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Asset Management

June 2010 | Tax takes centre stage

Asset Management

Featured inside:

Tax functions to transform

Government tax audits rise

Assurance for prime brokers

Private equity and sustainability

Insights & views from PricewaterhouseCoopers’global asset management practice

Section A:Tax takes centre stage

04 The coming tax functiontransformation

06 Continuous movement of the globaltax landscape

08 Government audit activity on theincrease

10 A move to simplicity

12 Reviewing holding companystructures

16 Global tax authorities expandinformation reporting requirements

18 The evolving landscape oftax technology

20 Private equity tax becomesmore onerous

Section B:Views from Asia, Europe &the US

22 India – the cadence of agrowth market

24 Independent prime broker reportsto become standard

25 Is UCITS IV’S Key InformationDocument a ticking time bomb?

26 Hedge funds come under scrutiny

27 AIFM update

28 Future Newcits regulation? ...CESR’sproposals for investor protection

29 From incentive to compensation

30 Managing sustainability issuesfor value

32 New GIPS guidance for alternatives

2 PricewaterhouseCoopersAsset Management News June 2010

Contents

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Tax illustrates just how the authorities are beginning to play by a different set of rules.As Will Taggart, PricewaterhouseCoopers’1 Global Asset Management Tax Leader, andFlorence Yip and Martin Vink and their teams explain through much of this issue, taxauthorities across the globe are looking to ascertain investors’ identities. They are alsoraising tax rates and questioning long-established holding structures. All of this is beingreinforced by increased audit activity.

For asset managers – especially alternative managers – this means institutionalisationof the tax function is vital. Information technology, of course, has a vital role to play.With investors now viewing tax issues as a potential area of risk, the tax function hasbecome a source of competitive advantage.

Beyond the tax section of this issue, articles demonstrate the impact of the crisis –through regulation, compensation, independent assurance and so on. In today’s world,raw investment returns are no longer enough. Transparency, responsibility andsustainability are all just as important.

PricewaterhouseCoopers 3Asset Management News June 2010

Kees HageManaging EditorAsset Management News PricewaterhouseCoopers (Luxembourg)+352 49 48 48 [email protected]

IntroductionFor asset managers, the legacy of the financial crisis that struck in2008 and rumbles on in 2010 is now clear. Gone is much of thefreedom they have historically enjoyed. Their investment activities,operating models and tax arrangements will be far more closelycontrolled and scrutinised in future.

1 “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopersInternational Limited, each of which is a separate and independent legal entity.

Despite the recent global economic crisisand the plethora of responses aimed atvarious parts of the financial servicesindustry, the future appears quite bright foralternative investment funds as an assetclass. As a result of the recent marketturmoil, there is a perceived pension gap(both public and private) which requiresindividuals to take more control of theirfuture.

A recent PricewaterhouseCooperspublication, The New Rule of 10%, foundthat US personal savings rates as apercentage of disposable income had risento 4% in December 2009, from a low of1% in December 2007 and could well riseto 10%, a rate not seen since the 1970s.2

One reason for this rise in savings may wellbe the need for personal responsibility infunding retirement. Additionally, investorssuch as endowments and sovereign wealthfunds are looking for investment vehiclesand strategies with superior, uncorrelatedreturns. The asset management industry,particularly alternative funds, isconsequently well placed.

However, to capitalise on this opportunitywill require something other thanbusiness as usual. Today, investors andregulators are looking for more trust andtransparency. Managers must anticipatehow best to address these expectationsand they must do so quickly and efficiently.To introduce greater transparency in thetax function, both the organisation andhow it operates will need to change.The changes will take advanced planningand investment; but for the successfulorganisations the short-term disruptionswill unlock long-term opportunity.

One of the new requirements for asuccessful investment fund manager,therefore, is an efficient tax function whichis fully integrated into all areas of theorganisation. The expectations of next-generation tax function will include:

• Responding quickly to investor taxinquiries with a complete command of allthe facts and the current and potentialtax issues faced by the organisation;

• Demonstrating a tax control environmentthat is able to address the myriad newtax rules and information reportingrequirements that are proliferating in thisindustry, and which carry significantreputational risk as well as monetarypenalties;

• Satisfying investor due diligencequestionnaires, which now focus on taxas well as other fund operationalaspects;

• Responding to comprehensive multi-jurisdictional tax audits, which are unlikethose seen in the past;

• Getting involved with investmentdecisions before they are made, andfollowing investments through their lifecycle to ensure tax issues do not arise;

• Producing tax reporting information morequickly than in the past; and

• Gathering information from anincreasingly global organisation, wherethere are multiple sources of informationand decision makers.

All of these functions need to beaccomplished in a coordinated fashion,likely with less resources than a few yearsago and yet a greater downside for error orinefficiency. Thus an enhanced use oftechnology solutions will also be required.This new tax function model, which mayhave been a luxury to some in the past, willbecome a necessity in the future. The taxdepartment will no longer only be a back-office function; it will now need to be onthe front lines of the organisation,becoming a distinguishing factor forinvestors as they allocate, or choose toreinvest, their capital.

Highlighted below are a number of areasthat have changed significantly over thepast 18 months, and are anticipated tocontinue changing in the near future.These areas are among the catalysts forthe changes necessitated in the assetmanager’s tax function. Each of theseareas will be explored in more depth inthe ensuing articles in this publication.

Aggressive legislative andenforcement agendaGovernments around the globe areexperiencing record budget deficitsas a result of the economic recession.Among the solutions governments havebegun to use to address this fiscaldilemma are broad-based tax rateincreases, comprehensive tax legislationthat combats perceived abuses andloopholes, significantly enhancedinformation reporting rules, and increasingtax enforcement for investment fundsand managers. Each of thesegovernmental actions will drain the taxfunction’s resources. Although it is easyto do so, the time required by each ofthese areas should not be underestimated.Any operational efficiency that can beachieved could pay large dividends.

Section A: Tax takes centre stage

4 PricewaterhouseCoopersAsset Management News March 2010

The coming tax functiontransformationA severe global economic crisis, coupled with changing investor demands and a forthcomingonslaught of legislative and regulatory developments, has created an environment where tax operations are under new and increased pressure. Consequently, they are poised for a major transformation.

William Taggart Global Asset Management Tax LeaderPricewaterhouseCoopers (US)+1 646 471 [email protected]

Amy McAnenyPricewaterhouseCoopers (US)+1 646 [email protected]

2 Published May 2010.

One popular method governments haveemployed to drive revenue is to increasethe audit activity of those who areperceived to be best able to pay, or whoare viewed as not having paid their fairshare of taxes. While these perceptionsmay not be rooted in fact, once theytake hold, they are difficult to reverse.Unfortunately, investment funds arecurrently at the centre of this maelstrom.Just one country focusing on this wouldbe bad enough, but heightenedcooperation and interaction betweeninternational tax authorities is nowcommonplace, with a torrent of auditsalready underway. Tax authorities aroundthe world are becoming increasinglysophisticated and, in some cases,increasingly aggressive in their quest toraise revenue. In this new audit-centricenvironment, regulatory preparedness isbecoming a focus for best-in-classorganisations. Today, it is no longer amatter of if but rather when an assetmanager or fund will be audited, eitherdomestically or abroad.

As governments are increasing auditactivity, they are also redefining standardsand providing clarity to many tax rules andinterpretations. In-country substance withrespect to treaty platforms is one areareceiving considerable attention and is onethat could potentially have a profoundeffect on the way funds conduct businessand are taxed internationally. Taxdepartments also need to deal with morefocus on the economic substance doctrine(recently codified in the US), emphasis oncreating enhanced relationships with thetax authorities (as advocated by theOECD), and GAAP’s FIN 48 standardsfor accounting for uncertain tax positions.In the new landscape, tax departmentswill need to continuously reassessinternational law and interpretationchanges, if they are to avoid adverse taxconsequences on long-establishedinternational structures.

Focusing on investors andinfrastructureIn addition to governments, investors arerequiring increased access to information.Transparency is important for bolsteringinvestor confidence, which will increasethe ability to retain and attract investors.One of the leading changes to emergefrom the financial crisis is the increaseddue diligence investors are displaying withrespect to their investments. Whereasinvestors used to focus mainly onperformance and strategy, they are now

increasingly scrutinising operationalefficiencies as well.

Managers have been inundated witha multitude of ad-hoc requests anddemands for information transparency.They need to have efficient and effectivetax technologies, tax reporting systemsand tax departments in place to quicklyturn around information and satisfyinvestor demand. The degree and levelof these requests can easily outpace theability of many organisations to adapt andrespond, and has placed an increasedburden on back office functions.Organisations need to start looking towardpeople, process and technology solutionsto successfully respond to increasedrequests. In addition, funds shouldconsider whether they want to proactivelypush out standardised information, asopposed to responding to each individualrequest. Whichever course is chosen,redefining tax technology platforms andthe strategic outsourcing to third-partyservice provides can help tax functionsstreamline the process. Organisationsmust invest in their processes, technologyand relationships to conform to newstandards.

Managers with unified approaches tothe front and back offices are the clearwinners in today’s financial world.Investors who perceive an organisation asinefficient and unable to deliver ad-hoc taxinformation may lose confidence and lookfor other investment opportunities

Tax-efficient structuresGiven the complexity of today’sinformation reporting, and investors’current desire for transparency ofinformation, managers are looking tosimplify the way they operate, wherepossible. Regular global health checks areneeded to ensure operational compliancewith tax guidelines. Businesses changequickly, memories are often short, andgovernments are looking for foot faults.In addition to periodically reviewingstructure and operations, funds are alsolooking for simplification. Structures havegrown quite complex, and a periodicentity and operational review is healthy,although time consuming, and removesunnecessary or redundant entities thathave served their purpose.

Organisational integrationIn order to keep up with increasing taxrates, investor requests and movinglegislation in the ever-changing economic

landscape, tax directors must integratetax functions within their businesses. Thetax agenda needs to be at the forefront ofcompany and investment decisions: fromwhat trades to make, to what structure toembrace, to which investors to take on.

The trend within organisations to includethe tax function as a part of everydaydecisions is gaining momentum amongbest-in-class funds. No longer can taxremain within its own silo. Full integrationof tax personnel within an organisationacts as a first line of defence to avoidabletax issues. Tax personnel must havetheir fingers on the pulse of new legislativeproposals and local jurisdiction taxlaws, in order to react swiftly andeffectively to changes in the landscape.Increased investment in effective taxoperations including technology,processes and personnel will allow taxfunctions to streamline processes andfocus on changes in the industry.Additional investment in operationswill quickly yield benefits in the form ofinvestor confidence, tax saving anddecreased audit exposure.

A tax function that is integrated withfinance, accounting, legal and third-partyservice providers allows funds to stayahead of their competitors and to offerinvestment opportunities that steer clearof potential tax pitfalls (e.g. exposure tohigher tax jurisdictions, surprisetax/informational filings for investors).Additionally, incorporating tax specialistsinto the overall day-to-day investmentdecisions of a manager ensures thatimplemented tax structures are maintainedand respected. By integrating tax fullyinto the business model of an assetmanagement organisation, all parties willbenefit from the renewed focus on taxoperations.

In today’s environment, where this industryis under the microscope as it never hasbeen before, fund managers need tomake sure that all aspects of theirbusiness are operating at maximumefficiency, and clearly demonstrate this.Taxes and the tax function are noexception to this paradigm. A highlyeffective and functional tax organisationwill be a distinguishing factor for investors,and it can also mitigate the economicimpact of the government’s approach tothe industry and the attendant reputationalrisk that can arise from a suboptimaloperation. The tax function has becomea clear source of competitive advantage.




AmericasIn the US, fund managers and US individual fund investors will soon be wrestling withhigher taxes. Beginning in 2011, tax rates will revert to the levels that preceded the Bushtax cuts of 2003 and 2005. The long-term capital gains rate will increase from 15% to20%. The maximum rate on ordinary income will increase from 35% to 39.6%. The taxrate on dividend income will increase dramatically from 15% to 39.6%. The President’s2011 budget proposal only proposed a rate increase to 20% for dividend income, butthat rate necessitates Congress to act. If Congress does act before the end of the year,the chairman of the House committee responsible for writing US tax legislation (Rep.Sander Levin, D-Mich.) predicts the Bush era tax cuts will expire for the wealthiestAmericans, even though the lower rates might be extended for middle income families.

