On April 6, 2015, the United Kingdom’s taxing authority (HMRC) enacted new rules that are designed to close an investment management fee “loophole” that allowed private equity fund managers to avoid taxes on management fees through partnership structures. The rules do not apply to fees that are otherwise subject to taxation (e.g., employment or trade or business income). This Locke Lord QuickStudy briefly outlines the “loophole” and explains the effect of the new rules.

The “Loophole”

The UK drafted the rules to target two different partnership structures that fund managers use to reduce taxes. The first structure involves a general partner/limited partner (GP LP) and the second involves a general partner/limited liability partner (GP LLP). In the GP LP arrangement, a limited partnership (the Fund LP) holds the investments of the fund and pays a management services fee (typically a priority profit share) to its general partner (the GP LP). The GP LP then pays this fee to a management company or a limited liability partnership. Private equity firms can reduce taxes by allocating a portion of the management fee to individual partners in the GP LP without passing it through to the management company. This “disguises” the management services fee and reduces the amount of the fee subject to taxation. The GP LLP arrangement is substantially similar. The following are simplified diagrams of both tax minimization structures: 

GP LP:

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GP LLP:

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Source: HM Revenue & Customs

The New Rule

To prevent this result, the rules provide that any sum paid, directly or indirectly, to an individual from an investment fund is a management fee (and thus subject to tax) if the structure involves at least one partnership. A payment is not a management fee if it represents the repayment of an actual investment, an arm’s length return on an investment, or a carried interest. 

What Is An Arm’s Length Return?

The rules provide that the fund manager’s initial investment must be of the same kind or reasonably comparable to investments made by external investors and the return (as well as the terms governing the return) must be reasonably comparable to what external investors receive. The rules do not mandate identical treatment between fund managers and external investors; the rules permit variations so long as there are genuine commercial reasons for the differences.

How Do The Rules Define Carried Interest?

The rules exempt carried interests in two different ways. The rules exempt traditional forms of carried interest (whether “whole fund” or “deal by deal” carry) so long as external investors receive all or substantially all of their original investments plus a return of at least 6 percent. The rules also exempt profit related returns that: (1) arise only if the fund is profitable, (2) vary substantially by reference to profits, and (3) the investments used to determine the first two conditions are the same ones by which returns to external investors are measured. In addition, there must be a significant risk that the sum will not arise when the fund manager becomes a party to the arrangement or begins performing management services. The UK enacted this condition in order to tax payments that were virtually certain to arise. 

Who Is Subject To The Rules?

The rules are limited to management services performed in the UK and will generally not apply to foreign fund managers. According to the HMRC, the rules do not apply to foreign fund managers who travel to the UK for a “small number of business meetings during the course of the year.” It is unclear what constitutes a small number of meetings. Foreign fund managers should consult with their tax advisors if they envision visiting the UK for work related matters to ensure that they do not become subject to these rules.