More often than not, managers will choose to manage that uncertainty by holding large cash reserves. However insurance is increasingly being viewed by investors as a more cost effective and secure way of handling the position.
The issue
In recent years, tax authorities in various jurisdictions have become more focused on the activities of non-resident funds, and most European tax authorities can at any point still decide to pursue outstanding tax exposures. For example, the Greek tax authorities have taken the unusual step of saying that it will require non-resident corporations and individuals to pay capital gains tax, payable on gains made on trading corporate and government bonds in 2012 and 2013.
The necessary preparation for an event in which tax authorities get their houses in order is key, and the approach of setting aside large cash reserves is increasingly being viewed as unsatisfactory due to the negative impact it very often has on fund performance. This is particularly true in circumstances where the size of a fund is decreasing and the relative size of the tax exposure is therefore increasing.
Moreover, in times of distress managers cannot allow the full redemption of cash to the end investor, often drawing out the liquidation process over the course of many months and years.
Finally, it is often very difficult to predict whether the tax authorities will impose penalties or fines on the fund for having made an error in its chosen tax treatment. If fines or penalties are imposed, the amounts can be large, which creates the added difficulty of deciding how much to reserve. In reality the directors tend to err on the side of caution which exacerbates the situation for investors.
Regulatory State of play
The expiration of the statute of limitations (the time in which tax authorities are permitted to issue enforcement notices against entities or individuals) is seen by some as the ‘promised land’, but our experience tells us that this should be treated with caution. In many jurisdictions there remains uncertainty around the operation of a statute of limitations, which can make managers vulnerable to potential tax exposures even after four years – at the end of the year when tax is due on the last trade (which is the typical limitation period). Limitation periods can also be extended where there is evidence of negligence or fraudulent intent, both of which are not uncommon allegations to be made in the event of a tax audit.
Some jurisdictions have given guidance on their stance with regard to pursuing outstanding tax liabilities. For example, Australia made their position clear in December 2010 when plans were outlined for a FIN 48 exemption applicable to previous income years. For most, however, the position remains unclear, creating further uncertainty amongst investors. Greece is the latest jurisdiction to nail its colours to the mast, and it will be interesting to see how managers and directors choose to deal with their exposures over the coming months.
That time of year
The issue of reserving for potential tax liabilities is particularly relevant at this time of year, as April is the month which sees many funds file their end of year accounts. The continued inclusion of a provision for tax liabilities is often a stark reminder of the need for funds to reassess the way they choose to deal with their long term tax exposures.
There is an approach for those managers who prefer to focus on generating returns for their investors and fund directors keen for certainty in the long term. This is an insurance policy that provides cover for taxes due together with fines/penalties imposed and the legal costs incurred in dealing with an investigation. It can combat the inconsistency of approach from the tax authorities and the uncertainty around the implementation of the statute of limitations.
With sensible, targeted analysis of your situation, an insurance policy can make commercial sense and give absolute certainty to Fund Managers preparing for any possible tax eventuality.
David Heathfield is partner and general counsel at Baronsmead Partners
