16/06/2010 Author: Tony Griffiths

Fin 48: what does it mean for hedge funds?

As the US administration tightens its grip on the financial sector and hedge funds finally address the implications of complying with the Fin 48 tax provision, HFMWeek examines how managers can adapt to the proposals across the short, medium and long term

After a reprieve spanning almost three years, Financial Interpretation Number (Fin) 48 has finally caught up with the hedge fund industry. The US GAAP provision – introduced by the Securities and Exchange Commision (SEC) and Financial Accounting Standards Board (FASB) in 2006 as a means of clarifying uncertain tax positions – is a well-trodden path for public companies. But for private structures, which benefited from a delay in implementation, 2009 was the first fiscal year it has bitten. And bite it has.

As of December 2008, every hedge fund – with US responsibilities – trading in a country without a bilateral tax agreement with its home domicile (Cayman has none, for example) has to reflect in its audit the likelihood that said country could successfully claim certain trading-induced taxes. Dividends, interest and, most prevalently, capital gains are the areas of contention. Brazil, China and Portugal are among the jurisdictions proving problematic, but it is Australia and Spain whose tax structures are causing the biggest headaches.   

Unclaimed taxes, or, as Fin 48 sees them, potential liabilities, will have to be reflected in the fund’s Nav, reducing its value in accordance with the probability of each tax successfully being reclaimed. Herein lies the rub; because these liabilities relate to taxes that, for reasons manifold, have not been collected by the relevant tax authority, their validity remains unclear. Would a certain tax authority try to reclaim? According to Fin 48, whether they would is irrelevant. It’s whether they could, and whether said claim would be successful, that establishes the basis for accountability. A fund’s value depends on it.

Last week, a source at insurance underwriters Chartis told HFMWeek that, in relation to the policies it had seen covering Australia and Spain, the firm rated the success of a claim as “in the region of 50/50”. Chartis has decided not to back the policies put to it by managers. Fellow underwriter Zurich is reported to have agreed to one such policy but capped it at that.

The thought of a fund’s value dropping due to a liability that may not exist is, unsurprisingly, proving hard to stomach, and with ambiguity and uncertainty surrounding the legislation, managers have been scrambling for advice for over a year. At legal firm Schulte, Roth & Zabel (SRZ), a “significant percentage” of the firm’s hedge fund clients have considered Fin 48 issues, according to partner Josh Dambacher. But with audit deadlines looming, and ambiguity no less a factor, funds are upping their search for either a long-term solution or a short-term fix. As Lachlan Roos of PricewaterhouseCoopers explains: “It’s going to be a melting pot of issues that we’re facing at the moment as to what actually creates the best Fin 48 answer.”

Following discussions with a number of auditors, insurers, and lawyers, it would appear that there are three main Fin 48 solutions currently doing the rounds, each with a varying shelf-life:

1 SHORT-TERM SOLUTION CHANGE TO SWAPS

“Depending on each jurisdictional law, trading through swaps is unlikely to trigger Fin 48 liabilities,” says Schulte, Roth & Zabel’s Josh Dambacher. Managers are getting comfortable with the prospect that most jurisdictions are happy with swaps, he adds, though a question mark still remains over Spain in this respect.

“Changing to derivatives/swaps is the immediate fix that people are looking at,” says Lachlan Roos,  PricewaterhouseCoopers' UK tax hedge fund leader. “But the life of that as a long-term solution is questionable. There are other regulations coming in that it won’t satisfy, such as Basel II.”

At Ernst & Young, credited by many as the first auditor to begin vocally warning the industry about Fin 48, derivatives are also a popular solution among managers.

Donal O’Sullivan, a corporate tax partner with the firm, however, is, like Roos, unconvinced by its lasting appeal. “A lot of people will look at whether they would do some more synthetic trading but that has limits from a commercial perspective,” he says. “There are a limited number of counterparties that you can trade with and that might increase the cost.”

According to O’Sullivan, technical analysis doesn’t present a problem in the context of Fin 48, which, he says, is part of the basis for its perceived unfairness. “You might have one trading strategy in derivatives, for example, and it doesn’t give you a problem, and another trading strategy where you are buying or selling on the Australian Stock Exchange and it does give you a problem,” he says. “This is the problem with tax laws – they can be antiquated, and they can come from various sources, and that can create problems. You really have to look at where you’re trading, what you’re trading in and how you’re doing it."

2 MEDIUM-TERM SOLUTION CHANGE ACCOUNTING STANDARDS

With US hedge funds able to report in either US GAAP or the International Financial Reporting Standard (IFRS), and Fin 48 a US GAAP provision, some funds are choosing to simply switch to IFRS. Side-stepping the issue, however, looks set to have its own sell-by-date, with a version of Fin 48 under IFRS – an amendment in the form of exposure draft IAS 12 – currently being prepared.   

  “It should come in at some stage,” says PwC’s Roos. “It was previously drafted and then went back to the drawing board. They’re re-doing it now.” According to Roos, some people are converting to IFRS, winding down their US GAAP fund and then starting a new fund with a clean slate so they don’t have the historical issues.

“It’s less an accountancy issue now than the fact the accountants applying the accounting standards have brought the potential liabilities to light,” warns SRZ’s Dambacher. “You can’t just change your accounting standard as the liabilities exist – it’s just a fact that no one has really been thinking about it.”

The problem has been that managers have in good faith determined their funds' Navs, and didn’t include these liabilities in their books, Dambacher explains. Accounting for Fin 48 means that they will have had people redeem money at a higher Nav than they should have  (ie receive more money than they were due), losing the fund money, and investors have come in (ie bought shares) at a Nav that was higher, and therefore more expensive, than it should have been.

3 LONG-TERM SOLUTION SPV OR DE-DOMICILE

The source of the industry’s Fin 48 troubles is the fact that the Cayman Islands has no double taxation treaties with other countries (which would create a structure for mutually agreed tax payment terms), only tax information exchange agreements (TIEAs). As such, some managers are choosing to nip the problem at the bud, and move to, or create a presence in, a jurisdiction that has the treaties it requires.      

“Some managers are looking at re-domiciling their fund,” Roos confirms, “and some are looking at special purpose vehicles (SPVs) below their fund, so putting in an Irish company or a Luxembourg or Netherlands entity.” The fund then uses the SPV to carry out those trades in problematic jurisdictions.  

“Trading subsidiaries cleans up problems in most jurisdictions,” says SRZ’s Dambacher. “If there isn’t a double (bilateral) tax treaty it’s a problem and Cayman has no such treaties. Ireland does, but Qualified Investor Funds (QIFs) wouldn’t benefit from them either. A Cayman fund or a QIF can create a trading subsidiary, such as an Irish 110 company or Luxembourg equivalent, to avoid the potential tax.

Ireland has an extensive network of 56 double tax treaties, including Germany and Spain, though not Brazil. Other potential new domiciles are Luxembourg and Malta, which have 57 and 50 double taxation treaties respectively.  All three have Memorandums of Understanding with China.

Re-domcilition may seem an extreme option compared to creating a simple trading subsidiary, but with hedge fund regulation currently up in the air, in Europe in particular, it may prove enticing. “It’ll depend very much as to where the EU’s Alternative Investment Fund Managers (AIFM) Directive goes as to what the best result is going to be for people looking at Fin 48,” Roos concludes. “The re-domiciliation of a fund could end up being a good avenue for people to go down if that also suits an AIFM satisfaction point.”