How to make the Atlantic Crossing

US managers will need to understand more than the art of drinking tea to open up shop in London, explain John Langan and Paul Brecknell from Withers

London is the European centre of the hedge fund industry, with 80% of European hedge fund assets, and around 21% of global hedge fund assets, estimated to be managed out of London. More than 900 hedge fund managers are thought to be based in London, representing in the region of $360bn of assets under management.

These figures seem, as things currently stand, to be on an ever-upwards trend, and will likely be more impressive still by the time this article comes to print.

London is also a leading centre for services to hedge funds: legal, accounting and consultancy, administration and, in particular, prime broking. London also has a strong asset-management industry, a favourable regulatory environment and a good potential investor base for hedge funds. Small wonder, then, that London is foremost in the minds of most US hedge fund managers, when they consider expanding their operations overseas.

US hedge fund managers will, however, need to bear in mind a range of issues when planning to move to London: this article summarises some of the main issues, and highlights also some differences in the regulatory and tax regimes, as between the US and UK, which have an impact on structuring.

Fund structures

One immediate difference which will strike most US fund managers is that UK-managed hedge funds are virtually always located offshore. The reasons for this are largely tax-driven. Further, the favoured structures for hedge funds are corporate, rather than limited partnership-based.

The main reason that hedge funds are incorporated offshore, apart from the low tax rates in such jurisdictions, is that many hedge fund operations will be considered as 'trading' (rather than investment) for UK tax purposes, and therefore, for practical purposes, impossible to accommodate within any tax-efficient onshore structure.

Therefore, in practice, the fund structure will typically be established in a jurisdiction such as the Cayman Islands (other choices include the British Virgin Islands, Luxembourg, Bermuda and Ireland) but with care taken to ensure that 'central management and control' of the fund, for tax purposes, resides offshore.

Three other jurisdictions rather closer to the UK - Guernsey, Jersey and the Isle of Man - are also developing their hedge fund capability, particularly as regards fund of funds: these jurisdictions may offer an advantage where there is a need for London-resident investment managers or directors (who should be a minority of the board) to attend offshore board meetings, to ensure tax residence offshore.

The reason why the manager can operate out of the UK tax efficiently, without creating a permanent establishment risk for the fund, is because of specific tax exemptions designed to attract managers to the UK and these are discussed below.

A key issue is therefore to ensure that the offshore fund is not deemed to be tax resident in the UK as this would make it liable to UK tax. It is also essential to ensure that the offshore fund is not deemed to carry on a trade in the UK through a permanent establishment, for example, through its UK-based investment manager.

It is, therefore, necessary to ensure that the offshore fund is managed and controlled offshore and also that the investment managers' exemption (which exempts from UK tax any profits attributable to a trading activity carried out in the UK through an independent fund manager provided that a number of tests are met) can be relied upon.

Changes are shortly expected to be made to the statement of practice with the UK revenue relating to this exemption, prompted in part by a desire to restrict certain tax strategies designed to limit the amount of UK tax payable.

The reason for the UK preference for a corporate rather than limited partnership structure for a hedge fund is that the limited partnership structure, being transparent for tax purposes, tends to create reporting complications for a fund involved in frequent and active transactions (as opposed to, say, a private equity fund, with a 'buy-and-hold' strategy).

Fund-Manager structure

As regards the fund-management entity, two structures are available: the limited company and the limited liability partnership (LLP).

One of the main drivers for using an LLP instead of a company is the likely tax saving, where the 'members' (that is, partners) of the LLP are individuals. A company has to pay a 12.8% employers' national insurance (NI) charge on salaries whereas no equivalent charge arises on amounts paid out to members of an LLP.

Further, LLPs are tax-transparent, which means that only the members pay tax and not the LLP. In the case of a company, profits are initially taxed at the company level and again at the personal level when profits are paid out as a dividend.

Certain loss reliefs are available to members of an LLP that could enable an LLP's losses, for instance, to be set off against members' income from other sources. They are, however, restricted to the higher of the amount of capital contributed by the member and the member's liability on a winding-up and therefore may not be that significant in practice. These loss reliefs are not available to the owner of a company.

The introduction of a new shareholder to a company may give rise to income tax and NI charges if the shareholder is to be an employee. This is usually not an issue in the case of a member joining an LLP.

The introduction of a company as a member of an LLP can offer flexibility and tax savings as a result of the lower corporation tax rate.

There are no restrictions on a member making drawings from a solvent LLP. This contrasts with companies where the maintenance of capital and tax rules restrict the payment of dividends and loans to directors and shareholders. However, withdrawals of capital need to be considered carefully for regulatory reasons, as they may impact on the LLP's regulatory capital.

Limited values

It is simpler to provide for differing capital and income rights of members using an LLP than it is within a company, where multiple classes of shares may be necessary.

An LLP's partnership agreement is not a public document and does not need to be filed at Companies House. An LLP also does not need to hold general meetings and file resolutions and other statutory forms at Companies House, save for its annual return and accounts and forms recording the appointment and removal of members.

There are, however, certain disadvantages with an LLP. The LLP's partnership agreement will provide that drawings in excess of allocated profits are to be repaid to the LLP. Drawings are therefore effectively loans to members until profits are formally allocated at the year end following which they are taxable in the members' hands.

Members are responsible for their own tax payments and returns, although in practice, many LLPs will deduct tax on behalf of a member and make arrangements for the preparation of members' tax returns.

UK-resident members have a potential personal tax exposure for profits made by the hedge fund if the investment manager exemption (discussed below) does not apply. If there is any doubt about the applicability of the investment manager exemption, a UK limited company should be used as the UK manager vehicle rather than an LLP.