On 20 May, Rep. Levin and Senate Finance Committee Max Baucus (D-MT) proposeda package of tax extenders and revenue raising proposals. The bill, the “American Jobsand Closing Tax Loopholes Act” (H.R. 4213, as modified), features provisions extendingthrough the end of 2010 for expired business and individual tax provisions, includingcarried interest legislation. On 28 May, the House passed the bill, and it is expected theSenate will take up the bill on or after 7 June. Fund managers typically receive anupfront management fee, which is treated as ordinary income for tax purposes. However,managers normally also receive a 20% allocation of the net return from the fund.This “carried interest” allocation can potentially be taxed at long-term capital gains rates,currently set at 15%. Taxing carried interest as ordinary income would increase the taxrate to 35% (39.6% in 2011), more than two times the previous rate. US legislators haveincreasingly focused on the tax treatment of carried interest over the past few years, withthe view that fund managers should pay tax on their share of profits at the same ratesthat regular employees do on ordinary wages.

The bill would phase in a change in the tax treatment of carried interest. Under thisprovision, the carried interest of investment services managers would be taxed as 75%ordinary income and 25% capital gains, fully effective as of 1 January 2013.

The carried interest legislation also includes a provision to subject the carried interest toself-employment taxes. Subjecting carried interest to self-employment taxes, and theincrease to the Medicare tax detailed later, combine to significantly increase the tax onthe carried interest.

The Patient Protection and Affordable Care Act, and the related Reconciliation Act of2010 (“Patient Protection Acts”) increase the Medicare tax on wages and self-employment income by 0.9% and subject unearned income to a 3.8% Medicare tax.For US individual investors, beginning in 2013, the acts impose a new Medicare tax equalto 3.8% of the individual’s “net investment income” subject to some threshold amounts.For purposes of this rule, net investment income includes: income from interest,dividends, annuities, royalties and rents; income from a trade or business that is apassive activity with respect to the individual or consists of trading financial instrumentsor commodities; and net gain attributable to the disposition of property. Net investmentincome is reduced by any properly allocable expenses to such gross income or net gain.Most income allocated to US investors from foreign and US funds will be subject tothis new tax.

On 18 March 2010, the final version of the Foreign Account Tax Compliance Actof 2009 (FATCA) became law. FATCA has significant implications for all financial servicesinstitutions (including asset managers) that have US citizen clients or receive US sourceincome. A significant provision in this law recharacterises ‘dividend equivalent’ paymentsreceived on swaps and repurchase transactions on US equities to actual dividends, andas such subjects these payments to the 30% US withholding (whereas previously,payments on synthetic instruments were, in general, paid with no withholding tax).


Continuous movement of theglobal tax landscapeAll over the world the tax landscape continues to change at a faster pace due to the increasedscrutiny of the asset management industry and the worldwide governmental budget issues.

Louis KovenPricewaterhouseCoopers (US)+1 214 [email protected]

Anuj KagalwalaPricewaterhouseCoopers (Singapore)+65 6236 [email protected]

Laurent de La MettriePricewaterhouseCoopers (Luxembourg)+352 49 48 48 3007 [email protected]

Given the dramatic change in these rulesand the potential impact on investors andtheir counterparties to these derivatives,there is an 18-month phase-in of the rules.This phase-in significantly limits thenumber of situations where arecharacterisation, and thus withholding,would need to take place. Following theexpiry of this phase-in period, the newrules will become fully operational.The proposed provisions still require theSecretary to write a substantial set ofregulations to implement the statute.The delayed effective date will only behelpful to the industry if the Secretarypromulgates regulations swiftly, as it willtake a substantial amount of time toproperly update and test the varioussystems and processes necessary toconform to these new provisions.

The Canadian Federal Government hasproposed a change in its most recentbudget to the definition of “taxableCanadian property.” This change wouldeliminate the need for section 116 taxwithholding and the tedious certificateprocess for many investments in Canadaby asset management organisations.

AsiaInvestment interest in Asia continues tobe on the rise, and we are again seeingmore fund managers, both indigenous andthose from the United States or Europe,expanding their reach and commencingoperations in the region. From aninvestment perspective, the region hashistorically been tough to navigate, as thetax treatment may not be set out in taxlegislation, but either be based onnegotiations or administrative practices.As tax authorities learn more about thestructures adopted by funds to mitigatetax exposures, they also seek ways tonegate the tax benefits. An example isthe Vodafone case in India,3 in which theIndian tax authorities imposed tax on thecapital gains arising from the indirectdisposal of shares of an Indian company.Similar cases have been encounteredwith respect to investments in Chinesecompanies. Indonesia also introduced newregulations to achieve the same effect.There is also an increasing trend of taxauthorities in the region challenging treaty-based structures, particularly those thatare not able to demonstrate substance.

Over the past few years, several Asiancountries, such as China and India, have

undergone major changes to their taxsystems, with new legislation, regulationsand circulars being issued over time.For funds investing in these countries,fund managers have to stay abreast of thedevelopments to assess how the returnsfor their funds may be impacted.

With the increased investment interest inthe Asian region, a number of countrieshave also introduced trading safe harbourrules to attract fund managers (e.g.Singapore and Hong Kong). These rulesgenerally provide for tax exemption offunds (typically offshore funds targeted atoffshore investors) managed in thecountry. The exemption is usually subjectto a list of conditions and is tagged to alist of qualifying investments and income,which may be amended from time to time.With the myriad variety of instruments andproducts that funds can invest in thesedays, fund managers need to ensure thatthe investments they make fall within thescope of the trading safe harbour rules.This can sometimes involve substantialtime to analyse, as the instruments/products may be new or may bestructured to cater to the specificcircumstances of the investee companiesand the funds.

EuropeThe European fund managementlandscape will soon be deeply modified bythe UCITS IV directive. The aim of thisdirective, to be applied as from 1 July,2011, is to reduce administrative burdenand to increase investor protection andmarket efficiency in the fund industry.

Although this directive is silent on taxmatters, as is typically the case with mostEuropean Union (E.U.) regulatory changes,this could potentially have significantly taximpacts on both funds and managementcompanies.

As examples of tax issues that could beraised, one can point out residency offunds, transfer pricing, permanentestablishment exposure, etc.

As taxes are, among other factors, a driverin the decision-making process aboutwhether to base a product or the managerin a specific country, several memberstates have implemented tax legislation to maintain or increase theircompetitiveness from a tax perspective in the context of UCITS IV.

Luxembourg has announced it willabolish its annual subscription tax (taxed’abonnement) for exchange traded fundsand will continue its efforts to enter intonew double tax treaties.

The UK has been very active in the fundstaxation area. Action has recently beentaken to make the Investment ManagerExemption more user friendly, to moveto a reporting fund regime, to introducean onshore UK Fund of Alternative Funds(FAIF), to provide certainty of investmenttax treatment for certain investing funds,to introduce an elective tax regime forUK domestic funds and to initiate aconsultation exercise on the tax rulesfor investment trusts. Given the recentchange in government in the UK, itremains to be seen whether the currentpolicies and attitude towards the industryremain the same.

Ireland has passed legislation that willprevent the taxation in Ireland of non-Irishdomiciled funds managed by an Irishmanagement company. It is likely thatmost other European jurisdictions will passsimilar legislation.

At the same time, in the context of thecurrent crisis, several E.U. member states(France, Luxembourg, and Portugal) haveannounced tax increases in order toreduce budget deficits.

In addition to the announced E.U. taxincreases, E.U. finance ministers in Maybacked stricter controls for alternativeasset management organisations, handinga defeat to the UK which lobbied againstthe regulation. London is concerned localfunds will move out and relocate to citieslike Geneva to avoid the regulation and theincreased tax environment. UK funds withlittle to no E.U. investors are most likely toleave London, since asset managementorganisations can move their bases farmore easily than other financialinstitutions.

OutlookThe international tax landscape impactingasset managers is continuously changing.The pace of these changes appears tobe accelerating as asset managers remainthe political scapegoats for the financialcollapse of 2008. Keeping abreast of thesechanges continues to challenge taxdepartments and operational departments.Asset managers need to be sure to devotethe resources to stay ahead of changesand to team with strong tax advisorsthroughout the globe.


3 In Vodafone International Holdings BV v. Union of India (Vodafone) [(2008) 175 Taxman 399 (Bom HC)], theIndian tax authorities have attempted to assert jurisdiction over a 2007 transaction between a Dutchsubsidiary of the UK-based Vodafone Group and a Dutch subsidiary of the Hong-Kong based HutchinsonGroup in which shares of a Cayman Islands holding company, which held shares in an Indian company, weretransferred. While the Bombay High Court essentially remanded the case back to the tax authorities, it didrule that the transaction was prima facie subject to Indian capital gains tax.



Over the past two years, the asset management industry, and particularly the alternativeinvestment funds sub-sector, has received a great deal of scrutiny from legislators andthe press. Whether the negative publicity has fuelled the flames, or just tapped into alatent sentiment is unclear. In either case however, the tax regulators have responded tothis highly publicised target. Tax authorities have created specialised groups to focus onthis industry and extensive tax audits have commenced. Legislators have called for moreregulations and more transparency. Enhanced relationship programs with regulators havebeen proposed. The interaction of funds and the government is changing, and changingin a way that will put more pressure on a fund’s infrastructure and operations.

For example, in the US, Senators Levin and Grassley have called for transparency andhave proposed legislation (“Hedge Fund Transparency Act of 2009”) that would amendcurrent legislation and require hedge funds and private equity funds to register with theSecurities & Exchange Commission (SEC).4 Similarly, the European Union is currently setto vote on the Alternative Investment Fund Managers (AIFM) Directive, which wouldprovide a regulatory framework for managers of hedge funds, private equity and otheralternative investment vehicles. In conjunction with this heightened scrutiny, taxauthorities have stepped up their efforts to audit hedge and private equity funds.

Taxing authorities are making managed fund audits a priority

In early 2009, the United States Internal Revenue Service (IRS) started a special initiativeto audit managers of hedge, private equity, real estate and venture capital funds(“Managed Funds Project”). The revenue agents hired to work on these audits havespecialised knowledge of financial instruments and partnerships.

The US government has pledged significant resources for the managed funds project.Following the US government’s lead, in the UK Her Majesty’s Revenue & Customs(HMRC) has set up a “centre of excellence” in London to improve HMRC’s ability to spotcompliance risks presented by fund-type clients. At this time we are not aware of anyother countries that have a tax audit group as established and specialised which focusessolely on asset management issues. However, it should be noted that over the past yeartax authorities globally have hired, and are continuing to hire, more tax examiners toconduct more audits of taxpayers. The onslaught is coming.

The general consensus in Europe is that when managed funds are audited, they canexpect an increase in scrutiny regarding transfer pricing, residency (actual place ofmanagement), cross-border interest flows and complex trading transactions. In particular,taxing authorities are moving towards taking a substance-over-form approach withrespect to residency and non-performing loan platforms.

Additionally, countries such as Japan and Singapore have stepped up tax audits onmanaged funds. Further, transfer pricing audits have become a common theme for assetmanagers in India, Singapore, Taiwan and Japan.

Examinations are becoming very intrusive, time consuming andexpensive to manage

In the United States, the IRS has become more sophisticated when conducting managedfunds audits and is asking very pointed and extensive questions at the onset of anexamination. This is happening since revenue agents from the inception of an exam arecollaboratively working with IRS Chief Counsel attorneys as well as industry specialiststo prepare their questions. The information requested from taxpayers is intrusive andonerous to gather. Often the audit plan will involve a year or more, which could have anegative effect on capital raising.8 PricewaterhouseCoopers

Asset Management News June 2010

Government audit activityon the increaseThere is an emphasis on audit activity that we expect to continue for several years – tax directorsshould maintain robust and defendable structures.

Louis CarlowPricewaterhouseCoopers (US)+1 646 471 [email protected]

Akemi KitouPricewaterhouseCoopers (Japan)+81 3 5251 [email protected]

Stuart Porter PricewaterhouseCoopers (Japan)+81 3 5251 [email protected]

Martin VinkPricewaterhouseCoopers (Netherlands)+31 20 568 [email protected]

4 See AIFM update on page 27

In Japan, specifically, the Tokyo RegionalTax Bureau’s (TRTB) approach toauditing Japanese management oradvisory companies has become moresophisticated. The TRTB examiners havea solid understanding of the typicalstructure and operations of hedge orprivate equity funds from previous auditexperiences and general industrybackground. Similar to the US approach,TRTB examiners will generally havegathered detailed background informationon the Japanese company and/or itsoffshore affiliates from publicly-availableinformation before visiting. Most recently,tax examiners have taken to visiting newly-established Japanese advisory companieson an informal basis to develop anunderstanding of the business operations.While this is not under the guise of aformal tax audit, the examiners may stillrequire answers to detailed questions inorder to gain knowledge of the businessfor future reviews of tax returns filed bythe company.

