The European Commission’s alternative investment fund management directive, which aims to locate hedge funds in Europe, has unsettled hedge fund managers. If the UK does not develop a competitive onshore regime, we will miss out on money, taxes and jobs.

The prospect of tax rises and the spectre of the directive are placing opposing pressures on the European Union’s hedge fund managers. The impulse may be to move out of the EU to a jurisdiction with lower taxes, but regulatory change may mean that managers will be at a competitive disadvantage unless they stay put or bring their products onshore.

Britain is Europe’s leading hedge fund centre for hedge fund managers. The same is not true for the hedge funds themselves, as Cayman is the domicile of choice for these. The regulatory and tax storm that lies ahead may shake this established structure.

Hedge fund managers may look to establish more funds in the EU. There is no reason why the UK should not be seeking to attract these funds. A year ago this suggestion would have been ridiculous, as many hedge funds would have been taxed in the UK on their trading profits, but from September this year it has been possible to trade in UK-authorised funds without tax charges.

There is a precedent for such an opportunity. Almost 25 years ago, a framework for the cross-border sale of EU-regulated funds was created. Luxembourg was first and now is the leading EU funds centre, with nearly 30 per cent of such funds. Ireland has grown as a rival cross-border centre in the past 15 years and has an 11 per cent share, more than the UK’s 9 per cent, despite a smaller domestic market.

The UK missed a trick, as many of the funds domiciled in Luxembourg and Ireland are sponsored by UK managers. It is estimated that, for every £1 billion of funds under management, almost £1 million is generated in tax revenues because administrators and other providers are needed to service the funds. These activities give rise to corporation tax, income tax and VAT receipts. If the value of UK-authorised funds under management was to double, about £400 million in additional tax receipts would be generated yearly.

Hedge funds themselves should not pay tax, because this would mean that investors would be better off investing in the underlying assets outside of the funds. Fund centres such as Luxembourg and Ireland understand this and have attracted funds because they offer tax neutrality (not tax breaks). The tax treatment of British funds is much more complicated because it is designed with UK investors, not a global market, in mind.

Regulatory and tax changes mean that established fund structures are being reassessed by managers and there is an opportunity emerging for the EU location that can offer the best environment for hedge funds. This will include a flexible but strong regulatory regime that is adapted to the specific requirements of the hedge fund industry, a deep pool of administrative and other support skills, access to prime brokers and a tax regime that does not get in the way. The UK has many of these but a new tax regime is needed, one that appeals to global investors. Nathan Hall is an Associate Partner, Investment Management and Funds, KPMG

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