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.
The new rules are now enacted in the Finance Act 2015 which was published on 26 March. HM Revenue and Customs (“HMRC”) also published a detailed technical note dated 29 March.
The rules adopt a broad brush approach, with exclusions, rather than targeting specific anti‑avoidance.
What do the new rules potentially catch?
The rules potentially catch any sum (cash or otherwise) treated as arising to an individual who performs “investment management services” (which is defined very broadly) in relation to an “investment scheme” involving at least one partnership, to the extent that the relevant individual is not already subject to tax on such sum as either employment income or profits of a trade.
Importantly, the rules extend to arrangements where a manager’s interest is held indirectly - either onshore or offshore, so that this could catch share arrangements also (and indeed indirect holding structures).
The scope of “investment scheme” has been extended from that in the original draft legislation, so that as well as catching collective investment schemes within the meaning of s235 of FISMA 2000, it catches investment vehicles which have the aim of spreading risk and whose shares are traded (other than REITs and venture capital trusts). Consequently, management arrangements relating to HMRC approved investment trusts and offshore investment trusts are now within scope (provided a partnership is involved in the structure).
Thus it goes beyond pure profit shares via traditional partnership arrangements.
What type of structure are the new rules intended to catch?
Broadly, the rules are intended to catch anything that is, effectively, akin to the annual management fee (i.e. of between 1.5-2%) or other fixed return, which is not taxed either as trading income (e.g. management fees in a management LLP) or as employment income in the hands of individuals involved in the management of the structure.
So, annual fees extracted as "profit shares" via the GP to the management LLP or the managers directly and which are, indeed, payable out of profits (e.g. capital returns, rental or dividends) are, therefore, likely to be caught, potentially giving rise to tax in many cases at a higher rate, depending on the underlying profits. Whether or not the arrangements are actually designed to avoid tax is irrelevant here.
The rules are, in particular, aimed at arrangements where the profit share allocated to the manager is taxed as capital and/or where prior profit shares are funded by way of loans in the early years of the partnership (e.g. where there are early year losses), as these loans would otherwise potentially escape tax, unless and until there are underlying taxable partnership profits available to repay the loans. Other arrangements caught could include a waiver of the management fee or a guaranteed profit share in return for a funded co-investment (e.g. deemed contributions).
What is not intended to be caught?
The rules are not intended to catch genuine profit sharing shares, which are performance related (see below), but they could nonetheless catch some profit sharing arrangements, which don't fall squarely within the exclusions.
There are four exclusions (see points 1 to 4 below). The first two are aimed at co-invest and the second two at different types of genuine carried interest arrangements. One of the carried interest exclusions is aimed at typical PE funds, which follow the Memorandum of Understanding between the British Venture Capital Association and the Inland Revenue of 25 July 2003 (the “MOU”), the other is aimed at more venture capital like arrangements. The idea for both carried interest exclusions is that genuine profit related returns should be outside the charge (i.e. the charge is intended to capture only those who are avoiding tax on what would otherwise be an annual management fee or some sort of fixed return).
- Repayment of an investment made by the manager in the investment scheme.
- An arm’s length return on an investment made by the manager in the scheme of the same kind and on terms reasonably comparable with that of external investors.
The effect of this exclusion for return on investment means that any investments which give managers an excessive or fixed return (say in lieu of an annual management fee) will be caught by the new rules. It is worth noting that this is a “cliff edge” test in that if the condition is not met to any extent (e.g. the return only slightly exceeds that which is reasonably comparable to that of external investors), the entire return (and not just the excess) will be caught by the new rules.
- Carried interest – PE type carry
A carried interest which is MOU compliant generally should be exempted from this new charge. However, it will be important to ensure it is structured to fit within this exemption as well as the MOU. In particular, the investor must have received all or substantially all of its money back first and have received a preferred return of 6% compound interest on all or substantially all of its investments. This rate is expressly set so as to be below the rate set out in the MOU (so is intended to be helpful).
The new rules reflect both whole fund carried interest and deal by deal carried interest. The term "substantially" is really only there to reflect that the capital is unlikely to have been repaid until the partnership is wound up. The terms of the waterfall will need to be looked at very carefully in this regard.
- Carried interest - other profit related returns
Other profit related returns may also fall outside the new rules. However, for this to be the case the following conditions must be met:
- there is no significant risk that the return would not arise to the individual (any part of the return which is not subject to this risk is not treated as carried interest for the purposes of the exclusion); and
- the return is variable to a substantial extent by reference to profits and returns to the investors are by reference to the same profits.
Risk for this purpose is assessed at the later of the time (i) the individual is involved, (ii) the services are performed and (iii) there is any material change to the arrangements.
Importantly, HMRC state that the definition of carried interest for this exclusion is not intended to extend the scope of the MOU, so particular care should be taken with the employment related securities rules in these cases.
What is the new tax?
The new charge is a tax on profits of a trade. Notably, it is not treated as income, so expenses or losses will not be deductible.
Credit for tax already suffered/to be suffered
To the extent that returns have already been taxed (e.g. as dividends, capital, interest or rental), these should be adjusted to avoid double tax. It is not the disguised fee that is adjusted, so there may be a time (cash) lag here, where the previous tax was paid earlier or where (in respect of earlier loans), tax becomes payable later.
When do profits arise?
Interestingly, it is accepted that profits can be realised or unrealised for the purposes of the exclusion from the charge.
Helpfully, too, for the purpose of the charge, profits are only deemed to arise when they are available to the individual (for these purposes, reinvested sums will be treated as being available). Therefore, sums allocated to a manager, but not actually available to him/her will not be caught: for example, awards which are deferred will only be within the charge when they can actually be accessed by the individual. If dealt with properly, it should, therefore, be possible often to avoid cash flow mismatches.
So far as loans, e.g. to managers, are concerned, these will be treated as profits arising, even if the fund is not actually in profit itself, such as in the early years of the fund. There would then be credit against the future tax if the loan is subsequently offset against actual profits.
What happens if the manager holds his interest indirectly?
The rules will potentially apply even if the interest of the manager is held indirectly. For example, he may hold shares in an investment trust, where the partnership is well below in the structure as an asset owning entity. The exceptions above would be applied in determining whether the return on the shares would be caught, so it would depend on the share rights.
HMRC have said that the charge will not apply in relation to indirect interests where the individual holds shares in the management entity and receives arm's length remuneration but that the simple holding by an individual of an interest via another vehicle (not a manager corporate entity) would not be sufficient to avoid the charge (assuming the relevant sum is treated as "arising").
What happens if the vehicle or manager is offshore?
The rules now capture only activities in the UK, so if the manager is in the UK, returns could be caught, regardless of whether the vehicle is in the UK or not. However, while non-UK tax resident investment managers are potentially within the charge, in practice it may well be that they are able to benefit from protection under a double taxation treaty (provided they have insufficient presence in the UK).
What about arrangements already in existence?
There is no grandfathering. The rules could catch existing arrangements with effect for any sums arising on or after 6 April. It may be that certain sums should be paid out before then.
What action should be taken?
New arrangement should be considered carefully.
You should also consider whether it will be necessary also to review historic arrangements and amend them to ensure that the manager is not worse off. The latter may be a balancing act in the commercial context.