The new anti-avoidance provisions aimed at ensuring that investment fund managers are not able to avoid or defer income tax on management fees, which we referred to in our Winter 2015 update, have now come into force. So what are the implications for fund managers?
New anti-avoidance rules have been introduced with effect from 6 April 2015, with the aim of ensuring that management fees arising to individuals managing investment funds are charged to income tax.
The rules are aimed in particular at private equity funds structured as partnerships with a limited liability partnership (LLP) or second limited partnership (GP/LP) as their general partner, but are not limited to these kinds of structures. The tax-planning which the rules aim to catch includes the payment of the fund’s annual fee by way of a priority profit share (PPS), some of which is then allocated to individual partners in the LLP or GP/LP before the balance is passed on to the fund manager/adviser. The chief perceived benefits of this kind of structure were the delay in accrual of tax on the amounts received by those individuals, and, in some cases, payment of tax on all or some of those amounts at the lower capital gains tax rate.
What is “disguised fee income“?
The new rules attack “disguised fee income“, which will arise if:
- individuals are performing investment management services;
- the arrangements involve at least one partnership;
- a management fee arises to the individual directly or indirectly from the arrangements; and
- that fee is not already charged to income tax.
The arrangements cover loans as well as fees (i.e. it will no longer be possible to defer tax on management “fees” by structuring them as profit shares which may be drawn in the fund’s early years by way of a loan from the partnership).
The new rules are not intended to affect carried interest, a return of capital invested by the individuals on the management team, or profits on that investment and there are three corresponding exceptions from income tax treatment for investment managers.
In terms of carried interest, a standard model following the pattern established in the 1987 MOU (‘Memorandum of Understanding between the BVCA and HM Revenue & Customs on the income tax treatment of Venture Capital and Private Equity Ltd Partnerships and Carried Interest‘) will fall within a safe harbour and be automatically excluded from the new rules. For any other carried interest model (including where the preferred return is less than 6%) the carried interest must satisfy certain other tests, although the nature of these means they will be satisfied in most cases. They require that
- the carry arises only if the fund is making profits (which can include on a deal-by-deal basis);
- the sum which may arise must vary substantially by reference to profits;
- the investments used for these tests must be the same ones by which returns to external investors are measured; and
- there must be a significant risk that the carry would not arise.
Similarly any standard management co-invest model should be excluded, as long as the team are investing their own capital and receiving returns reasonably comparable to the returns arising on external investments in the fund. HMRC have accepted that a waiver from management fees or carried interest in respect of the team’s co-investment will not cause it to fail this “reasonably comparable” test. Co-investments made using a loan provided by the team’s employer will need to be considered carefully, as these may fall foul of the new rules if the loans are not on arm’s length terms.
The rules as enacted contain a number of improvements to the original draft legislation (which was widely criticised). However the default position – that all returns to management will be treated as liable to income tax on receipt unless they fall within the three exceptions – means that it may be difficult for investment managers to adopt innovative fee structures or carried interest arrangements. We expect that managers may still want to adopt PPS structures owing to their beneficial VAT treatment but careful structuring will be required.