What are the key issuesidentified on managed fundsaudits?

A review of information requests issuedby various tax authorities worldwide hasrevealed several trends that are not

country specific. The tax authorities inthe US, Europe and Asia are focusedon: transfer pricing issues related tomanagement fees and other chargesbetween related parties; permanentestablishment issues; withholding taxissues; and fee deferral.

The use of technology is alsohelping agents with theirexaminations

Tax examiners worldwide are increasingtheir reliance on technology in order toobtain information and develop issues.For example, electronically-filed returns areincreasingly being used by both the IRSand TRTB examiners to sift through dataand make year-on-year comparativeanalyses. It should be further noted thatboth the IRS and other tax authorities areusing their own internal data accumulationsystems, the internet, third-partyinformation and electronic news andfinancial reporting services to developissues on audit. In particular, taxexaminers are using the internet to gatherinformation on funds before an audit, usingthis to check taxpayer information.

We have also seen an increase in the levelof cooperation between various taxauthorities worldwide. Globally, there is anemphasis on the exchange of information

programs authorised in various taxtreaties. Not only are agencies sharing taxinformation, but they are also sharingtraining materials and techniques toidentify non-compliance with tax laws.

What does the future hold?

We expect the emphasis on examinationsof alternative investment funds and relatedcompanies to continue for several years.We also believe that tax authorities willbecome more efficient and examinationswill become more difficult for taxpayers.Accordingly, asset managers would beprudent to review their documentationrelated to income, expenses, allocations,contracts and transfer pricing prior toreceiving a notice that one of their fundsor related entities had been selected foran examination. Tax directors shouldconduct a regular review of their tax riskmanagement strategies in order tomaintain robust structures that aredefendable in case of tax audits.



Asset management has evolved from simple beginnings to become increasinglycomplex. While the organisational charts of venture capital funds are straightforward,with rows of corporations resembling the single-story ranch homes in Americansuburbs, private equity funds more likely boast an organisational chart that would putLondon’s skyline to shame. Master funds, feeder funds, alternative investment vehicles,carry vehicles, blockers and offshore holding companies are commonplace structures,each with its own purpose. Each vehicle serves a purpose – or did at the time it wasset up. However, given that additional demands are now being placed on finance andtax organisations following the recent global financial crisis, managers are reassessingthe entity proliferation which has ruled the day for many years.

In this new world, cost control and efficiencies have become paramount and are drivinga move toward simplicity. In more detail, the factors behind this trend are:

• Doing more with less: With reduced budgets and headcounts, CFOs are being askedto provide more and different information to more and different users.

• Simple now, hard later: The cost of forming an entity can be enticingly low, perhapsjust a few thousand dollars. However, the ongoing cost of maintaining a legal entityover a 10-to-15 year expected life can reach hundreds of thousands of dollars.CFOs are, therefore, leaning toward leaner fund structures involving fewer entities.

• Extended fund life: Most venture capital and private equity funds are “closed-end”investments, often with 10-year stated terms. Few funds actually liquidate within theirstated terms, as portfolio investments (like college-age children) take far longer toleave home than we think they should. This increases the total number of activeentities the manager must maintain, and continues the high compliance costs ofcomplex structures into later years where costs are more likely to exceed benefits.

• Fiscal pressure on developed economies: Tax authorities across the world areaggressively auditing special purpose vehicles and offshore holding companies forevidence of residency, taxable permanent establishments and transfer pricingadjustments in their quest to raise tax revenues. Examples of these incidents includeChina’s December 2009 Circular 698, which asserts the right to tax sales of offshoreholding companies if they lack sufficient substance, and the broader “economicsubstance” provisions of America’s March 2010 Health Care Tax Act. These incidentsincrease both the cost of maintaining structures and the risk that tax benefits will notbe realised.

• Investor sophistication: A decade ago, institutional investors were wary of anyinvestment which might create a tax compliance burden. Today, experiencedinvestors are increasingly comfortable accepting tax and compliance costs fromfunds which produce superior returns. As a result, fund managers are less likely tocommit their best efforts to avoid any tainted income, such as UBTI (unrelatedbusiness taxable income) or ECI (effectively connected income).

Portraits of simplicity

In response to these changes, asset managers are rethinking their approach tostructuring funds. They are making radical changes to reduce their operating costs andto streamline the compliance cycle. Recent examples include:

• Managers persuading investors that their interests are better served by allowing themanager to maximise internal rates of return, even if this pushes some tax andcompliance cost onto them. One emerging trend is that managers are not trying tostructure their European funds in ways that are tax efficient for every type of investor,thereby minimising the number of entities held by the fund. In another emerging10 PricewaterhouseCoopers


A move to simplicityAsset managers are seeking targeted simplification including making radical changes to fundstructures, and thus reducing costs and streamlining compliance. While it is clear that the “simplicitysavings” will be spent many times over as new structures evolve, many funds have begun toundertake this effort in a serious way.

Fred Sroka PricewaterhouseCoopers (US)+1 408 817 7427 [email protected]

Teresa Owusu-Adjei PricewaterhouseCoopers (UK)+44 207 213 [email protected]

David KH Kan PricewaterhouseCoopers (Hong Kong)+ 852 2289 [email protected]

trend, some US fund managers havepersuaded investors to remove thecovenants regarding ECI and UBTI fromcurrent fund agreements.

• Managers are reducing the numberof holding companies within Europeanfunds by having one holding companywhich holds all special purposevehicles – rather than having a holdingcompany and a special purpose vehiclefor each investment. This approachis allowing mangers to achieve theappropriate level of substance for thatone entity, rather than incurring thecosts of having to put substance intoplace for every holding company. Inparticular, although governments havechanged their tax laws to attract fundsto “holding company” jurisdictions,some managers are less willing to usethese emerging jurisdictions. Regardingthe costs of putting substance into thenew jurisdiction as prohibitive, theyprefer to stay with existing jurisdictions.

• Managers are seeking to standardisetheir fund structures by using the sametype of financing and tax structuringfor all their investments, eschewingopportunities that would only result ina small incremental benefit to theirinvestors.

• A venture fund group focused onChina formed a domestic renminbi fundin place of the usual fund structurewhich would have comprised aCayman fund with holding companiesfor the Chinese investments.

• A life science venture fund isconsidering unblocked investmentinto new compounds, eliminatingseparately taxable portfolio companiesfrom the organisational chart, andpotentially enhancing investor returnson cash exits.

Will governments join in?

While most governments are increasingreporting and tax burdens on foreigninvestors, in the future they may possiblyrecognise the benefits of simplifyinginvestment opportunities and providingincentives. For example, the Canadiangovernment, hoping to attract increasedcapital inflows, recently proposed acomplete waiver of withholding tax forforeign investors. This eliminates theneed for complex holding structures.

Fund structures of the future

As commonsense would suggest, thebest opportunity to simplify organisationalcharts and operations tends to be whena new fund is formed. Sadly, thiscoincides with the time that the manageris most pre-occupied and least able toevaluate costs and benefits. As a result,successor funds are often structured tomirror their predecessors, under thepremise that anything which is not brokenneed not be fixed.

Managers would benefit from modellingcosts, risks and expected benefits wellbefore fund raising commences. A simplerule of thumb is that the cost of anystructure should produce an expectedreturn that at least matches the expectedperformance of the fund as a whole. It isclear that to remain competitive, assetmanagers will need to continually monitortheir operations to retire structures whichno longer generate value. They shouldalso avoid creating new entities unlesssubstantial future benefits are expected.



Within asset management, structuring a fund’s investments through a holding companystructure has become a popular strategy. Centralising investments through a holdingcompany, or a ‘super holding company’ in some cases, can afford a plethora ofbenefits, including cash management, regional supervisory oversight, efficient cashrepatriation and certain regulatory and legal advantages.

Such structures, if carefully implemented and maintained, may also mitigate funds’potential exposures to source country taxation for the funds and their investors.However, the use of special purpose vehicles (SPVs) to obtain treaty protection andother tax benefits (e.g. reduced withholding tax rates) is subject to ever-increasingscrutiny by taxing authorities across the world. Everywhere, we are witnessing anincreased implementation of general anti-avoidance rules (GAAR) and there has been aproliferation of cases where taxing authorities have forcefully challenged a tax payer’sentitlement to claim for treaty benefits in a number of different jurisdictions. Further, anOECD working group has been assembled to examine beneficial ownership in thecontext of double tax treaty entitlement. In light of such developments, building andmaintaining robust substance at the SPV level has become increasingly important inorder to enjoy the benefits that sound holding company structures can offer.

Bolstering substance

A sustainable treaty-based structure is one that has sufficient legal, operational andeconomic substance in the jurisdiction in which the SPV is incorporated. If there is‘insufficient’ substance at the SPV level, a taxing authority in an investee jurisdictioncould seek to deny the SPV (i.e., the investing company) treaty benefits and otherdomestic exemptions.

Building sufficient substance for tax purposes can give rise to practical difficulties andchallenges, particularly as there are no agreed-upon standards.5

What constitutes ‘sufficient’ substance is highly fact-specific and must be assessedon a case-by-case basis, taking into account tax authority practice. For example, theAustralian Tax Office (ATO) sought recently to freeze the Australian bank accountsof an entity associated with a private equity fund. The accounts were said to containproceeds from the sale of Australian shares following an initial public offering (IPO) onthe Australian Stock Exchange. The ATO considered that the transaction was withinthe ambit of Australia’s GAAR rules since, in their view, the Dutch entity (participating inthe IPO) was a SPV set up by its owners to avoid source country taxes.

Recent developments in India and China

Foreign investors have traditionally routed their investments in India through taxfavourable jurisdictions such as Mauritius, Cyprus and Singapore, and investments inChina have historically been structured through Hong Kong.


Reviewing holding companystructuresTaxing authorities across the world are placing treaty-based platforms under increasing scrutiny,causing some managers to review their structures and making proper planning important.

Oscar TeunissenPricewaterhouseCoopers (US)+1 646 [email protected]

Thomas GroenenPricewaterhouseCoopers (US)+1 646 471 [email protected]

Gautam MehraPricewaterhouseCoopers (India)+91 22 6689 [email protected]

Clark NoordhuisPricewaterhouseCoopers (Netherlands)+31 20 568 [email protected]

5 The term ‘beneficial owner,’ for instance, can be difficult to define. It is typically an undefined term in double-tax agreements, left to be interpreted under domestic law. The OECD Working Party 1 will be considering thedefinition of ‘beneficial owner’ as a result of some recent cases in this area. See, for example, the Indofoodcase in the UK, where it was held that an interposed company would not have been entitled to treatybenefits. Indofood International Finance v. JP Morgan Chase Bank, [2005] EWHC 2103 (Ch.) rev’d [2006]EWCA Civ 158.

The attempt by the Indian tax authoritiesto impose capital gains tax and relatedwithholding tax (WHT) on a transactionbetween non-resident companies on thetransfer of non-resident holding companyshares that indirectly held Indian assets inthe Vodafone6 case has raised a numberof controversies and created a greatdeal of uncertainty for foreign investors.The ongoing Vodafone case and recentE*Trade7 case should be carefullymonitored by taxpayers who have in thepast participated or are consideringparticipating in similar transactions, asthe outcome of the case may have asignificant tax impact on suchtransactions (i.e., indirect transfer ofIndian assets by non-residents).

Following the footsteps of othergovernments around the world, the IndianGovernment recently introduced a draftDirect Tax Code, effective April 2011.The new Indian Direct Tax Code includesproposals to introduce GAAR and a treatyoverride provision.

Under the proposed Indian GAAR, anarrangement would be deemed to belacking commercial substance if therewas no genuine commercial reason todemonstrate that its main purpose wasnot primarily tax avoidance. The GAAR

provisions are far-reaching and shift theburden of proof onto the taxpayer.Should the Indian tax authorities everchallenge a transaction, the taxpayer hasto meet certain evidence requirements toshow it has not entered into a taxavoidance transaction.

Recent cases in India, such as Vodafoneand E*Trade reflect the current mindsetand aggressive approach of the taxauthorities with respect to the use oftreaty-based structures. In light of thesedevelopments, and the introduction of thenew India Direct Tax Code, it is clear thatif a fund wishes to avail itself of treatybenefits, it should maintain propersubstance and corporate governancemeasures at the SPV level (e.g. inMauritius) in order to claim treaty benefits(e.g. India-Mauritius tax treaty).

