Taxation of credit funds in United Kingdom

Taxation

Is a credit fund vehicle formed in your jurisdiction subject to taxation there with respect to its income or gains? Is the fund required to withhold taxes with respect to distributions to investors? Are there any applicable tax exemptions?

Private credit funds aimed at international investors are not usually established in the UK. The English limited partnership is sometimes used as a feeder vehicle into a master fund or specifically for UK-resident institutional investors on occasion. The limited partnership is tax transparent from a UK tax perspective so that profits arising to the fund are referrable directly to the limited partners and investors in the limited partnership and are not assessable on the limited partnership itself. There are no UK withholding taxes on distributions to investors in the limited partnership except that a limited partnership might be required to withhold UK tax from payments of interest to an investor in respect of a loan made by that investor to the limited partnership. The qualifying asset holding company (QAHC) was launched on 1 April 2022 as a vehicle to be used to hold assets typically as a subsidiary entity of a fund. It is generally not subject to UK corporation tax, except on a small transfer priced amount referable to the limited services it provides and assuming also that it meets the various qualifying conditions. There is a wide exemption from UK withholding tax applicable to the QAHC in respect of interest payments that it might make, and no withholding tax applies to dividend payments.

What range of downstream tax structures are available and commonly used in your jurisdiction to mitigate any tax leakage?

The QAHC has recently become available as a potential downstream vehicle for funds to use to mitigate tax leakage (eg, in relation to withholding taxes that might otherwise arise on interest payments from an underlying debt portfolio). It is eligible to take advantage of the UK’s wide range of double taxation treaties provided that the QAHC is the beneficial owner of the interest payments (within the double tax treaty meaning of that term) and relevant anti-avoidance provisions contained within the double tax treaty can be satisfied. Minimal tax leakage should be incurred within the QAHC, limited to a transfer priced amount for the services it provides. The QAHC must meet certain conditions in order to be eligible for the tax advantaged regime, including conditions as to its ownership and its activities (in particular, these should be investment in nature), which may mean that it is not suitable for all credit fund strategies.  

Certain funds have held investments through a UK securitisation vehicle within the definition of the Taxation of Securitisation Companies Regulations 2006, which is also entitled to benefit from the UK’s double taxation treaty network. Furthermore, such a securitisation vehicle need pay only a minimal amount of UK corporation tax on a specified residual amount of profits as it receives a tax deduction for all payments made by it. However, various conditions need to be fulfilled to qualify as a UK securitisation vehicle within the regulations, and it would typically need to issue funding instruments as part of a capital markets arrangement mainly to independent investors, which usually makes this option either more expensive or inappropriate for many scenarios. Given the new QAHC option, we would expect this to be preferred in most cases.

Are non-resident investors in a credit fund subject to taxation or return-filing requirements in your jurisdiction?

Non-resident investors investing into a tax-transparent credit fund would usually be liable to tax in the UK only if they are considered to be trading in the UK through a permanent establishment, which is unlikely to be the case with most credit funds. UK withholding tax would also generally not be applicable in relation to underlying UK credit assets provided that the fund or an underlying downstream entity holds the asset and is either a UK corporate entity or a treaty-entitled entity subject to a full exemption under the treaty. To the extent that any UK source income (such as interest) is subject to UK tax at source, an investor in a limited partnership might be entitled to the benefit of a double taxation treaty between their country and the UK to reduce or eliminate such liability.

Non-resident investors in a limited partnership would not normally be required to file a UK tax return, although the limited partnership itself will usually be required to file a UK partnership return that will include details of income and gains (or losses) allocable to each investor. This may require a non-resident investor to obtain a unique taxpayer reference number from HM Revenue & Customs (HMRC) except where the limited partnership is already providing information about that investor to HMRC through Foreign Account Tax Compliance Act or Common Reporting Standard reporting.

Is it necessary or desirable to obtain a ruling from local tax authorities with respect to the tax treatment of a credit fund vehicle formed in your jurisdiction, or the services provided by the investment manager or investment adviser? Are there any special tax rules relating to investors that are residents of your jurisdiction?

It would not be usual to obtain a ruling from HMRC in respect of the tax treatment of a credit fund, although it is recognised that there could be situations where seeking confirmation that relevant conditions are satisfied would be advisable if a QAHC is to be used.

