Recent reports that Finance Minister Hans-Rudolf Merz is consulting about changes to the tax regime for investment fund managers are an encouraging sign that the Federal Government has realized that only fundamental tax reforms can make Switzerland an attractive location for private equity and hedge fund management.

While Switzerland's corporate tax system has played a key role in attracting inward investment from foreign multinationals, London's dominance of the investment management industry in Europe and its advances towards global preeminence have also to a large extent been underpinned by a very competitive tax environment.

Although it is little known outside the world of financial and tax professionals, the relatively high-tax UK is a comparative tax haven for investment managers. Despite its many other strengths, not least a highly skilled labour pool, strong financial markets and relatively low overhead costs, Switzerland will struggle to complete with the UK in this industry unless its tax rules are radically overhauled.

Investment funds are normally structured as partnerships with limited liability or as companies which are formed in tax havens such as the Channel Islands, the Cayman Islands or Bermuda. This ensures that partners or shareholders only suffer tax in the jurisdiction in which they are tax resident, not in the jurisdiction where the partnership or company is formed. 

This means that investors who are themselves resident in tax havens will receive their returns tax-free. There is some tax leakage at the level of the fund’s investments, but a key issue for such funds is the tax treatment of the activities of the fund managers.

A fund will normally be managed by a professional investment manager who will usually be located in an onshore taxing jurisdiction. Sometimes the investment manager will be located in a tax haven with delegated authority given to an onshore subsidiary company.

In either case, the question is: to what extent is the growth in value of the fund attributable to the activities of the investment fund manager taxable in the onshore jurisdiction?

The UK has for many years operated a special scheme to encourage private equity and hedge fund managers to locate their operations in London. It is called the investment manager exemption, the word 'exemption' indicating the degree of generosity intended by the tax authorities to this very special class of taxpayer.

Ordinarily, a foreign company or partnership that carries on a trade through a presence in the UK is subject to tax in respect of the trading profits of the UK operation.  As a London based hedge fund manager is transacting business on behalf of an overseas fund, it could be argued that the profits of the fund generated by the manager are taxable in the UK, resulting in a 30% tax liability on such profits.

However, the special rules provide that, where a UK based fund manager is acting as an independent agent, then the activities of fund managers will not bring the profits of the fund into the UK tax net. The managers instead receive a management fee which, although subject to tax in the UK, will be a fraction of the profits generated by the manager. In many cases, the management fee will just about cover the operating costs. 

In addition to the management fee, investment managers generally receive a proportion of the annual growth in value of the funds under management known as a “carried interest".  This is often received by the managers in a personal capacity and can be structured so as to be taxed under the generous capital gains tax regime at 10%, rather than subject to income tax at 40% with social security taxes on top. 

For private equity funds, there is a set of guidelines which enable managers to structure their arrangements in order to achieve this result, although with hedge funds and distressed debt funds, achieving capital gains tax treatment is more complicated.  In Switzerland, the carried interest would be subject either to corporate tax or personal income tax at the prevailing marginal rates, which will generally be a more expensive result from a tax point of view than in the UK.

Is the UK Government simply jeopardising principle in order to shore up its share of the investment fund management industry and benefit from the increased employment and the other consequential economic benefits that this delivers? Perhaps not.

The UK rules are based on the view that, where a fund appoints third party agents to manage its assets, neither the assets nor the profits belong to the manager.

The managers receive a management fee for the provision of a service, but the funds and the growth in value of such funds belong to an overseas partnership or company and should be subject to tax in the UK only to the extent that a UK resident person is a partner or shareholder of the fund.  

So far, no difference in principle from Switzerland.  What is perhaps more difficult to defend is according capital gains treatment to carried interest where this is paid to onshore managers personally.  Here, the UK has in the past taken a pragmatic view, but there are signs that this is changing.  Switzerland would regard carried interest as subject to income tax and this is a major reason why managers have historically been comfortable with the UK.

Certain of the cantons take a more pragmatic view, closer in fact to the UK view. Where Swiss managers simply act according to authority delegated by an offshore investment manager, or operate within investment guidelines set by an offshore board, certain cantons will accept that the Swiss manager can be taxed on a management fee alone where the facts support this. But there is little or no consensus on what constitutes sufficient physical and economic substance in the offshore jurisdiction for this approach to be adopted across the board. Ad hoc arrangements are not in themselves sufficient to cause businesses to consider Geneva as an alternative to London.

In order to really put Switzerland in a genuinely competitive position, adopting a similar tax regime to the UK would be a useful starting point.

The UK Government is currently reviewing its rules and is considered to be seeking to narrow the scope of the exemption. In the absence of genuine competition from other European jurisdictions, they probably feel confident in doing so without losing business.

In particular, the tax treatment of carried interest is a much more complex issue with modern hedge funds and there is an opportunity for Switzerland to take advantage of this, perhaps by introducing a reduced rate of income tax on carried interest. 

If the Federal Government is bold enough on tax reform, the UK's complacency could be Switzerland's opportunity.

Jonathan Ivinson is an international tax lawyer and partner in the London and Geneva offices of Hogan & Hartson (www.hhlaw.com)