Regulatory authorisation

One of the major concerns for any fund manager looking to set up in the UK is regulatory authorisation. A UK-based hedge fund manager will need to apply to the Financial Services Authority (FSA) for permission to manage investments and to carry on other regulated activities.

There are (narrowly drawn) exclusions from the requirement to be authorised for overseas persons: however, these do not apply where a person maintains a permanent place of business in the UK, so before a US fund manager sets up an office in the UK and commences activities here, it will need authorisation.

Carrying on a 'regulated activity' in the UK without authorisation by the FSA is a criminal offence (punishable by fine or imprisonment or both) and resulting agreements entered into may be unenforceable.

The hedge fund itself does not need to apply for authorisation as it is based overseas and will act through its (FSA-authorised) investment manager, to the extent it carries out activities in the UK.

Any firm seeking authorisation in the UK has to apply to the FSA for permission for each of the regulated activities it wishes to carry on. An applicant must satisfy certain 'threshold conditions', including that it has adequate resources (human and financial) to carry out those activities.

The FSA may take up to six months to review an application and come to its decision, although in practice, the FSA aims to determine 70% of applications within 16 weeks. A US fund manager will need to allow for this time lag in deciding when to establish its business in the UK.

The FSA rules provide that individuals who carry on specified controlled functions within authorised firms require prior approval from the FSA. For example, the function of investment manager is a controlled function and such individuals therefore need to be FSA-approved. The firm in question will have to submit applications for approval for all persons carrying on controlled functions.

GET FIT AN PROPER

The FSA will have to be satisfied that the applicants are 'fit and proper' to carry out the functions in question and may require them to take examinations.

Each individual will have to satisfy the FSA of his honesty, integrity, competence, capability and financial soundness. There are ongoing compliance requirements in relation to all approved persons.

Generally, the FSA will take between four and seven business days to give approval but may take longer in certain circumstances.

US fund managers will also need to become acquainted with the rules on 'financial promotions'. UK law has the effect that no person can "communicate an invitation or inducement" (that is, a 'financial promotion') to invest in a fund, subject to certain exemptions (in particular, for promotions to high-net-worth companies and trusts and so-called 'sophisticated investors').

An FSA authorised firm is permitted to issue 'financial promotions' generally, but is restricted in doing so as regards unregulated funds (such as hedge funds).

It may, however, promote a hedge fund investment to certain restricted classes of person (such as those just mentioned) and also to a person for whom the firm has taken reasonable steps to ensure that investment in the fund is suitable and who is a client of the firm.

Taxation

A fund structure will usually be structured to suit (in so far as is possible) the tax profile of both the investors and the principals. Gains made in relation to offshore hedge funds are generally taxed as income, which can often be less beneficial to UK investors than the capital-gains tax regime. However, structures do exist that are designed to 'recapture' capital-gains tax treatment.

As regards the principals, complex issues arise where there are both UK and US principals which should be addressed in structuring the fund. Further, principals invariably have an interest both in the UK management vehicle and the offshore fund itself.

As mentioned above, a key part of structuring any fund managed out of the UK is to ensure that the investment manager exemption (IME) applies. Under the current rules, to qualify for the IME, a UK investment manager must generally satisfy the following conditions:

nit must carry on the business of providing investment-management services;

nthe investment transactions must be carried out in the ordinary course of its business of providing investment management services;

nit must act in an independent capacity - that is, the relationship between the investment manager and the non-resident fund must be at arm's length (see below);

nit and any connected persons must not be or intend to be beneficially entitled to more than 20% of the income of the non-resident fund (see below); and

nthe remuneration received by it must not be less than that which is customary for this type of investment-management business. (The transfer-pricing analysis should confirm the customary rate of remuneration).

The interpretation of these requirements is subject to a statement of practice by HM Revenue and Customs (HMRC), which is shortly due to be replaced. This statement of practice is currently under review, however, and a revised draft has been circulated for comment.

One area of focus with this revised draft is an emphasis on sufficient income being paid and retained in the UK, as opposed to being paid initially but then being siphoned off outside the UK by way of available tax deductions.

It is also critical that a full and complete transfer-pricing analysis is prepared and relevant benchmarks documented and confirmed in order to successfully defend the structure adopted from any HMRC attack (often under the transfer-pricing rules or on the basis that the IME is not available for want of customary remuneration).

mayfair keeps passing 'go'

About one in five of the 'Billion Dollar Club' have a London presence, but that number seems to grow dramatically. The geographical focus is Mayfair, home of the US Embassy, some-time home of John Adams, and now a second home to dozens of US hedge funds.

As in Monopoly, so in life: Mayfair continues to hold the 'Boardwalk' position next to 'Go' (seeing off a brief challenge from the 70th anniversary edition in 2003 which saw Canary Wharf usurping that space). Exuding an image of glitz and sophistication, it is the premier European office location. It is also the most expensive.

London has the biggest office market in Europe, but it also has the greatest demand. Prime West End space (centring on Mayfair) goes for up to $200 per square foot. This compares with $120psf in the City and $95psf in Canary Wharf. Demand is up across the board, and supply is down. So far as rents are concerned, for the foreseeable future the only way appears to be up.

Leasing arrangements in London are not dissimilar to those in Manhattan, but there are crucial differences. Term lengths are typically 10 years (rather than 5 years with an option to renew). Landlords will often require sizeable rental deposits. In some cases, value-added tax - analogous to sales tax - will be added to the rent increasing it by 17.5%.

As in the US, incentives should be on offer even in a highly competitive market, as landlords are willing to trade a 'rent-free' period (read: 'rent holiday') for a higher 'headline' rent. So far as exit strategy is concerned, assignments will generally involve guaranteeing the incoming tenant's performance. Other issues to address include liability for 'inherent defects' in new building, security and 24/7 access arrangements.