Investment Managers Face a Growing Myriad of Foreign and State Tax Issues

In the good old days, an investment manager was content to signing managed account agreements with clients located only within the borders of its state of registration. During the last decade and perhaps even beyond, investment managers have faced the challenges of a global economy and a dwindling U.S. client base as a result of increased competition and catastrophic market collapses. Evolution waits for no one including investment managers. Those investment managers that have chosen to restrict themselves to the states in which their offices are located face the brutal reality of inevitable extinction.The survivors will by necessity offer their investment advisory skills to clients located throughout the United States and beyond. The concept seems simple enough, but there are a number of obscure tax rules, both old and new that can diminish the rewards for even the best investment managers. Let’s take a look at a very simple hypothetical fact pattern that illustrates a number of tax issues confronting those investment managers who are the survivors.

Kick Investment Advisers, LLC (Kick) is an investment manager located in New York City.It has aggressively courted new clients in virtually every state in the country. Kick now claims to have clients located within 40 states.It recently expanded its operations by opening an office in London where personnel will market the investment advisory services to potential clients throughout Europe.Kick formed a separate entity, Kick UK Ltd (Kick UK), a United Kingdom corporation to operate the London office. It has entered into a cost plus 5% contract with Kick UK in consideration of the marketing and related services provided by Kick UK. Kick personnel occasionally accompany Kick UK personnel on visits to clients and prospective clients in Europe.In addition, Kick personnel occasionally visit clients and prospective clients in approximately 20 states. As a limited liability company with more than one member, Kick is treated as a partnership for income tax purposes.

Business is great and Kick has survived.However, Kick has recently received a tax inquiry from France and several tax inquiries from various states.The CFO for Kick calls his favorite tax partner at Marcum, LLP and asks a number of questions that should have been asked several months earlier:

1. Does Kick or its partners have any exposure to state income taxes outside of New York?
2. Is the cost plus 5% contract satisfactory remuneration to Kick UK for tax purposes or could Her Majesty’s Revenue and Customs assess additional income tax?
3. Does Kick UK have exposure to foreign income taxes in other European countries?
4. Does Kick have exposure to income tax in the United Kingdom?
5. Does Kick have exposure to income tax in other European countries?
6. If the Kick management company financial statements are audited in accordance with U.S. GAAP, does Kick have to worry about FIN 48 (Codification Section 740-10-25)?

The Marcum tax partner responds by indicating that the questions are good ones even though they were received a little late. He suggests that the CFO meet with him tomorrow morning to discuss the possible outcomes. The CFO arrives for his meeting with the Marcum tax partner. He is seated in the executive conference room and offered a continental breakfast.

Does Kick or its partners have any exposure to state income taxation outside of New York?

The tax partner begins the conversation by addressing the very first question: does Kick or its partners have any exposure to state income taxation outside of New York? He informs the CFO that states are desperate for revenue and he explains that a substantial number of states have adopted a new revenue enhancing approach to the taxation of businesses located outside their borders.Instead of limiting income taxation to only those businesses with sales, offices, property and/or payroll within their borders, many states (approximately 39 at last count), have adopted an economic nexus standard for taxing non-resident businesses. Under the economic nexus standard, the mere provision of services to a resident of a state will subject the service provider to income taxation regardless of the location of the service provider.

Thus, Kick and its partners will generally be subject to income tax in those states that have adopted the economic nexus standard even if Kick does nothing more than provide investment advisory services to the clients located within those states.The income tax will generally be determined by a fractions allocation formula that may either be more onerously based upon service income received from clients within the state to total service income firm wide or a more gently based fractions allocation formula that also takes into account the proportion of property and payroll within the state to total property and payroll firm wide in addition to service income. However, the tax partner also notes that many states adopting the economic nexus standard are also revising their allocation formula to the more onerous one factor formula of service income received from clients within the state to service income firm wide.

The CFO is clearly unhappy with this message, but the tax partner offers some consoling advice.The income taxes paid by the partners in the other states will be eligible for a credit on the partner’s resident state income tax return. If the partner resides in New York, things won’t be so bad after all since the New York income tax rate is among the nation’s highest state income tax rates.On the other hand, the results could be devastating to a partner located in a state like Florida since Florida imposes no income tax. The tax partner closes out the first question with three more important observations:the state income tax imposed by the non-resident state may be mitigated by utilizing the cost of performance in determining the amount of service income allocable to a particular state; and to utilize the credit for income taxes paid to another state, the partners of the investment adviser must generally file income tax returns in the non-resident state within a prescribed period of time.Finally, some states also impose significant entity level taxes on partnerships (most notably, Illinois, New Hampshire, Washington and prior to 2012, Michigan).

The tax partner informs the CFO that a hedge fund structure, unlike a managed account, can insulate the investment adviser from most of the out of state tax issues since the hedge fund is generally located within the same state as the investment manager.The hedge fund, generally a limited partnership, is responsible for the payment of all the investment advisory fees (both management fees and the carried interest which is treated for tax purposes as a profits allocation). Therefore, there are no clients located outside of the investment adviser’s state even though the limited partners may reside in many different states. In many instances, this benefit of the hedge fund structure is often overlooked.

