Revisiting transfer pricing in the alternative asset management sector has been saved
Revisiting transfer pricing in the alternative asset management sector
Authors: Ralf Heussner, Enrique Marchesi
3 minutes read
New concepts introduced by the Organization for Economic Cooperation and Development (OECD) as part of the Base Erosion and Profit Shifting (BEPS) initiative in 2015 ─ aimed at aligning taxation with the economic activity that generates profits ─ are fundamentally reshaping the international tax landscape. This positions transfer pricing as one of the most contentious topics in today’s tax environment. Specific to the asset management sector, the new principles embedded in BEPS Actions 8-10 have an impact on the appropriateness and defensibility of existing transfer pricing approaches, with a potential impact on the effective allocation of fees across the different functions of the business.
Additionally, the BEPS initiative has inspired many tax authorities around the world to follow their own interpretation of these new concepts. Scrutiny is being applied to both formalistic aspects (i.e., the appropriateness of existing documentation and available support) as well as material aspects based on local tax authorities’ individual concepts of appropriate substance, control over risk and financial capacity.
The interaction between regulatory and tax aspects is becoming increasingly complex, especially considering the rise of structures regulated under the Alternative Investment Fund Managers Directive (AIFMD) and the resulting impact on operating models that are unique to the asset management sector. According to the latest statistics issued by the Commission de Surveillance du Secteur Financier (CSSF), the number of Luxembourg domiciled alternative funds reached a new all-time record at the end of December 2017, and this growth is expected to accelerate further in future years.
In this article, we will revisit recent transfer pricing developments for alternative asset managers and provide insight into key issues and important practical takeaways.
Transfer pricing is not a new concept. The first guidance to elaborate on the arm’s length principle was published by the OECD in 1979 under the title “Transfer Pricing and Multinational Enterprises”. In 1995, the OECD published the “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration”, which were subsequently updated in 2010. The BEPS initiative in 2015 marks one of the most significant overhauls of the international tax system and has put a new spotlight on transfer pricing. The aim of the BEPS initiative is to: i) increase transparency via higher documentation requirements in order to provide tax authorities with the relevant information to direct their audit activities; ii) substantiate and align the tax base/profit allocation with economic activity and value creation; and iii) increase consistency between international tax rules to avoid low-taxation and no-taxation.
Impact of BEPS on sector-specific transfer pricing approaches
Transfer pricing for asset management essentially covers the question of how to split management and performance fees to remunerate the key activities along the value chain covering:
- Capital raising and distribution/fund marketing;
- Deal-sourcing and investment advisory/asset management (as well as property management in the real estate sector);
- Fund administration;
- Principal functions of regulated AIFMs and unregulated GPs;
- Other support functions; and
- Activities related to the creation of potential intangibles (e.g. the development of software, investment platforms or trading algorithms as well as marketing activities/trademarks), which should be revisited in light of BEPS.
Historically, we can identify two main transfer pricing models that have emerged in the alternative asset management sector:
- The centralized model, where the activities of foreign related parties are limited to routine functions such as investment research/advisory or distribution/marketing support activities that are remunerated on a cost plus basis; or
- The integrated model based on a fee or profit split, where foreign related parties perform routine as well as non-routine functions (incl. portfolio management and capital raising) and their remuneration is based on a share of the management and/or performance fees (or profits) using appropriate allocation keys.
Whilst it is generally correct to say that the basic value chain is similar for many businesses within the asset management sector, the choice of an appropriate method to remunerate, for example, a distribution or investment advisory function is in practice quite complex. Indeed, what have traditionally been fairly straight-forward pricing policies are now becoming increasingly complex due to the recognition of new value drivers, a more diverse split of revenue flows, and additional cross-border transactions.
BEPS should be the trigger for all asset managers to revisit the appropriateness and defensibility of their transfer pricing models in light of the functions performed by local affiliates and the value-added of these functions.
Considering the rise of AIFMD-regulated structures, alternative asset managers will also need to consider the inclusion of regulated AIFMs in the operating and transfer pricing model. It is important to remember that AIFMs play a unique role. Their functional profile can vary significantly, from a more limited profile where the AIFM typically focuses on risk management, oversight of delegated functions and compliance/reporting, to a more fully-fledged profile where the AIFM also performs part or all of the investment management, distribution and fund administration activities.
AIFMs also have a unique risk profile since they are exposed to regulatory, investor and liquidity risks. In addition, they also own the regulatory license as a key intangible asset. The operating model and functional profile of the AIFM (based on the delegation model) needs to be taken into consideration when determining its remuneration.
Interaction between the regulatory and tax environment
It should come as no surprise that financial regulation influences the creation of operating models in the financial sector. This is also relevant for the asset management sector. One common feature that resulted from the introduction of the UCITS and AIFMD regimes is the cross-border distribution model whereby a regulated ManCo/AIFM is responsible for the production, distribution and management of investment funds.
