Hong Kong's Inland Revenue Department has recently issued an interpretation to existing tax laws that has the potential to impact any company that transfers fee revenue offshore, including many hedge funds.

The Hong Kong government's official policy is to encourage asset managers to do business in the territory, so it's unclear whether the new interpretation will be applied to fund managers.

There is a risk, however, that hedge funds, particularly smaller ones, will be affected.

This comes a few years after Hong Kong put to bed a threat to tax hedge fund managers, which in the early 2000s helped drive many firms to set up in Singapore instead.

Inland Revenue's 'departmental interpretation and practice note number 46' may reflect international pressure on Hong Kong to toughen its tax collecting, says one lawyer. Hong Kong has been accused by OECD members of being a tax haven, and in the current environment, many governments are keen to fight indebtedness by raising taxes.

Ironically, the move could also reflect Hong Kong's fading appeal as a tax haven. Today jurisdictions such as the Cayman Islands and the British Virgin Islands, where many hedge funds are domiciled, are reputable. Hong Kong may have been a genuine tax haven 20 years ago, but it's not as generous today. Hence, it has seen some hedge funds (and other business organisations) elect to set up in the Caribbean, and the authorities are feeling the loss of taxable revenue.

Inland Revenue doesn't state the thinking behind its decisions, so this remains conjecture. What is clear is that the Hong Kong taxman is prepared to flag a business in which most fees are accrued to an offshore entity, while most of its business activity is deemed to take place in Hong Kong.

Many hedge funds are set up to delegate investment decisions to an offshore manager, which in turn delegates some functions to an affiliated manager established in Hong Kong. The hedge fund pays management and performance fees to the offshore manager, which in turn pays a service fee to the local entity.

Larger hedge funds often draft 'transfer pricing' documentation, which justifies why fees are paid to the offshore unit, as well as the level of service charges paid to the Hong Kong entity. If a hedge fund can argue these arrangements are comparable to what would be paid to an independent provider on a commercial basis, the structure is kosher.

If, however, the tax authority suspects the arrangements wouldn't make commercial sense in a third-party transaction, it can accuse the offshore entity of being a sham, and the structure designed to evade tax.

The new interpretation now gives Inland Revenue the go-ahead to seek out the shams and bring civil or even criminal charges against perpetrators.

Hedge funds are reportedly adopting a wait-and-see approach. It is possible that Inland Revenue will never attempt to enforce this interpretation with regard to asset managers. But the tax authorities now have the legal power to pursue such cases, should they desire to do so.