Disguised investment management fees: panic over?

Pat Dugdale

In our earlier blogs here and here, we reported on draft Finance Bill legislation which would potentially have resulted in income tax on private equity managers’ coinvestments in the funds they manage.  Fortunately it transpired that this was a case of “cock-up before conspiracy” (probably due to lack of industry knowledge on the part of the draftsmen) and the revised clauses in the Finance Bill published on 24th March should steady the nerves of the fund management industry. Since this blog was originally posted, the Bill has become law and useful Guidance Notes have been published which clarify some of the issues flagged up in the blog. The following has been updated to reflect these.

The Government did not intend to drive a coach and horses though the long-established tax regimes for carried interest and coinvestment but was targeting arrangements which sought to avoid income tax on guaranteed profit shares, typically GPLP arrangments. To recap, these enabled individual managers to receive part of the general partner’s priority profit share as limited partners in a general parter limited partnership (GPLP) rather than as a management fee. The amounts they received were taxed in the same way as the fund’s receipts, i.e. as dividends, interest or capital gain, or maybe  not taxed at all until the fund began to make profits. The tax was invariably much less than it would have been if the amounts had been paid to them as management fees and in some cases the managers  used their shares of the GP’s profit share to fund their co-investment commitments, with a larger net-of-tax sum to invest.

The original legislation included purported exemptions for carried interest and coinvestment but they did not reflect industry practice. For instance, coinvestment was exempted from charge only if the returns were comparable to a commercial rate of interest – obviously inappropriate for equity and real estate funds. Carried interest was excluded only if investors had a preferred return of at least 6%.

The Government has taken on board many of the points raised during the consultation process and the revised legislation is a marked improvement in many respects.

The coinvestment exemption now omits the commercial rate of interest requirement and now stipulates that:

  • the investment must be of the same kind as investments  by external investors in the scheme;
  •  the return, and the terms governing the return, must be reasonably comparable to the returns made by external investors.

There may still be some lack of clarity about the scope of “reasonably comparable”. Would it, for instance, cover coinvestment which is not subject to the general partner’s share or to carried interest? Guidance now published confirms that this will be treated as reasonably comparable.

The carried interest exemption now has two limbs, one being the original carve out for carried interest where investors have a preferred return of at least 6%. The other is more complex but is designed to distinguish between a genuine profit-related return and amounts where there is no significant risk of non-receipt. A sum will be treated as profit-related return if:

  • the sum arises only if there are profits on the investments (or on particular investments in the case of deal-by deal carried interest) or profits on the disposal of the investments;
  • the amount of the sum is variable to a substantial extent by reference to those profits;
  • returns to external investors are also determined by reference to those profits; and
  • the “no significant risk” carve out does not apply.

Amounts will not be carried interest for this purpose (and will therefore be taxed as trading income) if there was no significant risk that a sum of at least that amount would not arise to the individual. The risk is not measured at the time the carried interest kicks in (when receipt is, of course, highly likely) but instead at the the time the individual became party to the fund arrangements or began to perform investment management services to the fund or the time when a material change was made to the arrangements, whichever is later.

Carried interest is, of course, not always paid out of profits. In the case of fund-as-a-whole carried interest, it is often the case  that the best investments are sold first and investors are repaid out the proceeds. Investments realised after the carry kicks in may be realised at a loss, but the carried interest holders still receive 20% of the proceeds. This should not prevent the carried interest exemption applying provided that “investments” means the investments of the fund taken as a whole, rather than those whose proceeds are used to fund the carried interest. The Guidance notes now confirm this interpretation.

Internationally mobile managers

The revised draft legislation makes it clearer that individuals will only be treated as carrying on a trade in the UK to the extent that they provide the relevant services in the UK,  making the charge more proportionate than before.   Some commentators argued for a de minimis provision, ensuring that those who spent less than, say, 60 days a year in the UK would not be dragged into the scope of the disguised fees charge merely because they come to the UK for a few days to work on a transaction but that is not in the revised draft.

“Untaxed” fees

The legislation is designed to catch guaranteed amounts which are not already taxed as income. The original draft defined “untaxed” as income not charged to tax as employment income or profits of a trade in “the tax year”. It has been amended to refer to “any tax year” to prevent amounts falling into a double income tax charge merely because of timing differences.

Investment schemes

The legisation has now been extended to managers of investment trust companies. Previously it applied only to collective investment schemes (including partnerships, unit trusts and open-ended companies). Managers of venture capital trust companies and REITs are, however, still outside the scope of the legislation.

All in all  then, a great improvement on the December draft, but possibly still some wrinkles to iron out.


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