• Riccardo Giannone, Expert |

Overview of the Transfer Pricing considerations in Asset Management

For many years, the Organization for Economic Cooperation and Development (“OECD”) has introduced guidelines aiming at aligning companies’ value creation with the taxation of their profits. These principles also apply to the Asset Management industry.

Transfer Pricing (“TP”) complexity materializes when the Management Company (“ManCo”) delegates part or the totality of its asset management activities to other entities or branches within the same group. Such contracted out activities can either consist of value adding functions such as investment advisory/sub-advisory, investment management, and distribution services, or routine functions such as mid-office or back-office support services.

The key challenge is determining how the income earned from the fund (i.e. management fee/performance fee) should be split across the different group entities/branches based on their value contribution. A set of questions can help the Asset Manager with defining the most appropriate Transfer Pricing policy:

  • Which functions contribute to value creation within the asset management group?
  • Which are the functions delegated to related party companies and which are the functions performed by the ManCo?
  • Which are the key contributing entities?
  • How is the ManCo remunerated? Is this remuneration aligned with its functional profile?
  • How are the related parties remunerated for the activities delegated by the ManCo?
  • What is the most appropriate TP method (e.g. CUP, cost plus or profit split)?

Tax authorities worldwide have recently started to enhance their TP knowhow in the Asset Management area, an industry which has historically not been intensively audited for Transfer Pricing purposes. The result is a widespread effort to clamp down on Asset Management structures designed to shift taxable profits to offshore locations.

Overview of court decisions in Switzerland

The trend observed in Switzerland is very much aligned with the global effort to increasingly audit Asset Managers for TP purposes. This is supported by two recent court cases where the transfer pricing set up of Asset managers was challenged.

Geneva court case (Federal court, December 20, 2019, case n° 2C_1073/2018, 2C_1089/2018)

Facts and circumstances

  • In 1999, “A.”, a Swiss Asset Management company incorporated in Geneva established a subsidiary in Guernsey: “C Ltd”. C Ltd acted as the fund investment manager for different funds and had no employees until 2005 (4 employees since 2008)
  • The investment advisory activities were outsourced by C Ltd to third parties and as of 2001, to A. in Switzerland as well.
  • In addition to the investment advisory services, A. was also in charge of order placement services as well as marketing and distribution activities (i.e. C Ltd benefited from the customers’ network of A)
  • For the activities carried out and risks borne, C Ltd paid A. a 0.75% Management fee.
  • For the activities carried out and risks borne, C Ltd paid the third-party investment advisor the same 0.75% Management fee, plus a Performance fee (40 to 70% of the total)
  • C Ltd retained the residual profit once both A. and C Ltd had been remunerated

Geneva Tax authorities’ position

  • In 2010 a procedure had been opened by the Geneva Tax Authorities (“GTA”) against A. for tax evasion. The GTA argued that the remuneration received by A. was insufficient considering the functions performed by A., respectively the functions carried out by C Ltd. and by the third-party Investment advisors

Federal Supreme Court’s decision
After several appeals and decisions pronounced by various Swiss courts, in December 2019 the Federal Supreme Court confirmed the position of the GTA. Specifically, the Federal Supreme Court stated that:

  • The lack of remuneration in the form of performance fees did lead to an insufficient remuneration of the investment advisory services performed by the Swiss company. A performance fee should have been paid by C Ltd to the third-party advisors as well as to A
  • In addition, C Ltd should have compensated A. for the order placement services performed and for the marketing and distribution activities

Zurich court case (Administrative court of Zurich “Verwaltungsgericht”), February 7, 2020

Facts and allocation of functions

  • A private equity fund located in Jersey was being managed by Jersey Ltd (“Investment manager”), with some functions delegated to a related party, Swiss AG, located in Switzerland (“Investment advisor”)
  • Swiss AG was involved in investment advisory services (i.e. identification of investment targets, evaluation of these targets, risk management services and supervision of the performance of the investments). The investment manager allegedly reviewed the suggestions made by the Swiss Investment advisor, approved the investment decisions, and borne full investment risk
  • The investment manager retained 1/3 of the management fee, remunerating the Investment advisor with the remaining portion 

Zurich tax authorities’ position

  • Zurich tax authorities (“ZTA”) focused on the lack of substance of the company located in Jersey. Specifically, it was argued that almost no wages/salary expenses were recorded by Jersey Ltd (only CHF 15,000 paid to two external directors, compared to almost CHF 4m earned by the two Swiss employees of Swiss AG). It was therefore deemed unlikely that such two directors could have taken any final decisions on private equity investments
  • It was also argued that Jersey Ltd was not bearing 100% of the risk. In the event that a deal did not happen, Swiss AG had to bear the sunk costs associated with the preliminary preceding research activities

Zurich Court’s decisions
The first of the Zurich courts (“Steuerrekursgericht”) embraced the decision of the ZTA confirming that:

  • Under the model, risk (market risk) was outsourced to an entity that did not perform the corresponding people functions (i.e. DEMPE/KERTs functions) associated with such risk. This is clearly not supported by the OECD transfer pricing principles
  • None of the other relevant functions involved in a typical private equity deal (due diligence, negotiation with owners and managers of potential investments or sales and distribution) could have possibly been carried out by anyone else other than the two Swiss asset managers of Swiss AG
  • None of the investment recommendations made by Swiss AG had ever been challenged or turned down by the alleged ultimate decision-maker Jersey Ltd. Recommendations were directly approved by Swiss AG and then only formalized by Jersey Ltd
  • Based on the functional analysis, the investment manager Jersey Ltd should be regarded as a routine entity entitled to a cost-plus remuneration only, while all residual remuneration should be retained by Swiss AG

The claimant appealed against the decision of the Steuerrekursgericht to the Verwaltungsgericht in second instance, which eventually turned down the appeal and upheld the argumentation of the ZTA.

Takeaways and recommendations

The abovementioned court cases demonstrate that:

  • Offshore structures characterized by low level of substance are increasingly being scrutinized by the Swiss Tax Authorities, leading to increased risk of corporate income tax adjustments, late payment interests, penalties and withholding tax
  • The Swiss Tax Authorities rely on a pragmatic and substance-based methodology when dealing with similar issues
  • It is paramount that the remuneration of entities in offshore jurisdictions be consistent with the substance of the arrangements

What should you do?

In order to minimize the risk of getting audited for TP purposes, and reduce potential adjustments and penalties in the case of one, it is recommended that Swiss-based Asset Managers focus their attention on the following key topics, currently under the lens of the Swiss tax authorities:

  • Presence/substance in low tax jurisdictions/tax heavens and profit allocation
  • Outsourcing of decision-making responsibilities to related parties that do not possess the relevant capabilities/resources
  • Intra-group prices deviating from third party internal comparables

Our services and further information

Stay up to date with what matters to you

Gain access to personalized content based on your interests by signing up today