Investment managers should consider the UK tax consequences of the new regime for taxation of carried interest and investment management fees, with the latest rules introduced in April. It is now timely to evaluate whether fee structures create tax risk for individual staff but it may also be an opportunity to take a fresh look at both fee and entity design to respond to growing investor challenge of the traditional "2 and 20" fund remuneration model and the evolving landscape of trading entity and individual taxation.


The remuneration of UK investment managers in private equity ("PE") has historically been advantaged compared with other investment managers including hedge fund managers ("IMs"). IM remuneration is typically taxed as trading profits; while the "carried interest" returns allocated to PE managers have been taxed at significantly lower marginal rates as capital gains, reflecting the capital enhancement nature of their activity on the assets managed. In recent years, investment management fee structures emerged to take advantage of the beneficial tax treatment of carried interest. In response, HMRC introduced new rules to ensure that rewards for trading performance could not be effectively "disguised" as capital receipts, but would be taxable as income and the tax treatment of long-term investment returns as capital gains would be protected.

Disguised Investment Management Fees and Carried Interest

The Disguised Investment Management Fees ("DMF") rules were introduced in April 2015 and further refined in 2016 with "Income Based Carried Interest" ("IBCI") rules. Taken together the rules are designed to treat all investment management returns as trading profits subject to income tax, unless they are structured as carried interest and relate to investments held for an average period of 40 months or more. Carried interest as defined in these rules is specifically excluded from the income tax treatment of disguised fees, to allow capital gains tax treatment for genuine risk-related investments acquired on terms comparable with external investors.

Under the new tax regime it is now possible for investment management returns with genuine commercial characteristics of carry, which relate to long-term underlying investments, to be structured as carried interest subject to tax as capital gains within the new statutory definition of carried interest.

IMs with longer-term asset holdings should reconsider their remuneration strategy to combine an arm's length management fee treated as income and a carried interest participation, which might benefit from the capital gains regime. This may be relevant, for example, to managers of long equity and infrastructure asset strategies.

Anti-avoidance rules will apply where the main, or one of the main purposes of any arrangement is to circumvent the DMF rules and any remuneration structure will need to be focused on commercial objectives.

LLP or Limited Company?

The divergence of income, corporation and capital gains tax rates has always been significant and historically has driven the design of corporate structures for IMs, particularly hedge fund managers, to take advantage of the corporate and capital gains tax regime indirectly through hybrid LLP/corporate structures.

The use of hybrid structures was limited in 2014 (mixed membership and salaried member rules were introduced) and the choice of an LLP as the investment manager vehicle is no longer necessarily the natural one. These changes coincided with regulatory changes (introduced by the Alternative Investment Fund Manager Directive) requiring investment managers to defer remuneration into cash and/or investments in funds managed. Complex income tax implications resulted: LLP members became subject to a "dry" tax charge on deferred income and employees who were awarded fund investments became subject to the detailed rules of the employment related securities (ERS) regime.

With corporation tax rates falling (17% proposed for 2020 and the possibility of even lower rates in the future), trading through a limited company may reduce complexity and enhance tax efficiencies.

Employee or Member?

Typically, staff at an investment management business will be treated as either employees subject to PAYE and NIC, "deemed employees" (salaried members of an LLP) or self-employed individuals. Taking the IBCI and ERS rules into consideration, it may be beneficial for individuals to switch from self-employed to employed status, either as salaried members of LLPs or as employees.

Carried interest issued to an employee, or deemed employee will be treated as an ERS. Complex rules apply to the taxation of ERS, which apply throughout the holding period. Income tax arises on acquisition, when restrictions are lifted or varied and on vesting. Broadly, income tax is calculated by reference to the proportion of the carried interest that has been received gratis, or is subject to income tax and the unrestricted market value at the time of the taxable event.

An income tax charge will not apply to future growth in value where either the full, unrestricted market value is paid on acquisition, or an election is made to pay income tax on the difference between the amount paid for the carried interest and the unrestricted market value. The growth in value should then be subject to CGT (subject to a limited number of exceptions). Importantly, carried interest that is an ERS is not subject to the IBCI rules.

Carried interest is not an ERS where the recipient is a member and not an employee. Where carried interest is not IBCI, CGT will apply at 28%, but where it is IBCI it will be subject to income tax and NIC at 45% and 2% respectively. Where carried interest relates to shortterm asset holdings and falls within the IBCI rules, members taxable as self-employed traders at income tax rates may consider a shift to employed status and the ERS regime with carried interest returns taxable as capital gains.

In Summary

The new DMF and IBCI rules are the latest development in the complex and changing tax environment in which IMs operate. IMs should review the rules and evaluate the risk of tax liability for IM staff where carried interest returns may be re-characterised as disguised management fees. However, carried interest now has a statutory definition for the first time and IMs with longer term investment strategies may be able to structure returns with genuine carried interest characteristics within these rules and capital gains tax treatment should be available. Fee redesign should be driven by commercial objectives and might be combined with a review of IM trading in a limited company or LLP and status of staff as employees or members. An opportune time for fresh thinking on all fronts?