Hedge fund managers’ performance incentives: consultation launched

Pat Dugdale

In addition to the changes to the capital gains tax treatment of private equity carried interest announced today, HMRC has published a Consultation Document which appears to be targeted mainly at hedge fund managers. It aims to ensure that individuals who manage funds where the underlying activities are more closely aligned  to trading than investing  pay full income tax on any carried interest or other performance incentive.

The issue does not arise where the managers receive performance fees under their management agreement (as that is already trading income), nor where a partnership is clearly trading (as any carried interest would be taxed as a share of trading profits and therefore as income). HMRC is concerned that there is a grey area between trading and investment and that the traditional “badges of trade”, which were designed for old-style sale of goods, are no longer fit for purpose in this context.  HMRC believes that an increasing number of managers are taking an over-bullish approach and treating profits as investment gains rather than trading profit where more cautious managers would treat the fund as trading.  The advantage of investment over trading is that the managers’ carried interest profits are taxed as capital gains with a lower effective tax rate than income, and that is still the case despite the scrapping of base cost shift for carried interest in today’s Budget.

The proposal therefore is that there should be a default rule that all performance linked rewards paid to an individual performing investment management services are taxed as income unless the fund’s activities satisfy new tests for investment status.  Views are invited on two options:

Option 1: a list of activities which in the Government’s view are clearly investment including:

  • controlling stakes in trading companies intended to be held for at least three years;
  • real property where reasonable to suppose it will be held for at least five years;
  • debt instruments purchased on a secondary market and expected to be held for at least three years; and
  • equity and debt investments in venture capital companies subject to an, as yet, unspecified holding period; or

Option 2:  focusing on the average period for which investments are held by the fund, with 0% of the return eligible for capital treatment if the average holding period is less than 6 months, 25% for 6 – 12 months, 50% for 12- 18 months, 75% for 18 months to two years and 100% for over two years.

While the new rules appear to have been prompted by partnership funds, the new rules may also apply to managers’ shares in corporate fund vehicles if they serve the same purpose as carried interest.

The Government believes these would increase certainty and prevent distortions. This may be so but only if the investment qualifications are sufficiently clear. It will become even more important for fund managers at the time of investment to document their expectation to hold investments in the medium to long term to reduce the risk of trading treatment in the event of an earlier than expected sale. The plan is to publish a response document and draft legislation in Autumn 2015 with a view to commencement of the new rules in April 2016.

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