China has also introduced a number ofsignificant changes to their income taxlaw in recent years impacting inboundinvestors. The majority of these changesare geared towards tightening treatyclaim administration and combating treatyshopping. By way of example, China hasintroduced new clearance proceduresthat require investors to obtain pre-certification before they can enjoy certaintreaty benefits under a PRC double tax


6 In Vodafone International Holdings BV v. Union ofIndia (Vodafone) [(2008) 175 Taxman 399 (BomHC)], the Indian tax authorities have attempted toassert jurisdiction over a 2007 transaction betweena Dutch subsidiary of the UK-based VodafoneGroup and a Dutch subsidiary of the Hong-Kongbased Hutchinson Group in which shares of aCayman Islands holding company, which heldshares in an Indian company, were transferred.While the Bombay High Court essentiallyremanded the case back to the tax authorities, itdid rule that the transaction was prima faciesubject to Indian capital gains tax.

7 In the case of E*Trade Mauritius Ltd., the Indian taxauthorities, on the basis of specific facts, havedisregarded the TRC of E*Trade Mauritius Ltd anddenied the capital gains exemption under theIndia-Mauritius tax treaty on the basis that theMauritius company lacked substance and was ineffect controlled by the US parent. On furtherappeal, the Commissioner, on specific facts, heldthat there was a comingling of the assets andmanagement of the Indian company by personsfrom the US and their activities in India lead tocarrying on business of the US Company in India.Further, he held that the E*Trade Mauritius Ltd wasa façade and that the capital gains had arisen inthe hands of the US holding company and not theE*Trade Mauritius Ltd. The tax authorities haverendered this ruling for the limited purpose ofdetermining the withholding tax liability of thebuyer of the shares. In a recent ruling delivered on22 March, 2010, the Authority for Advance Rulings(AAR) upheld the capital gains tax exemptionavailable to E*Trade Mauritius under the India-Mauritius tax treaty.

treaty.8 Further, the Chinese StateAdministration of Taxation (SAT) alsoreleased a Circular9 on 27 October 2009,providing guidance for the determinationof “beneficial ownership” for the purposeof claiming treaty benefits in respect ofdividend, interest and royalty by taxresidents of a treaty country (region).In assessing the claims of treaty benefitsfor passive income, a non-residentclaiming treaty benefits needs to meetcertain “substance/control” tests, someof which appear to be stricter thaninternational experience and the relevantOECD Commentaries. For example, onearea of focus appears to be the effectivetax rate of the holding company seekingtreaty benefits. Not only will theseprocedures increase the administrativeburden for fund managers investing inChina, but they will also mean the SATsubjects treaty-based structures tocloser inspection.

China further introduced GAAR into itstax legislation. In particular, Circular GuoShui Han [2009] 698 which was issued on10 December, 2009, targets the use ofSPVs. Under the Circular, the Chinese taxauthorities could examine the true natureof an offshore transaction. Should theequity transfer be achieved through“abusive use of company structure” (e.g.no substance in the intermediary holding

company), the Chinese tax authorities could invoke GAAR, deem direct transferof equity and impose a 10% WHT rate.

Recent developments in Europe

Similar to the emerging markets,European taxing authorities havegenerally been looking more closely atthe level of substance maintained in anSPV. This can be seen, for example, inthe UK and Germany.

A non-resident lender that receivesinterest from a UK borrower and wants tobenefit from a reduced interest WHT ratebased on a double-taxation agreement(DTA) must first obtain treaty clearancefrom Her Majesty’s Revenue & Customs(HMRC) before the treaty rate can beapplied to an interest payment.In considering whether to grant treatyclearance, the HMRC takes into accountits interpretation of the Indofood10

decision. If a SPV is set up in a treatycountry by a non-treaty lender for thesole purpose of obtaining a reduced rateof UK withholding tax, the HMRC maydeny the treaty clearance.

In Germany, the domestic dividendWHT rate may be reduced under DTAsor the E.U. Parent-Subsidiary Directive.However, Germany has introduced certainanti-abuse provisions based on whichthe reduced WHT rates may be deniedif the recipient of the dividend is aforeign company that, in general, hasshareholders that would not be entitledto a corresponding reduced WHT rate ifthey were to receive the dividendsdirectly. In such a case, the reducedtreaty rate would apply only if certaintests, one of which was a substance test,were satisfied.

Level of substancerequirements

Substance requirements, for taxpurposes, are generally determinedprimarily by the countries where theassets are located, rather than by theterritory where the entity is established.This makes it difficult to provide auniversally accepted definition ofsubstance, as the requirements varyfrom country to country.

Similar to the emerging markets, Europeantaxing authorities have generally beenlooking more closely at the level ofsubstance maintained in an SPV. This can be seen, for example, in the UK and Germany.



08 Since 1 October, 2009, the claim of tax treaty benefits by treaty residents with regard to passive incomederived from China has been subject to approval by the authorized Chinese tax authorities pursuant to taxcircular Guoshuihan [2009] No.124 (“Circular 124”).

09 Guoshuihan [2009] No.601 (“Circular 601”), which provides important guidance for applying circular 124.

10 In the Indofood case in the UK, it was held that an interposed company would not have been entitled totreaty benefits. Indofood International Finance v. JP Morgan Chase Bank, [2005] EWHC 2103 (Ch.) rev’d[2006] EWCA Civ 158.

In common holding company jurisdictionssuch as the Netherlands, Luxembourgand Ireland, as a rough guideline, certainminimum substance requirements shouldbe met, e.g.:

(i) At least 50% of the directors of theholding company should be residentin the jurisdiction where the holdingcompany is located

(ii) The directors should be sufficientlyqualified

(iii) The holding company should havelocal employees, local office premises,communication equipment, etc.

Additionally, aside from the operationalsubstance requirements, fund managersshould pay attention to the very fluidconcept of beneficial ownership. As ageneral guideline on the ‘beneficialownership test’, an SPV should have the‘freedom to avail of the income’ itreceives, as laid down in the Prévost11

case. Further, the SPV should not belegally obliged to pay all (or almost all) ofa certain income stream (e.g., back-to-back loans), so that beneficial ownershipcan be demonstrated if and whenchallenged by a taxing authority.

Practical recommendations

Fund managers have traditionallyemployed holding company structureson an investment-by-investment basis.Building sufficient substance in eachSPV can be challenging and in somecases simply not practical. For thisreason, fund managers are nowconsidering the use of ‘super’ holdingplatforms, where substance is built in asingle entity rather than across many.The optimal holding company jurisdictionis a multi-faceted determination thatdepends on a range of factors, includingthe prevailing legal, regulatory andtaxation climate, as well as proximityto target markets, availability of qualifiedpersonnel and local infrastructure.If properly implemented, such a structuremay be less susceptible to challengeby a foreign taxing authority than thetraditional multiple-holding companymodel.

Further, given the global climate ofheightened scrutiny by tax authorities,proper planning in monitoring substancerequirements within a holding companystructure should be a key area of riskmanagement. Ultimately, those fund

managers with well-organised internalprocedures, and robust “housekeeping”,are much less likely to endure protractedtax authority disputes, and are betterplaced to enjoy the full plethora ofbenefits that carefully implementedholding companies can deliver. This helpsthem to sustain more profitable outcomesfor their investors.


11 In Prévost Car Inc. v. The Queen, the Canada Revenue Agency argued that a Netherlands holding companyestablished in a treaty jurisdiction (the Netherlands) was not the beneficial owner of the income in question(dividends paid out by the Canadian operating company). The Tax Court of Canada decided in favour of thetaxpayer, ruling that the monies represented by the dividends were fully available to its creditors and until itin turn declared and paid a dividend, the funds continued to be its property.


Across the globe, there has been a strong call for greater transparency in tax reporting.This call emanates from the assumption that significant amounts of assets and incomeare being sheltered from taxing authorities. With the current economic climate, wheretax revenues are at a premium, there is zero tolerance for taxpayers “hiding” income intax haven jurisdictions. Governments and their legislative and regulatory arms havetapped into this anti-tax shelter sentiment, and have enacted a number of complex andoften overlapping information reporting requirements. These new reporting rules willlikely continue to increase in number, complexity and will come from an increasingnumber of jurisdictions. Unfortunately, given the regular use of “tax haven jurisdictions”by the asset management industry, the government and public perception is that fundsare available vehicles to be used to shelter income. As a result, the burden of thesenew information reporting regimes falls heavily on asset management.

In addition to the sheer administrative burden of these new rules, which should not beunderestimated, the rules often carry stiff monetary and sometimes criminal penaltiesfor non-compliance. And make no mistake, governments are looking to make high-profile examples of non-compliance with these rules. Given the significant risksassociated with even inadvertent inaccurate or incomplete filings in this area, it isimperative that funds and their tax departments not only stay current on the rules asthey evolve, but also institutionalise the data gathering and form preparation process.Set forth below is a brief summary of some of the recent information reportingdevelopments in three different geographic locations around the world.

United States

Foreign Account Tax Compliance Act (FATCA)

The US government recently enacted new laws that greatly increase informationreporting for investment partnerships that have US source income. The FATCAprovisions were first introduced in 2009 and signed into law by President Obama onMarch 18, 2010 as part of the Hiring Incentives to Restore Employment Act. Once themajority of these provisions are effective in 2013, most non-US investment funds withUS source income will be required to enter into disclosure agreements with the InternalRevenue Service (IRS) in order to avoid US income tax withholding on various types ofincome, including the gross proceeds from the sale of assets that generate USdividend and interest income. This new regime is much broader than the currentwithholding tax rules and detailed information about direct and indirect US investorswould need to be provided in order to avoid over-withholding on US income. From aglobal perspective, depending on how the rules are written, there could be far-reachingimplications, particularly where the fund does not have access to the direct or indirectowner information, such as when third-party distributors are used or when you haveprivate label funds. The full extent of these rules is not yet known, but because of thepotential implications, a number of industry associations are working with the USTreasury in an attempt to soften their impact.

Foreign Bank Account Reporting (FBAR)

The other area of focus in the information reporting area encompasses foreign bankaccounts held by US persons. Targeted at the same concern driving the FATCAprovisions, namely that US persons are hiding money offshore, the IRS has not onlysignificantly increased the penalties for non-compliance, but also is in the process ofexpanding the rules so that US interests in foreign hedge funds and private equityfunds may be reportable financial accounts. Changes to the foreign bank accountreporting forms in 2008 created a flurry of activity for fund managers in 2009, due tothe ambiguity of the definition of foreign accounts as well as who was required to file.16 PricewaterhouseCoopers


Global tax authorities expandinformation reporting requirementsGovernments are demanding greater transparency in tax reporting, and asset managers must be ableto comply with their mounting requirements.

Allison RosierPricewaterhouseCoopers (US)+1 646 471 [email protected]

Dieter WirthPricewaterhouseCoopers (Switzerland)+41 58 792 [email protected]

Rex ChanPricewaterhouseCoopers (China)+86 10 6533 [email protected]

Numerous legal and industry groups havesubmitted comments to the IRS regardingrecently proposed regulations, so futureguidance is expected in this area as well.

Cost Basis Reporting

New rules require brokers to report theadjusted cost basis of certain securitiespurchased and sold by their customers toboth taxpayers and to the IRS. This newlegislation is far reaching and impactsbroker/dealers, mutual funds, transferagents and professional custodians (suchas banks) that regularly arrange sales orreceive gross proceeds from the sale ofsecurities. The effective dates for thesenew rules vary and additional guidancehas been issued in the form of proposedregulations. Due to the many openissues, including the definition of a brokerand what constitutes a security, the exactscope of these reporting requirements isexpected to evolve over the next year.

Europe

Information exchange is one of the mostdelicate topics for the European Union’s(E.U.’s) banking and asset managementindustry, involving political debates aboutexisting E.U. members’ and non-membercountries’ banking secrecy legislations(e.g. Luxembourg, Austria andSwitzerland).

In order to achieve greater taxtransparency on a global basis, the G20finance ministers and central bankgovernors have engaged the OECD towork on the implementation of theinformation exchange, mainly throughArticle 26 of the Double Tax Treaties (DTT)or with Tax Information ExchangeAgreements (TIEAs). Since 2009, anumber of such bilateral agreements havebeen concluded so that many additionalcountries would no longer appear on theOECD’s black or grey list. Liechtenstein,for example, has negotiated 12 TIEAswhich support and provide information inconnection with tax investigations byother countries.

E.U. Savings Tax Directive (EUSD)

Since the enactment of the EUSD in2005, an automatic information exchangeof interest income of E.U. residentindividuals applies between the memberstates and certain non-member or “third”countries. It is envisaged that the EUSDwill be amended and the transitionalperiod – withholding instead ofinformation exchange – for Austria,

Luxembourg and certain third countrieswill not be extended. In addition, thedirective might be expanded in order tocover income from life insurance policiesand derivative-based products.

