There have been concerns that the proposals on disguised investment management fees, announced in December’s Autumn Statement, would inadvertently sweep many profit sharing arrangements commonly used by funds into the income tax charge.
However, the government has listened to representations made by BLP and others and the final form of the legislation, published in the Finance Bill earlier this week, alleviates many of the concerns with the original draft. In particular, the carve-outs for carried interest and co-invest have been widened so that most returns linked to investment performance should not be affected.
Any sums paid to investment managers (including loans) by a fund on or after 6 April 2015 that do not fall within these carve-outs will be treated as ‘disguised management fees’ and charged to income tax. This is regardless of when the arrangements were entered into, so existing arrangements will need to be reviewed in order to assess the potential impact of these rules. Please do get in touch to discuss.
When do ‘disguised investment management fees’ arise?
The rules are aimed at structures which are used to avoid an income tax charge on management fees calculated by reference to funds under management. Such fees that are already taxable as employment or trading income are not, therefore, within the scope of these rules.
But any other amount that an individual performing ‘investment management services’ receives (directly or indirectly) from a fund or investment trust involving at least one partnership will now be subject to income tax and NICs, unless it falls within one of three exceptions. ‘Investment management services’ remain broadly defined and include researching potential deals and fundraising.
One of the concerns with the original draft was how it would have dragged the whole fee into the UK tax net even if only some of the services were performed in the UK. That has been fixed so that a non-UK resident will only be taxed under these rules to the extent that they perform their services in the UK. This change will also help non-UK domiciled managers, who will also only be taxed under these rules in respect of the services they perform in the UK. Their non-UK element may still be taxed under other rules if they remit those sums to the UK.
There are three exceptions i.e. where the amount received will not be subject to income tax under these rules:
- the repayment of capital invested by the individual;
- an arm’s length return on that capital (i.e. co-investment returns); and
- carried interest, where it is a profit-related return.
Some key points on the second and third exceptions are set out below.
A sum is an arm’s length return if comparable investments are made by external investors, and the return and the investment terms are reasonably comparable to those for external investors. Helpfully, the new drafting removes the reference to the return being akin to a commercial rate of interest, and allows for indirect investments, for instance through another entity. HMRC guidance is also useful: for instance, it confirms that ‘reasonably comparable’ allows there to be different returns to internal and external investors based on genuine commercial reasons, for example where external investors bear costs of carried interest and management fees.
Although it is not set out in the legislation, HMRC says it will accept that this exception can apply where the capital invested by the individual was lent to them on an arm’s length basis. The requirement for arm’s length terms suggests that HMRC may seek to attack arrangements involving “soft” loans. It is also not clear how lending to a co-invest vehicle rather than the individual manager will be treated. Managers using such arrangements should review them carefully in light of these rules.
There are two alternative definitions. First, a profit-related return that meets the following conditions:
- there are profits from the fund’s investments for a relevant period or from a particular investment;
- the sum arising to the individual is variable (to a substantial extent) by reference to those profits; and
- those profits are also used to determine returns to external investors.
It rules out sums that are essentially fixed.
Second, sums paid out of profits of the fund after investors have received all or substantially all of their investment, and external investors have also received a preferred return (of equivalent to at least 6%, compounded annually), either on a fund or a whole deal by deal basis.
The second, narrower definition summarised above remains from the original draft, and the intention is to reflect the description of typical carry arrangements agreed between the BVCA and Inland Revenue in the 2003 Memorandum of Understanding (which refers to higher hurdles) to ensure that sums described as carried interest do match the usual commercial arrangements. The first alternative may be of more general application for funds whose carried interest arrangements diverge from this.
Some other points
An anti-avoidance provision captures any arrangements the main purpose of which is to avoid the rules. There are also provisions to prevent double taxation.
Finally, these provisions relate to ensuring fees or other sums paid to fund managers are charged to income tax, and do not impact on other tax treatment, for instance VAT.
The Finance Bill is expected to receive Royal Assent imminently.