Investment Fund Managers: taxation of “disguised fees”

In his Autumn Statement, the Chancellor announced measures to prevent investment fund managers receiving guaranteed income from investment funds without paying income tax on it as trading or employment income. While this is no doubt targeted at arrangements such as GPLP structures, the draft legislation goes much further and potentially brings carried interest and co-investment interests into charge to income tax unless they fall within narrowly defined exclusions. The changes are due to come into force from 6 April 2015 and will apply to existing as well as new structures.


In a traditional limited partnership structure, a priority profit share of between 1.5% and 2% of investors’ commitments is paid to the general partner company which uses all or almost all of it to pay management fees to the investment manager, an LLP or company which pays tax on the fees as trading income. Where the fund does not have profits to pay the GP’s profit share, it makes an interest-free loan to the GP to put it in funds to pay the manager. HMRC did not have any problem with this.

In recent years, however, a number of funds have set up limited partnerships to act as general partner (so-called GPLPs) and brought individual managers into the GPLP as limited partners who then receive part of the GP’s priority profit share as limited partners in the GPLP rather than as a management fee. The tax treatment of these amounts reflects the nature of the profits of the fund. They might be dividends, interest, capital gain or – best of all, if the fund has not yet made any profits and has made an interest-free loan to the GP – possibly not taxed until the fund begins to make profits. The tax is invariably much less than it would have been if paid to them as management fees. In some cases, the managers have used their shares of the GP’s profit share to fund their co-investment commitments, with a larger net-of-tax sum to invest. HMRC are much less comfortable with this type of arrangement.

Finance Bill measures

The draft legislation treats any amount received by an individual investment manager from a collective investment scheme as potential disguised fee income if the scheme involves one or more partnerships, unless the amount:

  • is charged to tax as employment or trading income;
  • is carried interest (on a fund-as-a-whole or deal-by-deal basis) paid out of fund investments after investors have received all or substantially all of the amount invested plus a preferred return of not less than 6% compounded;
  • is paid by way of repayment or return of an investment in the fund; or
  • constitutes a commercial return on co-investment by the individual in the fund, defined as a return reasonably comparable to a commercial rate of interest and on terms reasonably comparable to those on comparable investments by external investors.

While the carried interest exclusion should cover standard MOU compliant carried interest, there are several funds with arm’s length commercial carried interest with a lower preferred return, generally coupled with a lower carry percentage. Such carried interest will be taxed as income if the draft legislation is not changed. This would be inappropriate if the managers receive a market-rate management fee and the carry is genuine carried interest on fund investments. It certainly is not a guaranteed amount of the sort which the Autumn Statement suggested was the target of these measures.

There is even greater concern about managers’ co-investments. These are excluded only if their return is equivalent to a commercial rate of interest, obviously inappropriate in the case of a fund invested in equities or real estate. This seems to be an obvious error on the part of the draftsman which it is hoped will be corrected before the legislation comes into force. It should be sufficient that the managers’ co-investment is on terms reasonably comparable to that of external investors, but even that could bring into charge co-investment which is not subject to the GP’s priority profit share or carried interest.

Action points

Fund managers should consider the terms of their management agreements and partnership arrangements to check that carried interest and co-investment falls within the exclusions as the legislation progresses through Parliament. In the case of co-investment in particular, the exclusion as currently drafted will almost certainly not be wide enough to provide any comfort, but this will be the subject of representations by the BVCA and others and seems likely to be reformulated. Existing GPLP or similar arrangements will probably lose their tax efficiency from April 2015 so consideration should be given to whether they should be dismantled in favour of a larger management fee or left in place and the additional income tax paid.

If you are party to arrangements which might give rise to disguised fee income, would like to receive further information or have points which you would like us to raise in the consultation process, please contact Natasha Kaye, Barry Stimpson, Graham Chase or your usual Olswang contact.

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