The shifting sands of the taxation landscape for investment managers continues apace. Just when you perceive an oasis of stability on the horizon, it is revealed to be a mirage by the announcement of yet further changes.

As noted in our previous update numerous unsettling changes have recently been made to the taxation of investment management fees, carried interest and performance related returns. The recent March Budget and related revised Finance Bill 2016 have introduced yet further changes to an already complex set of rules. Admittedly, much of the new detail included in the latest version of the Finance Bill results from HMRC’s commendable desire to listen to sensible and appropriate industry lobbying but the added complexity and detail now present in the legislation will add to the cost of compliance and should not be underestimated.

Performance Related Fees/Carried Interest

Some of the key proposed new changes are summarised below.

  • The headline change from the proposal set out in the original Finance Bill is that funds with a weighted average asset holding period (WAAHP) in excess of 40 months will now be able to avoid carried interest being automatically taxable as income. This is a welcome reduction from the original proposal of four years, but full income taxation will still apply if the WAAHP is three years or less. Essentially, the transitional period of mixed income and capital gains treatment has been shortened to four months.
  • Important changes have been made to the treatment of so called “conditionally exempt” carried interest, which should now make it easier for genuine long term funds to avoid difficulties with the rules in relation to disposals of assets in the first four years of a fund’s life.
  • Further improvements have been introduced aimed at direct lending funds. In order for holders of carried interest in such funds to avoid automatic income taxation, various conditions must be satisfied. These conditions have been relaxed in some respects, including by reducing the required minimum hurdle rate from 6% to 4% and by extending the category of “qualifying loans” to include non-corporate borrowers.
  • Special rules have been introduced for specific types of funds, such as funds holding controlling interests in trading companies, real estate funds, venture capital funds and funds that acquire large equity interests in trading companies. The rules are generally designed to ignore certain incremental acquisitions or disposals of the same asset to provide greater fairness in the application of the WAAHP.
  • Special rules have been introduced for funds of funds and secondary funds which, broadly speaking, will enable such funds to focus on the underlying funds as the relevant assets in calculating the WAAHP rather than requiring a “look through” to the ultimate assets of the underlying funds.
  • A further helpful change involves so called “unwanted short term investments”. Broadly, these are assets acquired as a minor part of a package in order to obtain an investment which are then sold on within a specified time following acquisition. Such assets will generally be ignored in calculating the WAAHP. This change recognises that in order to acquire key assets which it wishes to retain, a fund may be required to acquire certain other assets which it does not wish to retain. There is also a further relieving provision with respect to “loan to own” investments where the intention is broadly to acquire impaired debt interests in order to obtain underlying assets. The acquisition of any such underlying assets upon enforcement of the impaired debt will be treated as acquired at the point when the original loan was acquired for the purposes of calculating the WAAHP.
  • One of the provisions that caught the eye in the original Finance Bill and which is retained in the revised proposals is the exemption from the application of the income based carried interest rules for employment related securities. This exemption applies whether or not the carried interest return is itself taxed as employment income. However, a specific provision has been included in the legislation to permit removal or amendment of the exemption by regulation (which could presumably affect pre-existing carried interests arrangements which were relying on the exemption).
  • Although UK resident but non-domiciled individuals have been hit by various changes and await the impact of further proposed changes, the carried interest provisions include a relieving provision for such individuals in respect of the first four years after their arrival in the UK. During this period, such individuals may be able to claim the remittance basis with respect to any carried interest otherwise caught under these rules to the extent that it is attributable to services performed outside of the UK before coming to the UK.  

Other Measures

One of the big surprises announced in the Budget was a reduction in the headline rate of capital gains tax from 28% to 20%. Although the 20% rate does not apply to carried interest or residential property assets (gains on which remain subject to a 28% rate) it does apply to disposals of other assets such as a co-investment holding in a fund. The rate reduction takes effect from 6 April 2016 so delaying disposals until after this date is an obvious strategy.

A new “investors’ relief” has also been announced and is likely to attract substantial interest going forward. It is, in many respects, an extension of existing entrepreneurs’ relief to external investors. Under the new relief, qualifying investors may be eligible for a 10% rate of capital gains tax on up to £10 million of capital gains over their lifetime, irrespective of their percentage holding in the relevant company. There are, however, other conditions attaching to the relief which do not apply to entrepreneurs’ relief. In particular, officers or employees of the company (or a connected company) cannot claim the relief (or indeed any investor connected with such an officer or employee). In addition, in order to obtain investors’ relief the shares must be newly issued for new consideration, be in an unlisted trading company or unlisted holding company of a trading group and be held for a continuous period of three years before disposal (which cannot include any period prior to 6 April 2016). Furthermore, there is also an anti-avoidance provision disallowing relief if the individual subscribes for a share for tax avoidance purposes, although it is not entirely clear what circumstances are envisaged to be caught by this provision.