Hong Kong’s Inland Revenue Department is making a more concerted effort this year to audit fund managers working in the city’s alternative investment firms, and it is currently peak season for audit requests, according to Ernst & Young.

Hedge fund executives are likely to receive the most scrutiny, says the consulting firm, since these firms tend to have structures domiciled offshore in jurisdictions like the Cayman Islands.

The IRD's move coincides with a crackdown on tax avoidance on wealthy individuals in the West. One such case relates to the UK’s HM Revenue and Customs, which claimed victory in June regarding a tax-avoidance scheme whereby directors of Sloane Robinson Investment Services channelled bonuses to a Guernsey-based trust to avoid a £13 million tax bill.

One large auditing firm says that fewer than of its 10 hedge fund manager clients have been selected for a tax audit since April 1. Given that it expects to see more chosen before April 1, the number for the most recent tax year will certainly be above the two audits in the previous tax year.

“For the short-term, the IRD may pick a few investment funds to understand their business and operation structure to see if the investment managers have any commercial substance”, says Joe Chan, partner in E&Y's tax and business advisory services unit.

Commercial substance refers to whether the manager has obtained the necessary licences from the supervising authority to carry out investment activities, or if the hedge funds have offices and employees.

Chan warns fund managers not be complacent. It is currently peak season for the IRD to request audit to taxpayers, because if the IRD spots an issue with a tax return after the new tax year begins on April 1, it loses a year of the six allowed by statute for investigating cases.

One way the IRD selects auditees is by looking into related-party transactions with non-residents and transfer-pricing policies, to verify whether payments for investment advisory services, capital-raising functions and/or support services are consistent with market rates.

The IRD also relies on informants – most notably spouses – as well as manager citations in newspapers and magazines, and verifies whether the information provided is consistent with the fund’s financial statements.

Hedge fund managers should review their own positions and assess whether they are at risk of an audit during the current peak season, suggests Chan.

In cases where investment management companies are domiciled offshore, he says fund managers should give detailed proof of where meetings with boards of directors have taken place and about whether the funds were managed and controlled outside Hong Kong.

Firms must also provide evidence that services performed in Hong Kong were part of routine office management and administrative in nature and that therefore fund raising and investing activities were happening overseas.