Alternative Investment Fund ManagerDirective (AIFMD)

The AIFMD provides that funds managedin non-E.U. countries can be marketedto E.U. investors only if an informationexchange agreement is concludedbetween the involved countries, and ifequivalence of supervisory and regulatorybodies with the E.U. rules exists. As aresult, asset managers that are targetingE.U.-based investors will be encouragedto set up funds in jurisdictions that allowfor information exchange or perhapsnon-E.U. countries will be encouragedto adopt rules to satisfy this directive.Ultimately, the AIFMD furtherdemonstrates the overall trend towardsinformation exchange and enhancedtransparency for tax purposes.

Asia

As one of the biggest markets in Asia,expanded information reporting in Chinais indicative of other changes in theregion. From an income tax treatyperspective, most Chinese tax treatiesinclude an Exchange of Informationclause. In addition to its treaty network,China completed TIEAs with the BritishVirgin Islands (BVI) and Bahamas in 2009.Both Bahamas and BVI used to beconsidered as not having substantiallyimplemented the internationally agreedtax standard. Now, with the TIEA in place,the Chinese tax authority has extendedits international tax network so that it cancollect tax information from suchjurisdictions.

The Chinese tax authority has issued anumber of domestic regulations focusingon information collection from taxpayers,including the following significant rulings:

• Decree [2009] 19 requests foreigncontractors, as well as their Chinesecustomers, to register service contractsdirectly with the Chinese tax authorityin order to facilitate tax collection.

• Circular Guo Shui Fa [2009] 124requests foreign taxpayers who claimtax treaty benefits to either performrecord filing or apply for a pre-approvalbefore they can enjoy any tax benefitsunder the applicable income tax treaty.During the record filing or application

period, foreign taxpayers are requiredto submit a lot of information includingthe treaty applicant’s own particulars,their shareholders, as well as related-party transactions in other countries.Some of the underlying concerns relateto treaty-resident status, beneficialownership, limitation of benefits andtreaty shopping.

• Circular Guo Shui Han [2009] 698imposes a reporting obligation onforeign shareholders that transferequity interests in an offshoreintermediate holding company whichin turn holds equity in a PRC residententity (“an indirect equity transfer”),if the intermediate holding company isin a “low tax” jurisdiction or ajurisdiction that does not tax foreignincome. This indicates additional effortsto collect information in order to helpChina initiate a General Anti-AvoidanceRule investigation, which woulddisregard the intermediate holdingcompany and thus create additionalChinese source revenue that would besubject to tax. It is unclear whetherthis circular will withstand challengesby other foreign tax jurisdictions due toits far-reaching scope.

Conclusion

As shown by recent developments in theUS, Europe and China, tax authorities areimplementing new reporting rulesdesigned to gather additional informationrelating to beneficial ownership andunderlying income and assets. There isa shared scepticism over the use ofinvestment vehicles in either low tax orno tax jurisdictions. New reporting,withholding and marketing guidelines aredesigned to discourage the use of tax-haven jurisdictions in connection with taxplanning and structuring. Furthermore,information sharing across countries isclearly being encouraged through theproliferation of tax-related agreementsand renegotiated tax treaties. Globalinformation reporting continues to evolverapidly for the asset managementindustry. Funds must be able to complywith these changing and often complexrules – not only from an economic andreputational perspective, but also asexisting and prospective investors viewoperational efficiency as an additionaldistinguishing factor for fund investments.




In today’s environment, tax directors at asset management firms are being asked todo much more. Not only must they comply with an increasingly complex maze of taxand information filings, they are also being asked to provide more comprehensiveinformation to more people in a shorter time frame. One often overlooked utility forassisting tax departments is increased reliance on technology. For the most part, taxdepartments have made use of ad-hoc technology solutions to address specific tasks.Once the solution works, it is left in place, no one considers technology enhancements,or seeks to link multiple functions together with a comprehensive technology solution.

Yet technology has advanced to a point today where tax departments should berevisiting their solutions to obtain further efficiencies. Technology adds value to thetax function through the acquisition, organisation, transformation and presentation ofdata. These activities have been happening, in one form or another, since before datawas even stored electronically. The basic nature of these activities has remainedunchanged – yet over time technology has exponentially increased efficiencies acrossthe data lifecycle.

Even so, significant opportunities exist for still more efficiencies, as many taxdepartments and functions spend large amounts of time manually managing andcleansing data. Additionally, technology capabilities have evolved and converged to apoint where the value of this data has the potential to extend well beyond its historicaluses. Among other benefits, these new capabilities are helping in the following areas:

• Collaboration: Facilitating how tax teams – both within and between enterprises –

work together in generating and delivering tax-related services. This includes theinitial generation of information, for example between firms’ accounting and taxdepartments in multiple locations, exchange of data and information to initiate workwith service providers, as well as the electronic interactions that sustain andultimately deliver the services.

• Transparency: Providing stakeholders such as regulatory authorities, investors andauditors with the kind of data they need in a timely fashion helps to boost confidencein the control environment, as well as the quality of tax deliverables and theenterprise as a whole.

• Decision-making: Enabling intelligence prospectively from historical data, promisingincreased value of data that previously had been seen as having a narrower utility.

This is the first in a series of articles planned to appear in Asset Management News,and it will focus on collaboration. The articles will expand upon the areas mentionedabove, explore their significance in different geographies and provide examples ofwhere technology can drive corresponding efficiencies.

Collaboration

Historically, the data required to generate a tax-specific end result – e.g. a tax return,provision or transactional analysis – was extracted and often exchanged with just thedelivery of that specific information in mind. Email has been the preferred medium forsharing information in this fashion. While a convenient way to communicate, email isnot secure by default and can expose confidential data to unintended recipients.Moreover, as reported in the February 2010 issue of the Journal of Accountancy,12 USfederal and state laws continue to get stricter about securing clients’ social securitynumbers, and sending sensitive information via email may soon no longer be an option.Instead, products such as electronic file rooms and portals, which typically rely onsecure socket layer (SSL) encryption and user authentication to maintain dataconfidentiality, should be used to provide encrypted document delivery.18 PricewaterhouseCoopers


The evolving landscapeof tax technologyTechnology is helping to provide solutions to many of the challenges faced today bytax departments – including the greater need for flexible collaboration with various stakeholders.

David SteinerPricewaterhouseCoopers (US)+1 646 471 [email protected]

Paul LockwoodPricewaterhouseCoopers (US)+1 202 346 [email protected]

Scott SteinPricewaterhouseCoopers (US)+1 646 471 [email protected]

12 Client Portals: A Secure Alternative to Emails,Journal of Accountancy, February 2010.

Collaboration software, by contrast,provides both a forum for data exchangeand a virtual “place” that allows differentparties to communicate and stayinformed as work progresses. Withinasset management firms which areincreasingly global, collaboration softwarecan be used by accounting and taxdepartments in different locations toshare financial documents betweenthemselves, with service providers andwith investors. This software can also beused by tax departments to share datafeeds from portfolio managementsystems with service providers.

Electronic file rooms allow users toreview, import and export portfoliomanagement system feeds, investordemographic information, trial balancedetails, quarterly estimates and taxreturns securely via the internet. Inaddition to facilitating secure documentexchanges, sharing data throughelectronic file rooms avoids file sizerestrictions imposed by email serversand firewalls. It can also provide versioncontrol functionality that eliminates therisk of superseded data being used, whilealso allowing users to revert back tohistorical versions of files. Whileextremely large data files, such as thosethat might contain millions oftransactional records, should be

transmitted using technologies designedexpressly for that purpose, today’scollaborative platforms routinely managelarge files with ease.

Collaboration around tax services can beenhanced through the use of Extract,Transform, and Load (ETL) software.Tax departments can work withstakeholders such as their tax preparersand fund administrators to understandthe data elements required to completedeliverables, and to utilise ETL on theirportfolio management systems to easilyprepare the necessary data feeds.For example, these data feeds can beconfigured to load directly into the taxpreparer’s allocation software, in turnreducing the data manipulation time byboth parties. Also, as data within theportfolio management system canchange at any time, standardised ETLqueries make it easy to generate updateddata feeds. These feeds can then bedelivered to the service providers via anelectronic file room.

Often, collaborative software technologiesare combined to create portals that aredesigned with specific stakeholders inmind. Portals allow investors to accesstheir personalised tax forms well as otherfinancial documents via the internet. Theyenable viewing and downloading of forms

and instructions, offer a centralisedrepository for multiple funds in a complexand provide access to historicaldocuments. Also, portals can reduce thedirect labour and supply costs associatedwith printing and distributing paper,while supporting environmentally friendlyinitiatives. Some portals also provideinvestors with the ability to delegateadditional user-account access totheir data.

As we are beginning to see, stakeholdersare demanding greater levels ofinformation from tax departments as theirown needs evolve. Technology solutionshave evolved significantly even over thepast five years. Tools such as electronicfile rooms, standardised data feeds andportals will continue to develop like alltechnology, but should now beconsidered as a necessary complementto an efficient tax department.

In our next article, we will expand uponthe topic of transparency and howtechnology can be used to empowertax departments through consistentdata reporting.



As we all know, the complexity and administrative burden of the global tax systemsfacing tax directors is at an all time high and continues on the ascent. With deficitsincreasing in most parts of the world, in part due to the global financial crisis,governments are focusing on expanding revenue streams and on greater regulationand transparency. A key industry that governments around the world are looking for“donations” from is private equity.

A typical private equity fund may be based in one country, have offices in severaldifferent countries and own portfolio companies with operations spanning the entireglobe. At the same time, the fund may have deal and operational personnel workingin every time zone. General Partners (GPs) and their tax directors must be attentive tofund, portfolio company and management company matters, in addition to stayingabreast of ever‐changing tax and regulatory rules. This is no small task.

When operating a fund, keeping track of fund staff and the activities they areperforming all over the globe is critical. Many taxing jurisdictions are tightening therequirements for having a “permanent establishment” or “trade or business” in thejurisdiction (i.e., being subjected to tax in the jurisdiction).

Having an unintended permanent establishment or trade or business in a particularjurisdiction can have disastrous economic and reputational results for a fund, as it maysubject fund‐level capital gains and/or fees to taxation in the jurisdiction, and thenthere is the attendant publicity which follows.

An increasing number of jurisdictions around the world have rules that result in lessfavourable tax treatment based upon threshold limits of ultimate ownership bydomestic vs. foreign limited partners, levels of real estate owned by portfoliocompanies, etc. Accordingly, it is critical that the private equity deal teams (and theiradvisors) who execute new portfolio company acquisitions are up to speed on thetax profile of the limited partners and any limiting tax provisions in the fund documents.Proper and timely coordination between the fund’s tax director and the deal/operationalteams on these issues continues to be critical to ensure that unsuitable transactionsdo not inadvertently result in unnecessary tax surprises. It is no longer reasonable fordeal teams to assume that we live in a zero-tax environment, or that historical taxnorms will continue to apply.

United States

Recently enacted and proposed legislation in the United States will directly affectprivate equity funds. Smaller firms will feel the greatest impact of increased costsand compliance obligations. The recently enacted Foreign Account Tax ComplianceAct (FATCA) rules will place significant burden on private equity funds and their taxdirectors, making additional resources and technology likely necessary. Proposedlegislation to tax carried interest as ordinary income and subject to self‐employmenttax will have a profound impact on the industry; tax planning and alternative structuringwill be necessary to consider as the proposals progress. Increasing tax rates onindividuals is inevitable. Financial regulatory reform could lead to additionalconsiderations for tax directors in the private equity industry as well. Proposedlegislation to require private equity fund advisors to register with the SEC will increasecosts and possibly require additional reporting. The “Volcker Rule”, which would forcebanks to exit proprietary trading businesses including private equity, could createadditional buying opportunities, but will also impact tax department infrastructures.Proposed regulation of swaps could alter their tax treatment, requiring tax directors todeal with a different taxing regime.


Private equity tax becomesmore onerousAs tax authorities across the world seek various ways to increase private equity taxes, managers needto devote significant resources to monitoring the myriad relevant tax rules.

