Navigating Transfer Pricing in the World of Alternative Investments—Part 1

Over the past two decades, investor interest in alternative investments—that is, investment classes other than conventional equities, fixed income, or cash—has blossomed, with global assets under management topping $11 trillion in 2020. This growth has been driven by an exponential increase in investable funds worldwide, as well as a desire for portfolio diversification as investors chase yields in a generally low interest rate environment. Whereas alternative investments were once the purview of a select class of sophisticated investors, the rapid growth of investment funds has opened the world of alternatives to a larger and more varied group of investors.

The spectrum of alternative investment classes is broad—it includes hedge funds, private equity, real estate, infrastructure, venture, and credit funds, as well as various hybrids of these categories. As these asset sectors have moved into the mainstream of investor strategies, the firms who run them have expanded their global footprints and attracted increased attention from tax authorities worldwide. Creating, marketing, and running alternative investment funds can lead to healthy profits as well as complicated transfer pricing and related tax issues. With the growing attention from tax authorities, taxpayers in the alternative investments sector increasingly view transfer pricing practitioners as key members of their tax teams—to assist not only with compliance, but to advise on planning and transaction structuring matters.

Historically, transfer pricing in the context of alternative investments was largely limited to the analysis and pricing of transactions between the fund management company (ManCo), which has the mandate to manage and provide investment advice to the funds, and its subsidiaries/affiliates overseas that provide services to the ManCo such as research, investment sub-advisory, or capital raising. While intercompany arrangements related to management companies continue to be a key concern, one cannot ignore the importance of transfer pricing issues at the fund level, where related-party transactions may arise as a result of acquiring a portfolio company, making a real estate investment, or structuring an investment by limited partners.

ManCo Transfer Pricing

Over the past decade, asset management firms have become more global with respect to the locations of their people and the assets that they manage. It is not uncommon even for smaller asset managers to have at least one or more offices overseas—perhaps to provide input to the management company on investment opportunities, or to assist with raising capital from local investors.

Often, the intercompany transactions between the management company and its affiliates are priced using a cost-plus model, whereby the overseas entity is compensated with its costs plus a profit markup. While this relatively simple and straightforward approach may be appropriate in some circumstances, it has come under increasing stress as firms have built up the skills, capabilities, and responsibilities of their overseas operations.

In addition, a straightforward cost-plus approach faces added scrutiny from tax authorities who are taking a more sophisticated view in examining what functions, risks, and management control are undertaken locally. For example, in 2017 the Organization for Economic Cooperation and Development (OECD) revised its transfer pricing guidelines (OECD Guidelines) to ensure transfer pricing outcomes are better aligned with value creation. This included guidance on not inappropriately allocating profit to a jurisdiction simply based on contractual assumption of risks or mere legal ownership of intangible property.

Value & Substance
Some firms have in recent years moved to evaluate whether their overseas entities are driving value through one or both of the following:

1. Exercising key investment management decision functions, such as (but not exclusively) through investment committee functions of setting investment strategy and approving investment/disinvestment decisions.
2. Performing activities that maximize the value of investments over the investment holding period and/or enhance cash flows/returns from the investments.

If the affiliates are performing such functions, compensating them with a share of management fees through either some percentage of assets under management (AUM) or a share of profits, rather than costs plus a fixed markup, may be appropriate under certain circumstances.

At the same time, driven in part by the OECD’s Base Erosion and Profit Shifting (BEPS) project and its focus on people functions and effective control of risks, tax authorities are taking a deeper look at roles and responsibilities in understanding who is making the key decisions and contributing materially to profit generation. For example, is the investment committee more focused on general strategy, or is it making specific decisions with respect to each investment and disposition? Is the head of a key team, such as capital raising, located in a certain entity and what is the significance of that, if any? Does the entity otherwise house highly compensated individuals?

In the U.K., the diverted profits tax regime is being applied with the presumption that the U.K. entity should receive more than a cost-plus if critical decisions are made in the U.K.—which may be the case if a senior officer or head of a team is resident in the U.K. entity (see INTM489500 - International Manual - HMRC internal manual - GOV.UK (www.gov.uk)). Other tax authorities such as in Australia (see Diverted profits tax | Australian Taxation Office (ato.gov.au)) are increasingly making similar types of arguments in their respective jurisdictions.

Transfer pricing analysis for an asset management business is further complicated by the fact that senior individuals often play multiple roles. For example, investment committee members or portfolio managers are often deeply involved in capital raising, as sophisticated investors focus on investment strategy and results rather than a sales-based approach. The fluidity of key functions in this industry has recently been accentuated by the work-from-home trend arising from the Covid-19 pandemic, and a wider move to more location-flexible working arrangements.

Further, emerging trends such as use of fintech and introduction of environmental, social, and governance (ESG) investing strategies can add additional complexity to the transfer pricing analysis. There is a need to assess where these trends fall in an asset manager’s value chain, e.g., should they be considered routine or are they key contributors to profitability and/or cost, or risk reduction? The answers to these questions will vary from firm to firm, and over time.

Beyond the Management Fee
Finally, there is what is sometimes called the third rail of transfer pricing for alternative investments—how should carried interest be treated or incorporated into the transfer pricing policies? Typically, carried interest is not allocated or transfer priced. (There are some exceptions that are outside the scope of this article.) One rationale for not doing so is that carried interest is not services income but rather an enhanced return on investment.

Another, potentially more compelling argument is that carried interest is earned by the general partner for inception and implementation of the fund structure—and it retains the discretionary investment mandate from the fund and its limited partners. The general partner delegates responsibility for administering the fund and providing investment advice to the management company, for which the management company earns an arm’s-length investment management fee from the fund. Its compensation typically does not include any carried interest. Subsequently, when the management company compensates its affiliates out of the total management fee for investment sub-advisory or other services, carried interest would not play a role. However, not all tax authorities share the view that carried interest should escape the transfer pricing net, either directly or as an indicator of the value of local functions.

Because of these and other complexities, and closer scrutiny from tax authorities, asset management firms must take a more comprehensive and pro-active approach to establishing and defending their transfer pricing policies. For example, a value chain analysis, which can be thought of as a “supercharged functional analysis,” provides an in-depth evaluation of key value drivers for the business as well as the relative contributions to those drivers by each entity-based on how its functions, risks, and assets interact with those of related entities. Such an analysis goes the extra step of assessing how a particular activity, department, and ultimately an entity fit into the global group’s generation of revenues and profits. This sort of holistic view of a multinational business provides more defensible support for the transfer pricing policy, whether that policy is brand new or a needed adjustment to a legacy policy, which may have become outdated as the business has evolved.

As complex as these issues can be at the management company level, some thorny and unique transfer pricing challenges are also observed at the fund level, as will be discussed in Part 2 of this article.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Vinay Kapoor is a principal in the Economic Valuation Services practice of KPMG LLP, Sherif Assef is a principal in the Washington National Tax practice of KPMG LLP, Brett Fieldston is a principal in the International Tax practice of KPMG LLP, and Anthony Brown is a transfer pricing partner at KPMG Canada.

The information in this article is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.

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