight on their own,” said the hedge fund executive. “If I were to win the court battle, everyone is going to benefit, but who is going to pick up the legal cost?”