Special tax rules may be of relevance to certain institutional UK investors, such as pension funds or charities that might make certain types of funds unattractive or require special structuring. For example, UK pension funds and charities that are usually exempt from UK tax might become liable to tax on any receipts considered to be trading income. In addition, various anti-avoidance rules could be applicable to UK-resident investors in a limited partnership to the extent that it invests in underlying non-UK companies or funds such as the controlled foreign company, offshore fund, attribution of gains (section 3 of the Taxation of Chargeable Gains Act 1992) or attribution of income rules (transfer of assets abroad) and could potentially render such investors liable to tax on undistributed income or gains in certain circumstances.

Are there any special tax considerations for credit fund sponsors?

UK executives of sponsors might want to consider whether it is possible or appropriate to structure incentive or performance arrangements as carried interest rather than performance fees because rates of taxes on earned income are generally higher than those on investment income or capital gains. This would usually be structured using a carry limited partnership that is admitted as a limited partner of the limited partnership. Each participant’s share of the carried interest is delivered through an interest in the carry limited partnership. Given that the returns from the limited partnership will likely be largely income based, it might be difficult to achieve returns in the form of capital gains. In addition, the UK tax rules relating to carried interest have become more complex in recent years, so it will be important to assess whether capital gains treatment can be achieved for any returns that are not in the form of income. It can sometimes be easier to achieve this if the fund is in the form of a partnership and the executive is an employee rather than a partner, although the specifics of each arrangement should be considered carefully. This is because the special income-based carried interest (IBCI) rules contain an exemption for interests held by employees or directors.

The IBCI rules are a set of anti-avoidance rules designed to prevent capital gains treatment applying to executives in respect of funds that (broadly speaking) are not considered to invest on a medium- to long-term basis. If the rules apply, carried interest that is otherwise taxable as a capital gain is instead taxed as deemed trading income. In general, this can apply where the weighted average holding period of fund assets is less than 36 months, although part can also be taxed as income if the period is less than 40 months. There are also special additional rules for loan origination funds that can also lead to the IBCI rules applying.

Although carry participants who are employees or directors enjoy an exemption from the IBCI rules, they will be subject to the special employment-related securities rules and, in this regard, care should be taken to avoid charges by reference to acquisitions of carried interest at an undervalue by complying as far as possible with the British Venture Capital Association and HMRC Memorandum of Understanding and its various conditions and also by making any appropriate section 431 of the Income Tax (Earnings and Pensions) Act 2003 elections.

Care also needs to be taken in relation to co-investment arrangements, which could also lead to inadvertent taxation at income rates under the general disguised investment management fee anti-avoidance rules. However, there is a specific exemption in the rules for genuine arm’s-length co-investment arrangements that are essentially on the same terms (with limited exceptions) as other investors in the fund.

Are there any relevant tax treaties to which your jurisdiction is a party? How do such treaties apply to the fund vehicle or any downstream structure?

The UK has negotiated a very wide range of double taxation treaties with other countries. Typically, it is difficult to rely on such treaties where the fund is in partnership form, except in limited circumstances. Accordingly, it is more usual for a downstream corporate entity to be formed as a vehicle to hold debt-related assets and it would seek to rely on the UK double tax treaty network to avoid foreign withholding tax (where applicable). This is of course subject to the requirement that the downstream entity is regarded as the beneficial owner of the interest returns (within the meaning of that term for double taxation treaty purposes) and also satisfies any anti-avoidance provisions in the relevant treaty. In addition, an investor in the limited partnership might be able to rely on a treaty between the UK and their home jurisdiction to the extent that they are allocated a share of UK source income or gains (and a UK investor might be able to rely on a UK treaty in relation to underlying non-UK source income or gains).

Are there any other significant tax issues relating to credit funds organised in your jurisdiction?

An ongoing concern in relation to the use of limited partnerships is VAT. Typically, any management fees charged to the limited partnership would attract VAT, which would not be recoverable. To the extent that this is a relevant concern in any given structure (as it might be that fees are charged elsewhere in the overall structure if the limited partnership is a feeder fund), consideration could be given to VAT grouping the general partner (GP) of the limited partnership with the investment manager, and having the limited partnership allocate a profit share to the GP to pay the fees. In this way, VAT would not need to be charged on the management fees, although it would likely lead to a loss of VAT recovery for the investment manager. Consideration might also be given to migrating the GP outside the UK as an alternative. The whole topic of VAT in relation to investment management fees is the subject of a consultation exercise as part of the UK funds review process, and it might be that change emerges as a result of this consultation exercise to alleviate this issue.