In practice, there is a broad range of operating models, but frequently ManCos/AIFMs tend to delegate investment management and distribution/capital raising while retaining the core functions of risk management, oversight of delegated functions and compliance. Oversight of delegated functions implies that the AIFM must ensure that the delegated entities have sufficient resources, qualifications and processes in place to perform these functions while the AIFM retains the key risks and liabilities towards investors and regulators.
The common denominator in these models is that they often rely on a centralized operating model where there is one regulated entity (i.e., the ManCo/AIFM) engaging with a number of related (or unrelated) parties across a range of jurisdictions linked to the activities that are delegated. One of the key tax-related concerns in connection with the cross-border delegation model is that all transactions flow back to the ManCo/AIFM, which in practice can cover a large number of jurisdictions and an even greater number of transactions. In the event of any transfer pricing audits and resulting adjustments, the ManCo/AIFM is typically always the counterparty to such transactions that could result in double taxation and/or penalties.
As such, it is essential for asset managers to address the management of potential tax audits and resulting controversies, given that most of the asset management industry relies on similar delegation models.
Status quo of tax authorities and regulators
Many tax authorities still lack the relevant experience and technical expertise in the asset management sector. As a result, some tax authorities have relied on rather formalistic criteria (i.e., whether reasonable efforts were made to document the arm’s length nature of transactions, the non-documentation of certain transactions, the non-recognition of a permanent establishment or the lack of sufficient cooperation during audit) as the basis for their assessments invoking presumptive taxation. In the past, other tax authorities have instead focused on less complex transactions such as the provision of intra-group services. Nonetheless, this is likely to change in the future as tax authorities are gaining more experience.
Transfer pricing has, and will continue to be, a key area of focus for local tax authorities. BEPS Action 13 specifically addressed the topic of documentation for transfer pricing and shows the consensus of the tax administration to establish minimum standards for the disclosure and documentation of transfer pricing (based on the master file, local file and country-by-country reporting framework). Many countries have already implemented BEPS Action 13 in their domestic legislation, covering not only documentation standards, but also dealing with specific domestic exemptions, thresholds, timing and penalty regimes.
In light of centralized operating models and given the potential impact of tax audits and any resulting controversy on the asset management sector, both tax authorities and financial regulators are currently focusing on tax as a governance issue. We are witnessing tax authorities (as an example, this includes the tax authorities in Luxembourg) requesting more and more information as part of, or even outside, their regular tax audits, in order to gauge the readiness of asset managers.
Mid-2018, the tax authorities in Luxembourg contacted a range of asset managers in Luxembourg to request supporting documentation to show that any intra-group transactions adhere to the arm’s length standard, thus testing how well-positioned asset managers are regarding transfer pricing as part of their tax governance. At the same time, financial regulators have also started to focus on tax as an indicator of the proper management of regulated entities as part of their inspections and on-site visits. This shows that both the tax authorities and financial regulators recognize the importance of pro-actively managing the potential rise in cases of tax controversy and their impact on the asset management sector.
Taxpayers will need to respond to the challenge by considering the following key questions:
- Are transfer pricing policies in place and are they implemented consistently?
- Is appropriate transfer pricing documentation in place and is the documentation aligned with respect to the regulatory position?
- Are transfer pricing policies defendable in the light of BEPS and recent changes in the asset management sector (especially the move to AIFMD-regulated structures)?
- How is the role of the ManCo/AIFM remunerated in AIFMD-regulated structures?
- Is the ManCo/AIFM involved in the process of setting the tax strategy and managing potential tax audits/controversies considering that most transactions will involve the ManCo/AIFM as counterparty under a centralized operating model?
- How are tax audits being managed to avoid potential inconsistencies in the overall transfer pricing model?
- Is management aware of the options available to manage tax audits/controversies ranging from domestic appeals, Mutual Agreement Procedure (MAP) and/or Advanced Pricing Agreements (APAs) (e.g. as lighthouse APAs that can be used to support the transfer pricing position vis-à-vis tax authorities in other jurisdictions)?
- How can existing transfer pricing and legal documentation be improved as a first layer of defense against upcoming tax audits?
The discussion highlights the complexity of transfer pricing for the asset management sector given the range of operating models. The BEPS initiative has a major impact on the defensibility of existing transfer pricing approaches. The remuneration of captive, regulated AIFMs is a complex issue that needs to be carefully considered in the transfer pricing model. It is also essential for any analysis to be aligned with the regulatory dimension given the critical interaction between both aspects on issues of substance and control over risk. An increasing number of regulators are currently considering transfer pricing as an indicator of the proper management of the AIFM, so the topic is relevant both for tax professionals and for management and conducting officers at the level of the AIFM.