Is the cost plus 5% contract satisfactory remuneration to Kick UK for tax purposes or could Her Majesty’s Revenue and Customs assess additional income tax?

The tax partner explains that the cost plus methodology has been employed by many investment managers utilizing entities organized abroad.However, he cautions the CFO that the cost plus arrangement should be analyzed by an expert to determine if the arrangement fairly apportions the income and expense between Kick and Kick UK.Assuming the expert’s report concludes the remuneration paid to Kick UK is fair (it is neither excessive or inadequate), the CFO can be relatively comfortable that neither the United States nor the United Kingdom will challenge the arrangement in an effort to collect additional tax revenue. If on the other hand, the arrangement is woefully inadequate in either direction, the CFO can expect a challenge by the country that is harmed.

Does Kick UK have exposure to foreign income taxes in other European countries?

The CFO is instinctively concerned about the trips by Kick UK to visit clients and prospective clients throughout Europe.He is concerned that the visits could create a taxable nexus within the countries being visited.The tax partner explains that just like the United States, the United Kingdom enters into many tax treaties with other foreign countries and just like the U.S. tax treaties, the UK tax treaties generally include a permanent establishment clause that limits the imposition of income tax to those UK taxpayers that maintain an office or other habitual presence within the foreign country. Fortunately, the occasional visit does not generally constitute a habitual presence, but the tax partner advises the CFO to keep very accurate records to demonstrate visits to foreign countries by UK personnel are in fact, just occasional.

Does Kick have exposure to income tax in the United Kingdom?

The Marcum tax partner immediately understands the reason for the CFO’s question. The CFO knows that the investment management team is located within the New York City office and the members of the investment management team will likely join the Kick UK personnel in visits to clients and prospective clients located in the UK.The tax partner informs the CFO that the same type of permanent establishment clause referred to above provides similar protection to Kick under the U.S. Tax Treaty with the United Kingdom. However, in this case the tax partner carefully warns the CFO that because the office of Kick UK is located in London, the visits by the Kick investment management team to the UK office may simply become too frequent to be less than habitual.

Does Kick have exposure to income tax in other European countries?

Again Kick is saved by the permanent establishment clause.But this time, it is the permanent establishment clause contained in the U.S. tax treaty with each of the foreign countries and not the UK tax treaty that provides the necessary relief from the imposition of income tax on Kick.

If the Kick financial statements are audited in accordance with U.S. GAAP, does Kick have to worry about FIN 48?

The tax partner has been down this road many times before.He explains to the CFO that any uncertainty with respect to the possible imposition of a state income tax at the management company (partnership) level is subject to a FIN 48 Analysis.Thus, he warns the CFO that investment advisory services income from clients located in Illinois, New Hampshire and Washington will likely trigger an income tax liability at the partnership level that cannot be explained away even partially through a more likely than not conclusion that Kick will receive the benefit of not having to pay an income tax in these states. However, it is possible that the amount of income tax could be immaterial to the financial statements.In the absence of immateriality, the audited financial statements must disclose an additional income tax liability for state income taxes.

Next, the tax partner tackles the cost plus 5% contract. In this case, he informs the CFO that the uncertainty of the income tax position will be determined by the expert’s report. If the expert concludes that the contract will be respected by the taxing authorities, it is reasonably certain that Kick and Kick UK will receive the benefit of not paying any additional income tax with respect to the cost plus contract and there will be no uncertain tax position. If the expert’s report expresses some doubt that the contract will be respected by Her Majesty’s Revenue and Customs, a FIN 48 analysis of the Kick UK income tax liability will be necessary. Ordinarily, any additional income tax assessed by the United Kingdom as a result of an increase in the profit deemed paid by Kick UK would potentially be offset in a consolidated financial statement by a refund of U.S. income tax attributable to the additional expense deemed paid by Kick.However, Kick is a partnership and there would be no income tax assessed at the entity level.Thus, any doubt expressed in the expert’s report regarding the adequacy of the profit percentage will likely result in the disclosure of an additional UK income tax liability in the audited financial statements

Finally, the tax partner addresses the exposure of both Kick UK and Kick to foreign income taxes. He warns the CFO that the word habitual may be subject to different interpretations.Accordingly, he advises the CFO that anything more than occasional visits to either the UK or other foreign countries by Kick personnel and more than occasional visits to other foreign countries by Kick UK personnel will necessitate a FIN 48 analysis that could result in the disclosure of an additional income tax liability in the audited financial statements.

Final Thoughts

Today’s investment managers compete in a global economy searching for investors in the four corners of the Earth.They have survived through the worst of economic times by exercising initiative and ingenuity. They are survivors and they are a financial resource.The taxing authorities, both foreign and domestic, are looking for them every day hoping to share in their success by imposing taxes in new and more aggressive ways. In planning for expansion, investment managers must exercise that same initiative and ingenuity to avoid paying more than their fair share of taxes.They must recognize the myriad of tax issues that come with expansion and they must obtain the right professional advice to accomplish their tax objectives.