Financial Services

Love's labour's lost? Tax loss restriction rules and management fees: where are we now

Published on 18th Feb 2019

Further to the BVCA's update on 9 November 2018 as to the outcome of its lobbying with HMRC, we look at where matters stand on carried forward losses and management fee structures in UK funds.

Background: changes to rules on carried-forward losses

The rules governing the use of tax losses for UK corporation tax changed with effect from April 2017, introducing a restriction as to how companies can use carried forward losses that cannot be used in the accounting period in which they are generated.

The new restriction applies on a group-wide basis to tax losses generated both before and after April 2017 and provides that a corporate group can offset carried forward losses against:

  • 100% of the group's taxable profits of up to £5 million; and
    50% of taxable profits above this threshold.

What does this mean?

The restriction means that for larger groups there is more likely to be a mismatch between a company's profits for tax purposes and the profits shown in its accounts. This is likely to be a particular problem for general partners of funds (or corporate members of general partner LLPs) as the example below illustrates.


GPCo is the corporate member of a general partner LLP. The LLP is entitled to an annual priority profit share (PPS). GPCo's share of the PPS as member of the LLP is £2m. The full amount of the PPS is paid out to the fund manager in tax deductible management fees and so GPCo is not expecting to realise any profit for accounting or tax purposes.

The fund was not profitable in years 1-4. It therefore cannot pay the PPS as a profit distribution so instead pays the cash out in the form of a loan. Over the four years, GPCo (as member of the LLP) has been advanced £8m by the fund in loans. The loans are not taxable so GPCo has no taxable profits but has still been using the cash to pay management fees, so has £8m of carried forward tax losses.

In year 5, the fund realises investments and makes a "catch up" distribution to the LLP to cover the full PPS for years 1-5. GPCo's share of the distribution is £10m. GPCo has no accounting profit, because £8m of the distribution is used to repay the loans to the fund and £2m is used to pay the management fees in year 5.

For tax purposes, however, after deducting the year 5 management fees, GPCo is deemed to have £8m taxable profits. It can reduce this figure using its carried forward losses, but only to £1.5m because of the loss restriction rule. (GPCo can reduce its taxable profits by the £5m allowance plus 50% of profits above that. This assumes the £5m allowance has not been used up elsewhere in GPCo's group). GPCo will pay UK corporation tax on £1.5m, even though its accounting profit is £nil.

In principle, GPCo can carry forward its £1.5m of unused losses, but it should not make a taxable profit going forward (now that it has caught up on all prior years' PPS). The unused losses will ultimately be stranded in GPCo when the fund is wound up.

Since the PPS model cited in the example above is standard in the UK funds market, these rules are expected to have widespread implications. HMRC is aware of the impact of the loss restriction for general partners and industry bodies such as the BVCA have lobbied for a funds carve out, but it does not seem likely that the legislation will be amended to exclude them.

What's the alternative?

If the fund pays management fees directly (instead of the general partner paying them out of its PPS and accumulating losses in the early years of the fund), there will be no accumulated losses in the general partner (or corporate member) and no ultimate mismatch between its tax and accounting profits (which would both be £nil in the above GPCo example). This could result in a significant corporation tax saving in the general partner.

The downsides to the alternative option are that:

  • the fund will be charged 20% VAT on the management fees (unless the manager is VAT grouped with the fund) and this VAT may be irrecoverable and an additional cost in many cases – in practice, many managers may already be VAT grouped with the general partner (and therefore the fund) under an existing PPS model, so this is likely to be a particular concern where there is a third-party manager; and
  • the fees may not be tax deductible for the fund investors (particularly for individual investors) leading to a slightly higher effective rate of tax on fund returns.

Osborne Clarke comment

Sponsors of capital growth funds whose returns come in the later years of the fund's life should give serious thought as to how the management fees are structured and whether the traditional PPS model leads to a material tax liability in the general partner (or corporate member). While smaller funds may retain the PPS model where the accumulated losses fall below £5 million, we would expect a shift in market practice towards a more US-style management fee structure.

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* This article is current as of the date of its publication and does not necessarily reflect the present state of the law or relevant regulation.

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