Transfer Pricing: Insights for the Alternative Investment Industry

In its recent strategic operating plan update, the Internal Revenue Service (“IRS”) delineated its future priorities, notably an enhanced audit focus targeting high-net-worth individuals, multinational corporations, and partnerships. The alternative investment industry should be particularly vigilant as the IRS plans to significantly augment its audit rates by as much as ten times on large-scale, complex partnerships possessing assets in excess of $10 million. The announcement, made on May 2, 2024, by the IRS, was discussed in a previous Marcum article.

This development comes against the backdrop of the anticipated increase in IRS revenue generation as a result of the funding provisions within the Inflation Reduction Act (“IRA”). Given historical precedent, the rise in IRS partnership audits will likely lead to an increase in transfer pricing audits. Accordingly, investment vehicles structured as partnerships with related-party transactions should review their arrangements with the aim of minimizing their overall tax burden while remaining compliant with local and international tax laws.

What is Transfer Pricing, and what are the Risks for the Alternative Investment Industry?

Transfer pricing considerations in the alternative investment industry involve the pricing of transactions between related entities (such as an asset manager and its sub-advisory subsidiary or between funds and management entities). These transactions can be relevant for various reasons, including tax considerations, regulatory compliance, and financial reporting. Intercompany or related party transactions have long been an area of interest and focus for both the IRS and global tax authorities. They are regarded as low-hanging fruit for audit purposes.

Events such as COVID-19, which have spurred the reallocation and development of skills, capabilities, and responsibilities within the group of related entities across various jurisdictions, continue to shape the changing structure of functions performed, assets employed, and risks assumed by asset firms.

With the expansion of fund management and operations globally, there has been an increase in cross-border intercompany transactions between asset managers and related parties, creating more audit opportunities. In an environment of increased audits in the US and globally, non-compliance becomes a much more expensive proposition. It should be noted that where there are significant cross-border intercompany transactions, a tax authority on either side of the transaction seeks to ensure that its jurisdiction allocates taxable income and related expenses in line with its value contribution to the arrangement.

What are the risks of non-compliance? The risks include audits in up to two jurisdictions, adjustments to the transaction amounts, if not considered arms-length, interest, and penalties. In the US, penalties are 20% or 40% of the tax adjustment, depending on the level of misstatement. In the UK, the penalty goes up to 100% of the tax adjustment. Most jurisdictions around the world have transfer pricing rules and related penalties for non-compliance. In the US, the IRS provides the taxpayer 30 days from receipt of the information request to provide a transfer pricing documentation report.

Transfer pricing audits will be on the rise for the foreseeable future, and it is imperative to address the requirements for treating intercompany transactions as soon as possible. Treating and recording intercompany transactions should include a full understanding of the transfer pricing rules and requirements to ensure compliance and mitigate tax risks.

What Are Some Relevant Intercompany Arrangements?

In a typical private equity fund structure (“PE”), the management company (“ManCo”), a related party to the PE, manages the fund’s investments and receives a management fee based on a percentage of assets under management (“AUM”) subject to an agreement. The General Partner of the PE, who is generally related to the ManCo, receives a performance fee or carried interest based on the performance of the PE investments, which is also subject to an agreement. The allocation of income earned from the fund is an area for robust transfer pricing analysis. The management fee and performance fee or carried interest (the “fees”) should be allocated across the intra-group entities operating across different jurisdictions based on the relative value contribution of each entity generating the fees. The analysis frameworks for intercompany arrangements are provided in the US transfer pricing regulations, Section 482, and the OECD Guidelines, which agree on the arm’s-length standard as the conceptual framework for determining pricing in line with the value contribution of the related party entities.

Sub-Advisory Fees

In the administration of the fund, ManCo may outsource some of its more routine activities, such as research and analysis, portfolio development, and compliance and reporting, to a related party entity established in a jurisdiction with a high level of human capital and low labor costs, such as Puerto Rico (“PR”). The intercompany arrangement for services from PR triggers transfer pricing compliance rules and considerations in both the US and PR. It should be noted that transfer pricing directly impacts the financial statements and flows through to the tax returns of both cross-border entities. In this case, ManCo is required to allocate a portion of the management fees it receives from the fund to the sub-advisor, located in PR, in a manner consistent with the transfer pricing regulations in the respective jurisdictions. Typically, sub-advisors that provide routine services receive a remuneration that encompasses the fully loaded costs incurred plus an arm’s-length markup. A transfer pricing analysis would determine the pool of allocable costs and the range of acceptable markups that meet the compliance rules and are optimized for the facts and circumstances of the intercompany transaction.

Management Fee Splits

There are times when key personnel, for example, an investment committee member employed by ManCo, may move to PR and take with them key functions, including final decision-making authority, setting investment recommendations, and providing investment approvals for the entire group. These functions are entrepreneurial in nature and not routine and, therefore, require a different approach to determine the percentage of residual management fees to be allocated to each non-routine service provider.

If it is determined that the related party sub-advisor is performing routine and non-routine intercompany services, ManCo would allocate management fees to pay the related party subadvisor on a cost-plus markup basis for its routine activities and then split the residual management fees with the related party sub-advisor based on each party’s relative non-routine value contribution to fund performance. Per Section 482 regulations and the OECD Guidelines, the taxpayer is expected to describe in its documentation the reasons for concluding that the allocation key produces outcomes that reasonably reflect the benefits likely to be derived by each service recipient in a third-party arrangement under similar facts and circumstances.

There are facts and circumstances that support allocating the residual management fees based on a percentage of assets for which the related party sub-adviser has a significant management responsibility. Headcount may be a more appropriate allocation key in other cases, such as when investment management committee members are spread amongst several jurisdictions. There is no set list of allocation keys that is permissible. The selection of the allocation key must be based on the facts and circumstances of each entity’s contribution to the fund’s performance. A transfer pricing analysis develops a supportable and optimized allocation key that the taxpayer may reliably use to meet compliance requirements.

What’s the Outlook?

Taxpayers can expect an increased audit burden in addition to current tax obligations. A focus area of note is the most common type of alternative investment structure, which calls for intercompany transactions between the asset manager/ManCo and its related parties to be priced using a cost-plus model. In this model, intercompany transactions between ManCo and its affiliates, domestic and overseas, are priced on a cost-plus arm’s length markup basis. This model does not assume an entrepreneurial return to the sub-advisors; accordingly tax authorities are spending resources examining what functions, risks, and management control are undertaken at the local level to determine if a bigger portion of the fees should be allocated to one or more cost-plus recipients of the group. In an environment of significant global decline in tax revenues, tax authorities in the US and abroad have the incentive and, in many cases, the bolstered resources to pursue audits to increase tax revenues.

The globalizing alternative investments industry is ripe for transfer pricing opportunities for tax optimization and potential compliance landmines. The Marcum Transfer Pricing team can guide the taxpayer through all aspects of their transfer pricing compliance requirements and planning considerations.