Judith Daly PricewaterhouseCoopers (US)+1 646 471 5292 [email protected]

Liang S Goh PricewaterhouseCoopers (Hong Kong)+852 2289 5609 [email protected]

Robert Mellor PricewaterhouseCoopers (UK)+44 20 7804 1385 [email protected]

Jason Silverman PricewaterhouseCoopers (US)+1 646 471-5411 [email protected]

United Kingdom

The UK has a long history of supportingthe private equity industry dating rightback to the original 1987 Memorandumof Understanding (MOU) between theindustry and the government on thestandard UK private equity fund model,the nature of carry and the taxationtreatment of the flows under the privateequity model. A similar MOU process wasundertaken when the UK tightened itstreatment of the taxation of EmploymentRelated Securities (ERS), which onceagain clarified the treatment of carry inthe hands of the employees within privateequity houses.

There is a potential risk, however,that this consensus will break down –

especially in the case of carry if the USmoves to treat this as employment orordinary income. Even if carry retains thepotential for capital gains tax treatment(depending upon the actual flows throughthe fund), we have already seen in recenttimes one hike in the rate of capital gainstax (which itself was partially inspired bymedia and political commentary on therelative effective tax rate which carryholders were achieving). It mustpotentially be the case that UK capitalgains tax (CGT) rates will increase underthe new government, both to close thegap between headline personal tax ratesof 50% and CGT rates of 18%, and toincrease tax take.

The private equity industry in the UK iscertainly experiencing an uptick in taxauthority audit activity, ranging fromVAT issues on structures using offshoregeneral partnerships, to VAT challengeson the recoverability of transaction-related VAT costs, to transfer pricing.

The recent tightening of the taxationrules for non‐UK domiciled personsover the last few years and the higherpersonal tax rates have led to someprivate equity houses re‐evaluating theUK as the best location for their activities,especially if their investment strategies orportfolios are predominantly outside theUK. Locations like the Channel Islandsand Switzerland are attracting anincreased level of interestas possible business locations.

One of the biggest concerns for the UKand European private equity industry,however, comes from E.U. regulatorylegislation in the form of the AlternativeInvestment Fund Managers Directive(AIFM) which will, in its current draft form,impose a whole new layer of costs andrestrictions.

Asia Pacific

The Asia Pacific region is similar interms of challenges facing tax directors.China, Indonesia, Australia, Japan, Koreaand India have all recently taken anaggressive stance on tackling perceivedtax avoidance arrangements. This isespecially the case for holding companystructures seeking to take advantage oftax treaties where there is no or littlesubstance in the holding company.

In May, for example, Indonesia confirmedit would effectively prevent persons otherthan “beneficial owners” of income fromclaiming treaty protection under theirrespective treaty arrangements. And inlate 2009 the Australia Tax Office deniedtreaty benefits in relation to a Dutchholding company owned by a privateequity fund disposing of an Australiancompany in an initial public offering.Korea (the Lone Star case) and India(the Vodafone case) have also hadnotable recent court cases that haveaddressed the substance issue.

The majority of Chinese companies haveHong Kong holding companies, whereunder the Hong Kong /China TaxArrangement, PRC dividend withholdingtax can be reduced to 5% (normally 10%)for shareholdings of 25% or more, andcapital gains tax (normally 10%) could beexempt if the shareholdings are under25% in a non‐land rich PRC company.

In late 2009 the Chinese tax authoritiesissued Circular 698 to combat capitalgains tax avoidance, which usually takesthe form of indirectly disposing ofChinese companies by selling the sharesof an immediate, or a higher level,holding company. Under Circular 698,non‐resident investors disposing ofoffshore special purpose vehicles withChinese investments may have reportingrequirements.

Due to the Asia Pacific tax authorities’more stringent reviews of treaty-linkedholding structures, it is becomingincreasingly difficult to structureinvestments to take advantage offavourable treaty benefits by the use ofa mere “shell” holding company structure.Genuine substance in the holdingcompany incorporated in the relevant taxtreaty country is now required. A numberof private equity funds have beenreviewing their holding companystructures to ensure that treaty benefitsshould apply.

There are varying degrees of substancerequirements in different countries andthe landscape is constantly changing.As a result, advice in relation to investinginto Asia Pacific countries (and ondisposition) should always be sought.

Conclusion

Running a private equity fund in normaltimes requires a significant amount oftime – yet we are not in normal times.An enhanced effort, and level ofresources, is needed in the currentenvironment, as well as thorough andthoughtful analysis and monitoring of themyriad tax rules. Accordingly, it is criticalthat fund management, deal teams andportfolio company management alloperate in an integrated fashion with thetax function to minimise the impact ofthe new world order.



An enhanced effort, and level of resources,is needed in the current environment, as wellas thorough and thoughtful analysis andmonitoring of the myriad tax rules.

Lifted by the rising middle class, and poised to achieve a high savings rate of 35%and investment rate of 37% in the economy,13 India’s asset management industry hasimmense growth potential. Already, the country’s asset managers have embracedseveral global best practices and offer a diverse range of products. Relative to otherAsian economies, India is fairly mature.

Assets under management as of 31 March, 2010 stood at US$ 136bn,14 havingachieved impressive year-on-year growth of 47.1%. Over the four years from March2006 to March 2010, the industry’s growth has compounded at 27.6% – remarkable atthe best of times but even more so considering last year’s financial crisis. Withincreased retail participation, retail investors (the raison d’être for mutual funds) hold26.5% of all assets, high net worth individuals 18.6% and corporates 60.0%, withbanks and financial institutions holding the balance.

Characteristics of expansion

In the retail segment, rising disposable incomes, favourable demographics andinnovations in distribution have triggered the expansion of assets under management;while in the institutional segment, rising corporate earnings have emerged as the primegrowth enabler. More recently, in order to stall redemptions and exits, most of the largeasset managers are increasing their exit loads for income funds. Smaller fund houses,on the other hand, are reducing exit loads to attract investors to their short-termschemes.

Product positioning and distribution channels have moved centre stage over the pastfew years. In order to monitor the distribution of mutual funds and to discourage mis-selling, the Securities & Exchange Board of India (SEBI) is planning to monitor andassess the examination and certification process currently managed by the Associationof Mutual Funds of India.

Facing a competitive scenario, integration of technology is acting as a critical successfactor. Asset managers are also looking to add gold and gold-related instruments tohybrid funds, such as monthly income plans, to provide investors with the benefits ofdiversified asset allocation.

Historically, mergers and acquisitions in the mutual fund industry have been used as ameans of market entry, rather than of consolidation. However, with the liquidity crisisleading to the exit of some small players, the trend may change.

Section B: Views from Asia, Europe & the US


India – the cadenceof a growth marketIndia’s assets under management are growing rapidly, and the local industry’s regulations arematuring fast.

Robin RoyPricewaterhouseCoopers (India)+91 22 [email protected]

13 Source: Reserve Bank of India.

14 Source: Association of Mutual Funds in India;converted into USD with exchange rate as of31 March, 2010.

Growth of assets under management Portfolio composition of assets undermanagement, as of 31 March, 2010

Income 51% Equity 28% Balanced 3%Money Market 13% Gilt 1% ELSS 4%

Source: Association of Mutual Funds of India (AMFI) Source: AMFI

Mar 06

231,862

362,388

505,152

417,300

613,979

Mar 07 Mar 08 Mar 09 Mar 10

Regulatory flux

Pace of growth is being matched byregulatory change – financial laws andregulations are being revampedsubstantially. The ongoing row betweenSEBI (capital market regulator) and theInsurance Regulatory & DevelopmentAuthority (insurance regulator) forjurisdiction over unit-linked insuranceplans (ULIPs) linked to marketperformance has raised the need for anover-arching regulator to intervene insuch situations and to sustain thecountry’s otherwise robust regulatoryframework. The question is whetherULIPs are collective investment vehicles,with insurance top-ups? If so, both theregulators can claim to have regulatoryjurisdiction.

Compliance with quickly-changingregulatory norms is emerging as a hugechallenge, with concerns like sustenanceof retail participation, unfavourable equitymarkets, high cost of trade and lowinvestment by pension funds. Investoreducation and awareness are criticallyimportant, as India remains an under-penetrated market.

To give further encouragement toinvestors, SEBI has initiated the removalof entry load in various schemes, nudginginvestors to reach out directly to

manufacturers. Yet this has resulted indistributors migrating to selling insuranceproducts, causing anguish in the mutualfund industry.

And India is displaying some of thetrends of more developed, lower growthmarkets. As a consequence of activelymanaged portfolios’ often poorperformance in the crisis, index andexchange-traded funds are steadilygaining popularity, having the advantageof low costs.

Conclusion

The mutual fund industry is in the gripof rising costs and new regulationsimpacting distribution. The challenge isto explore evolving business models andcome up with solutions that will enableasset management companies toparticipate actively in economic growth.At the same time, the industry needs toinvest time and money in financial literacywhich, in turn, will enable acceptance ofproducts as mentioned above and control“mis-selling”. The industry may even lookat a self-regulatory body to help managethe expectations of all stake holders.

The question iswhether ULIPs arecollective investmentvehicles, withinsurance top-ups?If so, both theregulators can claimto have regulatoryjurisdiction.


The Lehman Brothers insolvency, the credit crisis’s implications on funding and theramifications of the Madoff affair have all shaken investor confidence in hedge funds’dealings with prime brokers.

Hedge fund managers’ choice of prime broker had historically been driven by profile,performance, service, product and pricing. This has now been supplemented by afocus on greater transparency, risk management and asset security.

Prime brokers are reacting by changing their business models. To address investorconcerns, they are also providing independent controls assurance reports (e.g. SAS70reports or equivalent), demonstrating the robustness of their controls environments.Indeed, these reports are increasingly becoming industry best practice.

There is evidence to suggest that counterparty relationships are being strengthened asa result, and new business secured, at least in part due to improved transparency.From a competitive perspective, those prime brokers not providing reports could beconsidered at a disadvantage.

Hedge fund managers and their investors are asking new questions of their primebrokers, including how safe are their assets when in the hands of third parties and how“crisis-proof” are prime brokers’ operations.

Shifting service propositions

Reacting to the market, prime brokers are adapting their business models, to prioritisestructure, transparency, risk management and asset security. Prime brokerage’s shiftingdynamics have triggered large shifts in market share. Indeed, prime broker marketshare has changed considerably. There are more competitors in the market than twoyears ago, and they are offering different service propositions.

The majority of the very largest prime brokers have assigned assurance reports, or arein the process of doing so. These reports typically focus on cash prime brokerageservices, although some prime brokers have looked to incorporate more syntheticproducts (e.g. swaps) into their scope. Reports are produced along establishedbusiness lines, which would usually separate international from US domestic primebrokerage.

Prime brokers are documenting their key services, processes and underlying controls.They are also demonstrating how their business models and control frameworks havebeen updated to withstand future crises. These reports are seen as a positive reactionto hedge fund managers’ and investors’ concerns. They are being discussed in thesales cycle with prospective clients.

Investor requests

As investors have become more sophisticated, assurance reports go some way toimproving disclosure and to enhancing understanding of the services prime brokersprovide, as well as how they are controlled. Investors regard the independentassessments in these reports as strengthening due diligence, and they are increasinglyrequesting them.

As regulators and legislators continue to look at lessons learnt from the credit crisis,the focus on security of client assets and the requirement for greater transparencylooks set to increase (note the recent FSA Consultation Paper 10/9, “Enhancing theclient assets sourcebook”). Provision of independent controls assurance reports toaddress these requirements will become standard.



Independent prime brokerreports to become standardPrime brokers are using independent assurance reports to provide transparency and to restoreconfidence in their controls environments.

Neil HewittPricewaterhouseCoopers (UK)+44 207 804 [email protected]

From the analysis of the Committee ofEuropean Securities Regulators (CESR)papers, it is clear that the Key InformationDocument (KID) will not be a “simplified”simplified Prospectus. The contentrequirements and size limitations (twopages) will present a tough challenge.They will impact all parties in the funddocumentation chain, from the holder ofthe balance sheets to the disperseddistributors. To complicate matters stillfurther, these parties will often be workingin different languages.

Practical implications

The first hurdle is that the KID will, in alllikelihood, have to be prepared at theshare-class level, meaning the number ofdocuments to be produced anddisseminated will increase significantly.Based on CESR recommendations, it willbe relatively difficult to combine severalshare classes from the same fund in asingle KID.

The ‘plain language’ requirement aims ateasy investor understanding,necessitating a potentially laboriousprocess to ensure technical content isadequately conveyed through simplewords, while at the same time avoidinginconsistencies with the fund prospectus(which would generate civil liability).Additionally, the requirements to calculatea “synthetic risk and reward indicator”(SRRI) and to aggregate an “ongoingcharges figure” raise technical issues andrequire that additional data streams aredeveloped, including an appropriatecontrol framework to ensure accuracy ofthe (unaudited) calculations.

