The Government’s 2014 Autumn Statement included an announcement that rules would be introduced from 6 April 2015 to ensure that certain sums which arise to investment fund managers for their services are charged to income tax where the relevant manager has entered into an arrangement involving a partnership or other transparent vehicle. The announcement said that the rules would not apply to carried interest or returns which are exclusively from investments by partners.
However, draft legislation to implement these rules has recently been published and is significantly wider than expected: “management fees” are defined broadly and the exclusions for carried interest and co-investment returns are drafted unexpectedly prescriptively. This has given rise to concerns that many normal carried interest and co-investment structures could be within the scope of the new rules.
Summary of the draft legislation
Under the draft legislation, an individual who receives “disguised fees” from a collective investment scheme is liable to income tax (and national insurance contributions) for that year on such fees as if they were the profits of a trade.
For these purposes, a “disguised fee” arises where:
- the individual performs investment management services directly or indirectly in respect of the relevant fund under any arrangements;
- the arrangements involve at least one partnership;
- under the arrangements, a “management fee” arises to the individual in the tax year directly or indirectly from the fund (whether by loan, advance, allocation of profit or otherwise); and
- some or all of the “management fee” is not charged to tax as employment income or profits of a trade (so based on this amounts taxed as dividends or capital appear to be caught).
The term “management fee” is defined very broadly and catches any sum arising to the relevant individual directly or indirectly from a collective investment scheme. The only exclusions are for:
- “carried interest” (as defined);
- return or repayment of an investment made by the individual in the scheme; and
- a commercial return on such an investment.
For these purposes “carried interest” is defined slightly differently depending on whether it is paid on a “fund as a whole” or a “deal by deal” basis.
In the case of “fund as a whole”, “carried interest” is defined as, broadly, a sum which is to, or may, arise to the individual out of profits on investments made by the fund after investors have received back all, or substantially all, of their investments in the fund together with a preferred return at least equal to compound interest of 6% on their investments. In the case of “deal by deal”, “carried interest” is defined as, broadly, a sum which is to, or may, arise to the individual out of profits relating to the relevant underlying fund asset after investors have received back all, or substantially all, of their investments in the scheme attributable to the relevant underlying fund asset together with a preferred return at least equal to compound interest of 6% on those investments.
The draft legislation also contains an anti-avoidance provision to prevent fund managers structuring their returns to avoid the new rules.
The exact scope of the new rules is currently unclear. In this regard, perhaps the main concern is that a key feature of the draft legislation is the narrow and prescriptive exclusions for carried interest and co-investment returns.
- In relation to carried interest, issues may arise for fund managers when trying to reconcile the draft legislation’s requirement of a 6% compound interest preferred return for investors with the desired commercial position e.g. it is currently unclear how this requirement will apply to preferred returns calculated by reference to IRR or, indeed, where there is no preferred return.
- In relation to co-investment returns, fund managers should note that the exclusion only applies where a manager has himself/herself-made the investment in the fund.
Unless the management services are carried out entirely outside the United Kingdom, the trading income will be deemed to have a UK source. This makes it more likely that non-UK resident managers and managers who are UK resident but non-domiciled will be within the charge.
The investment management industry has been addressing these and other concerns with HMRC and, therefore, the draft legislation is likely to change to reflect this. We understand that HMRC is going to issue guidance in the near future. It will be important that fund managers monitor the position, so that they are prepared for 6 April 2015 when the final form rules will come into effect. As there are no grandfathering provisions, the new rules will impact on existing arrangements.