Certain New York City based hedge fund management companies have recently been audited with respect to how they account for certain expenses under the City’s Unincorporated Business Tax (“UBT”). Since a statutory amendment to the UBT law was passed over 15 years ago, hedge fund management companies located in NYC have bifurcated the structure of their operations by creating who advisory entities for the fund. One entity, the investment manager, is commonly allocated the fund’s management fee, while another entity, often organized out of state, receives the performance allocation, or capital gains attributable to the manager, from the fund. This bifurcated structure was implemented because the UBT was imposed on management fees but not performance allocations.
Until now, investment managers have generally deducted the same expenses on their federal return as they did their city tax return. In what appears to be a change in practice, NYC’s Department of Finance has proposed that certain expenses previously deductible by the advisory entity receiving the management fee will no longer be tolerated. Disallowing these previously deductible expenses will have the effect of increasing the management fee income subject to UBT. In connection with this change in practice the Department of Finance has signaled it believes its position is supported by Section 482 of the federal tax code which allows the IRS to reallocate income and losses between entities controlled by the same owners to prevent the improper manipulation of the Code to reduce tax burden.
Hedge fund manager’s based in NYC will have to determine whether this change fundamentally alters the costs and benefits of being based in the City. The easiest way to avoid the UBT altogether is to relocate outside the City. It remains to be seen whether this change has a significant enough impact on hedge fund managers to convince them that the costs of doing business in the City now outweigh the benefits of being in what likely remains the financial capital of the world.
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