Finally, the KID revision requirement, if notproperly managed, risks leading to morefrequent updates than just the annualperformance review, so creating anadditional source of pressure and costs.

All these issues, along with the highvolume of underlying work, demonstratethat integrated platforms to handle datasourcing, document creation anddissemination (including marketingfactsheets and other reporting

documents) may be the only way forwardin fund document management.

Strategic issues

From a strategic perspective, assetmanagers should consider that the KIDmay influence both their existing productranges and the wider fund distributionculture. For example, the performancepresentation will be highly visual: therequirement for five or ten years of pastdata could create a significant obstaclefor funds, particularly those with poortrack records. Furthermore, the SRRI willbe a critical risk measurement with thepotential to influence retail investors’attitudes (and distributors’), so we mightsee rising demand for risk-rated products.Therefore, promoters distributing a widearray of funds might be wise to reconsiderthe rationale for having several fundswithin the same risk category. And, sincethe KID should facilitate comparisonbetween products, we might expect anincreased need to monitor competition.This would allow both the product rangeand costs to be adapted to market levels.As the investor-facing distributor will beresponsible for making the KID availableto investors, its delivery will mainly be aproblem of finding real-time solutions tomanage its content.

A quick glance at European regulators’recent statements reveals the KID as afuture standard in pre-contractualcommunication for all packaged retailinvestment products (structured products,unit-linked insurance wrappers, etc.).Given that the KID has greaterimplications than are immediatelyapparent, it deserves the immediateattention of promoters and fundadministrators alike.

PricewaterhouseCoopers and theEuropean Fund and Asset ManagementAssociation are launching a surveyrevealing asset managers’ views aboutand levels of preparation for the KID on 7June, 2010.



Is UCITS IV’s Key InformationDocument a ticking time bomb?The Key Information Document has far greater implications than are immediately apparent, warrantingthe immediate attention of both fund promoters and administrators.

Thierry BlondeauPricewaterhouseCoopers (Luxembourg)+352 49 48 48 [email protected]

Sally CosgrovePricewaterhouseCoopers (UK)+44 207 804 [email protected]

Ken OwensPricewaterhouseCoopers (Ireland)+353 1 792 [email protected]

UCITS IV: Time for changeThe Asset Management Industry’s views on theKey Information Document

Asset Management

June 2010

For a sign that the hedge fund industry is facing greater regulatory oversight, you needlook no further than the fact that high-quality compliance officers are in demand andtheir remuneration packages rising. Soon new regulations will be introduced and manymanagers will have to be regulated from at least two jurisdictions. In the meantime,regulators have been beefing up their enforcement teams.

As we begin to emerge from the financial crisis, investors, regulators and tax authoritiesare all subjecting hedge fund managers to far more scrutiny. Many hedge fundsperformed well compared with equity markets during the crisis and have made uplosses; yet the market storm revealed unforeseen weaknesses in management ofinvestment liquidity, custody of assets and counterparty risk.

Investors and regulators are pushing managers to introduce greater controls. As forthe tax authorities, their newfound vigour stimulated by empty government coffers, iscreating a need for managers to hire more expertise to deal with more onerous taxrequirements.

For those managers that rise to these governance challenges, however, there is thepotential reward of new assets, which are on the rise. According to an April 2010survey,15 assets may grow 25% during 2010 to reach US$2 trillion by the year-end,slightly exceeding the pre-crisis peak of US$ 1.9 trillion.

Investors ask for greater comfort

More than a year after the breakdown in financial markets, hedge fund managersseeking to raise assets have heeded investor demands to improve the quality of theiroperating models, as well as often offering better liquidity and greater transparency.

Third-party assurance reports are playing a part, giving investors greater insight intocontrols throughout the value chain. In particular, many large prime brokers aresubjecting themselves to SAS 70-type audits, surveying their control objectives andactivities. Just two years ago, this was regarded as an expensive luxury – now it isa necessity.

In addition to the prime brokers, a number of hedge fund managers are providinggreater assurance to investors by commissioning SAS 70-type reports examining theirown control environments, and we expect more to follow.

In the United States and Europe, investors are seeking more transparency and liquidity.In the US, demand for managed accounts is rising. In Europe, smaller institutionalinvestors’ preference for regulated investments has led to a dramatic rise in the numberof UCITS hedge funds. According to the PricewaterhouseCoopers point of view FutureNewcits regulation?,16 hedge fund managers have now launched more than 200 UCITSfunds with hedge fund-like strategies.



Hedge fundscome under scrutinyAt a time when hedge fund assets are returning to growth, investors, regulators and tax authorities aremaking stronger governance the price of future success.

Damian NeylinPricewaterhouseCoopers (Ireland)+3531 792 [email protected]

15 Credit Suisse Annual Hedge Fund Investor Survey, April 2010.

16 Published in March 2010.

Asset Management

A second windThe regulation, taxation and distribution ofhedge funds around the globe

June 2010

Regulators insist on higherstandards

Across the world, regulators areintroducing more regulation andbecoming increasingly assertive.

Within Europe, the planned AlternativeInvestment Fund Managers Directive willhave a significant impact. Although notyet in a final form, it may lead tomanagers maintaining high levels ofregulatory capital, and adopting detailedinternal policies and procedures to dealwith, for example, liquidity management,conflict identification and compliance.

In the United States, the exemptionunder the 1940 Investment Act, whichallowed many hedge fund managers toavoid Securities & Exchange Commission(SEC) registration, is being removed.The changes will affect not only USmanagers, but also any managersbased outside the United States witheither material numbers of US clientsor material assets attributable toUS clients.

In Asia, too, hedge fund managers maysoon have to apply for formal licensingand fund registration in Singapore,one of the region’s most popular hedgefund centres.

Complying with regulations is becomingtougher everywhere. Both the SECand the Financial Services Authority havehired more enforcement staff andincreased enforcement activity. Althoughless publicised, regulators beyond thesemajor hedge fund centres are alsobuilding their resources.

Tax authorities seek revenue

Not to be left out, tax authorities areperforming more regular tax audits.They are questioning the validity of somestructures for holding cross-borderinvestments, increasing personal tax ratesand, perhaps most significantly, seekingto identify the identity of investors inoffshore funds.

As managers adjust to thesedevelopments, they may need to buildmore advanced tax functions, as well asan approach to tax that will be less opento question from the authorities.

Towards a new maturity

Improving controls requires considerableinvestment, as does introducing the newinvesting structures that investors areseeking.

Yet in all of this lies opportunity. Manyhedge funds acquitted themselves wellcompared with traditional financialmarkets in the crisis. If the sector reactsjudiciously to the changing externalenvironment, it will reach new levels ofsophistication and maturity, and reach outto a far wider investor base.

This article is based onPricewaterhouseCoopers’ 2010 hedge fund whitepaper entitled “A Second Wind”, published in June.



In the United States, the exemption underthe 1940 Investment Act, which allowedmany hedge fund managers to avoidSecurities & Exchange Commission (SEC)registration, is being removed.

AIFM update

There has been a lot of activityaround the Alternative InvestmentFund Managers Directive. The ECONCommittee of the European Parliamentand ECOFIN Committee of theEuropean Council have confirmed theirrespective drafts. ECOFIN endorseda draft which wound back from themore industry-friendly ‘SwedishCompromise’, and ECON endorseda draft reflecting a centre-leftParliamentary agenda, advocating anintrusive regulatory regime andembodying, to borrow a phrase fromanother commentator, both “FortressEurope” and “Prison Europe”. Theformer makes it hard for non-E.U.funds and managers to accessEurope and – the latter hard for E.U.professional investors to escapefrom Europe!

In terms of timing, trialogue discussionsstarted on 31 May, with an optimistictarget for a plenary vote in July, and apossibly more pragmatic likelihood ofadoption in September. There is a lot ofground to cover in the negotiations andsynthesising Council and Parliamentarydrafts will not be an easy task – insome key areas there is no obviouscompromise position between thepolar political differences in the texts.

What is clear is that many currentlyunregulated firms will be swept intothe new regime, custodians anddepositories will have their duties andresponsibilities widened and deepened(with knock-on consequences on coststo be borne by investors and savers),European small-and-medium-sizedenterprises will find their cost ofcapital raised, as private equityhouses accommodate and possiblyretreat from investing in Europeanenterprises to avoid onerous disclosureprovisions, and the ability of non-E.U.domiciled funds and managers toaccess European investors will beconstrained.

James GreigPricewaterhouseCoopers (UK)+44 20 7213 5766 [email protected]

As the number and variety of UCITShedge funds has grown, so haveconcerns that innovative strategiesmight lead to investor protection issues.In order to address these concerns, theCommittee of European SecuritiesRegulators (CESR) is seeking to improvethe rules regarding risk management forUCITS managers. Due to the level ofjudgement and assumptions required withany risk management tools, this area haslong caused heartache for regulators.Is it more art than science?

CESR’s recent consultation paper onguidelines for risk management, publishedin April 2010, certainly attempts to takea more scientific approach. Anomalieshave arisen where some UCITS using theabsolute Value at Risk (VaR) approachend up with leverage which is significantlyhigher than that authorised by thealternative commitment approach.CESR’s guidelines aim to harmonise riskmeasurement in Europe by introducing adefinition of global risk exposure and amethodology for its calculation using boththe commitment and VaR approach.

CESR’s guidelines apply to themeasurement of risk for UCITS fundsand, therefore, play a crucial role indetermining the level and complexity ofderivatives usage. Fund managers whohave recently launched “Newcits” funds

(UCITS hedge funds) will be relieved tohear that CESR’s new guidelines seekneither to hamper the use of derivativesnor to hinder managers’ ability to usealternative strategies. CESR’s proposalssuggest that the commitment approachshould not to be used where a fund eitheradopts complex strategies that representmore than a negligible part of the UCITS’investment policy or have more than anegligible exposure to exotic derivatives.This will often be the case for Newcits.

What is more, the proposed commitmentapproach may be so prescriptive mostmanagers will opt for the VaR approach,as the commitment approach maybecome too cumbersome or onerous toimplement and maintain in those lesscomplex strategies where it is permitted.This is not necessarily a negative, as itmay lead to greater consistency with howmanagers are actually measuring andmanaging market risk.

What is proposed?

The proposals are that VaR and thecommitment approach will still be usedbut will be standardised in order toharmonise practices across Europe.The proposed methodology for thecommitment approach is quite demandingand prescriptive. It is proposed that fundmanagers should calculate the leveragelevels for each individual derivative,identify netting and hedgingarrangements, and calculate their “netcommitment” (ongoing liability to themarket). It is likely that this will result inincreased costs and operationalrequirements for the UCITS manager.Managers may, consequently, abandon

the commitment approach and adoptVaR instead, which would appear to beless cumbersome and less expensiveto implement.

In terms of VaR, there is no guidance onthe calculation methodology. The UCITSmanager still has a choice between anumber of methods including the ‘deltanormal’, ‘historical VaR’ or ‘Monte CarloVaR’. The cause for concern with this liesin the potential mismatch between thenature of hedge fund returns versus riskprofiles, and the nature of the implieddistribution in the VaR calculation. Hedgefunds typically do not follow a normaldistribution and yet the delta normalmethodology assumes a standardisednormal distribution. The use of thismethod, therefore, may not beappropriate for hedge funds. Also, theavailability of choice in methodology islikely to lead to differing practice.

Innovation is always a step ahead of theregulators, who are constantly seeking toplay catch up. While CESR’s proposalsmay bring some level of standardisation(and “science”) with the use of VaR, thechallenge will be with the inputs andassumptions (the “art”) being used intheir implementation.



Future Newcits regulation?...CESR’s proposals for investorprotectionCESR’s new risk measurement proposals are likely to make risk management more scientific, but itsinputs and assumptions may still be an art form.

Olwyn AlexanderPricewaterhouseCoopers (Ireland)+353 1 792 [email protected]

Even though there are signs of economicrecovery, the financial services industrycontinues to be battered by criticism overpay practices by governments, regulatorsand the public. Although the criticisms arein many cases becoming more confined tobanking, these have some knock onimplications for other financial servicesbusinesses, including asset management.

One observation is that the pressure toincrease base salaries is already noticeable.Where banking organisations haverestructured their compensation offerings tomitigate the encouragement of excessiverisk taking, this has often involved arebalancing of both fixed and variable pay,and short- and long-term reward.

In parallel, the focus placed on base salaryby employees has increased as bonuspayments have been heavily scaled backand the certainty of regular income has, atleast to an extent, overtaken the higherrisk/return profile of leveraged incentiveplans. As a result, a perception appears tobe developing that to pay competitivelymeans to pay a market competitive basicpay, as well as providing a competitiveoverall compensation package. There is agood chance that as such a perceptiongrows it becomes a reality.

This is something of a departure fromfinancial services’ previous approach ofminimising fixed costs wherever possible,and maximising the alignment betweenvariable pay and personal, team andbusiness success. It also brings to the foreone of the biggest problems with marketbenchmarking.

Rising basic salariesIn one industry i.e. banking, base salariesare being increased to form a greaterproportion of the total compensationpackage – that is to say that incentiveopportunities are being scaled back andcash bonuses are being suppressed. Insalary terms alone (that is ignoring the factthat packages are being restructured), thisappears to be inflationary.

It is probable, if not inevitable, that atraditional pay benchmarking exercisecarried out at the end of 2010 will showsignificant inflation in basic pay levels for anumber of roles in asset management,

particularly where the overlap with bankingis strong.

High quality individuals working in bankinggroups have over recent years come toform a key component of the talent poolfor asset management businesses – be itfor fund managers, research, operations,compliance or support staff. There arealready many examples of pay rounds anddiscussions with potential new hires wheresalary levels are being negotiated up usingmarket pressures as rationale.

The counter argument is that manyorganisations have frozen salaries forsenior staff for a number of years and insome cases, where bonuses and otherincentive plans are not paying out athistoric levels, there may be individualswho are now genuinely underpaidcompared to their peers. The challenge lieswith balancing this requirement to correctover-suppressed salaries with the inflatedpressure to match basic pay levels in amarket which is inappropriate and not fullyunderstood through over-simplisticbenchmarking exercises.

Challenges for HR professionalsThis gives shareholders and HRprofessionals in asset management anumber of major challenges movingforward, most notably:

• How to preserve return to shareholdersin the face of rising fixed costs

• How to operate and manage annualbonus pools when other elements ofcompensation are becoming more costly

• How to redefine the overallcompensation offering taking intoaccount upwards pay pressure fromemployees and criticism fromshareholders, regulators and the publicover ‘excessive’ incentive outcomes

Looking forward, we can expect moreorganisations to move to a more holistictotal compensation approach to design,costing and funding in place of operatingseparate budgets for each componentof compensation. In the meantime, assetmanagement businesses must be mindfulof the reason for upward pressure onsalaries and should take decisionsresponsibly in the knowledge of whatthese might mean for shareholders.



From incentive to compensationA growing emphasis on base salaries appears likely to increase costs, creating a number ofchallenges for HR professionals.

Tim WrightPricewaterhouseCoopers (UK)+44 20 7212 [email protected]

In the past 18 months, private equity firms have started to address sustainability issuesas part of their strategies for realising target returns. Through our work, we are seeingmany private equity firms evolving from regarding sustainability as a compliance andminimal risk management issue into ‘managing for value’ (see diagram below). A fewleaders are also pushing on into realising ‘strategic advantage’.

They are factoring sustainability into due diligence at acquisition, into enhancing valueduring the investment period and into developing an attractive equity story at exit.

An illustration of the ‘journey of sustainability management’

From compliance and risk management, through managing for value,to strategic advantage

PricewaterhouseCoopers’ most recent annual CEO Survey17 illustrated just how riskmanagement topics such as sustainability are rising up the agenda throughoutbusiness. Aggregating the opinions of almost 1,200 business leaders, one of itsconclusions was that ‘more CEOs are planning ‘a major change’ to risk managementthan other elements of their strategy, organisation or operating model’. For privateequity firms, protecting value will require an understanding of whether and howsustainability-related risks are being effectively managed in their portfolio companies.

Sustainability and risk

Due diligence at acquisition increasingly covers sustainability issues, but until recentlyrarely extended beyond the traditional site-specific environmental, health and safetyissues. Over the past year, we have helped proactive private equity firms to review theirportfolios to understand their sustainability risks and, as importantly, opportunities. Inparticular, private equity firms are reviewing the risk in supply chains. Social andenvironmental malpractice in the supply chain can damage brands, so reducing sales.



Managing sustainability issuesfor valueSustainability issues have growing implications for value, both positive and negative. They should beconsidered throughout the investment lifecycle, from acquisition, through investment, to exit.

Phil CasePricewaterhouseCoopers (UK)+44 207 212 [email protected]

17 The CEO Survey report is available in full atpwc.co.uk/ceosurvey

Opportunity

Time

RiskComplianceand risk

management

Managingfor values

Strategicadvantage

Source: PwC

BusinessOpportunity This is wherethe leadersare heading

RiskManagement This is where manyorganisations start

Product/servicelife-cycle management

Cost efficienciesBrand differentiation

Product/serviceinnovationAttract best staffBrand enhancementBuild market share

Cost inefficiencies

Licence to operate

Brand protection

To ensure upfront risk managementcovers consideration of the impactsof sustainability mega-trends (such asclimate change, resource scarcity andpopulation growth), as well as localisedimpacts, firms are seeking to enhancecorporate policies and screeningpractices, and to develop a suite ofguidance materials and practical toolkitsfor deal teams. As with any otherinvestment issue, systematicallymanaging sustainability risks andopportunities throughout the investmentlifecycle is expected to improve thevalue and saleability of portfolio assetsover time.

For UK firms, a significant legalcompliance and reputational risk recentlycrystallised. In April 2010, the UKGovernment’s CRC Energy EfficiencyScheme18 came into effect. The schemetargets large energy users, effectivelytransferring money from those that areworst at reducing energy usage to thebest. The scheme treats private equityfunds as ‘parent’ organisations (withattendant ‘aggregation risk’ across allcompanies in a fund), so managers mayneed to demonstrate compliance forthose portfolio companies with UK assetswhere they have a controlling interest.

On many stock exchanges, articulatingmaterial environmental issues, employeematters and other principal risks anduncertainties is already a requirement for

listing. The Securities and ExchangeCommission recently enhanced itsrequirement that listed companies reporton relevant climate change risks.19

To achieve target exit values, privateequity firms will increasingly need todemonstrate that top management iswell versed in managing key sustainabilityissues and that good governancecontrols are in place.

Sustainability as a value creator

Sustainability issues can be creators ofvalue. Our CEO Survey found that‘reputational advantage is the leadingdriver of responses to climate-changeinitiatives’. Additionally, it highlightedthat ‘access to capital is expected tobecome more difficult’. Showing investorsthat their money is being investedresponsibly is likely to be an increasinglyimportant differentiator when fund raising.It is, therefore, no surprise that moreinvestors are signing up to the UN’sPrinciples for Responsible Investment forPrivate Equity.

According to the CEO Survey, climatechange is also presenting ‘significantnew product and service opportunities’.While the level of private equityinvestment in clean technology hasrecently slowed following rapid growth inthe preceding five years, private equityfirms are still exploring opportunitiesassociated with the wider sustainability

agenda. They are, for example, tappingincreasing demand for insulation productsor devices for saving resources (such asenergy and water).

Conclusion

Management of sustainability issuesis a new business frontier which rewardsthe proactive and those who embedaction throughout their investmentprocesses. In a fast-changing arena,private equity firms need to manage boththe opportunities and risks. We expectto see sustainability play a larger part inattracting investment and in definingcompany value going forward.


18 The CRC Energy Efficiency Scheme is amandatory cap and trade scheme for non-transport aggregated CO2 emissions from theenergy consumption of UK assets.

19 www.sec.gov/news/press/2010/2010-15.htm

While most traditional managers have long complied with the Global InvestmentPerformance Standards (GIPS®), managers of alternative investments, including hedgefunds, private equity funds and real estate funds have recently become increasinglyinterested in exploring compliance with the standards. For alternatives managers,the added credibility brought on by the claim of GIPS compliance can help to keep upwith best practice, reinforce investor trust and create new relationships with newprospective clients. Furthermore, adherence with GIPS can help to establish a moreconsistent set of procedures regarding calculation and reporting of performance.

Alternative managers face an additional hurdle in complying with GIPS given theunique characteristics and complexity of alternative products. Therefore, the GIPSstandard-setters are currently working on a dedicated GIPS guidance for alternativeinvestment strategies, which is due for public comment in 2010. Representatives ofPricewaterhouseCoopers play a leading role in this working group.

GIPS 2010 update

This guidance is part of GIPS’ second major update since they were introduced backin 1999. GIPS 2010 will become effective on 1 January, 2011, introducing changes thatwill pose additional challenges for asset managers.

The review follows several GIPS provisions that took effect on 1 January, 2010,including a new requirement that portfolios be valued on the date of all large externalcash flows and restrictions on the inclusion of carve-out returns in single asset classcomposite returns. These new provisions were already included in GIPS 2005 as futurerequirements; nevertheless, they could require that firms incur potentially greater costsor implement operational modifications.

Traditional asset managers have embraced GIPS for some time, and most are currentlycompliant. The GIPS changes which went into effect on 1 January, 2010, as well asthe proposed revisions included in GIPS 2010, represent incremental, yet significant,challenges to asset managers already coping with a wide variety of business andregulatory demands.

Benefits for alternatives

Many alternative investment managers would benefit from GIPS compliance and theadditional transparency, credibility and validation it would bring. In spite of the potentialbenefits, some of these firms are likely to struggle with some of the GIPS standards,given the unique characteristics of their business and its complexity. While the specificGIPS guidelines for real estate and private equity have existed for a long time and havebeen further enhanced within the current GIPS revision, the proposed dedicated GIPSguidance for alternative investment strategies is completely new.

Ultimately, providing some form of independent assurance of financial performancereporting is crucial to traditional and alternative asset managers alike. Nonetheless,meeting the GIPS criteria is only one path to obtaining such third-party assurance.Other paths include an independent audit of a manager’s investment performance,performed under the attestation standards of the American Institute of Certified PublicAccountants (AICPA) and International Standards on Assurance Engagements.



New GIPS guidancefor alternativesAt a time when independent attestation is growing in importance, the GIPS standard setters areworking on specific guidance for alternatives.

Barry BenjaminPricewaterhouseCoopers (US)+1 410 659 [email protected]

Steve PerazzoliPricewaterhouseCoopers (US)+1 617 530 4177 [email protected]

GIPS take two:The second generation ofglobal investmentperformance standards*

pwc

view

*connectedthinking

poi

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f

Highlights

• Some GIPS provisions effectiveearlier this year, includingchanges to valuation practicesand reporting of carve-outreturns, will make demands onthe operating structure at someasset managers, includingsmaller firms.

• GIPS 2010, the result of a reviewscheduled for every five yearsgoing forward, will take effect in2011 and will bring a number ofnew provisions especially in theareas of presentation anddisclosures, valuation, privateequity and real estate.

Summary: What will changes to GIPS mean for asset managers?

The Global Investment Performance Standards (GIPS®), which enable assetmanagers to voluntarily provide standardized and transparent measures oftheir performance, have been in effect in nearly 30 countries since 2005. The predecessor to GIPS standards, the AIMR Performance PresentationStandards, had been in effect in the US until completely superseded by GIPSon January 1, 2006 (effective date of GIPS 2005). The use of these standardsbenefits investors who can better compare performance and can be confidentin the reliability of the data provided by compliant asset managers. Assetmanagers also benefit, since the use of these standards enables them tobetter compete internationally and attract assets from institutional investors.Compliance with GIPS also can serve as an important independent source ofvalidation for a manager’s performance.

Several GIPS provisions took effect on January 1, 2010, including a newrequirement that portfolios be valued on the date of all large external cashflows and restrictions on the inclusion of carve-out returns in single assetclass composite returns. These new provisions were already included in GIPS2005 as future requirements; nevertheless, they could require that firms incurpotentially greater costs or implement operational modifications.

April 2010

http://www.pwc.com/us/en/asset-management/investment-management/publications/gips-point-of-view.jhtml

Global Asset Management contactsAsset Management News is produced by experts in their particular field to address important issuesaffecting the asset management industry. If you would like to discuss any aspect of this document,please speak to your usual contact at PricewaterhouseCoopers or a member of our global or territoryleadership team.


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Editor: Rupert Bruce

Global Asset Management Leadership Team

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Brendan McMahonPricewaterhouseCoopers (Channel Islands)Global Asset ManagementPrivate Equity Leader+44 1534 [email protected]

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Pars PurewalPricewaterhouseCoopers (UK)UK Asset Management Leader+44 20 7212 [email protected]

Robert GromePricewaterhouseCoopers (Hong Kong)Asia Pacific Asset Management Leader+852 2289 1133 [email protected]

Tony ArtabanePricewaterhouseCoopers (US)Global Asset ManagementHedge Funds Leader+1 646 471 [email protected]

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