Refresher on UK taxation of fund managers

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In recent years, HMRC have become concerned that some individuals working for asset management businesses were not paying sufficient (or in some cases any) taxes on their remuneration, namely investment management fees, carried interest and performance fees.

The government, therefore, introduced rules which were designed to ensure these individuals paid an appropriate amount of tax on their earnings.  These were introduced in stages, the first of which took effect on 6 April 2015.

The rules are extremely difficult to navigate. HMRC seem to be of the view that there is a high risk of non-compliance amongst fund managers, due to the complexity of the rules and, in some cases, individuals not being aware of them. We are increasingly seeing HMRC audits, and in some cases HMRC are trying to use their powers of ‘discovery’ to assess tax for years for which the usual statute of limitations has closed.  From experience, HMRC are focused on whether the correct amount has been reported on the individual’s return, taking account of the detailed operation of the legislation, discussed below.

As such, we thought this would be an appropriate point in time to provide a refresher on the rules.

When an individual performs investment management services for a fund, it is necessary to consider the application of the rules.  There are two sets of rules to consider, the ‘disguised investment management fee’ (‘DIMF’) rules and the carried interest rules.

A DIMF charge arises when:

• an individual performs investment management services in respect of an investment scheme under any arrangements; and
• a ‘sum’ (i.e. ‘money’s worth’) arises from the scheme to (i) the individual, (ii) to someone else connected to the individual other than a company (e.g. spouse, close family member or family trust) or (iii) to an unconnected person or a connected company and one of the ‘enjoyment’ conditions is met.  The ‘enjoyment’ conditions are very widely drafted and give rise to interpretation difficulties.  However, very broadly, they are intended to kick in if the sum may benefit the individual or a connected person, either now or at any time in the future.

A sum arising to an individual that is considered DIMF income is subject to 45% income tax and 2% NIC.

There are, however, certain cases where a sum is received for investment management services and it is not considered DIMF. These exceptions apply when the sum received is:

• A capital repayment of co-investment made by the individual in the scheme. The sum arising must be in relation to an investment that has the same terms as an investment made by an external investor in the same fund.
• An arm’s length return on co-investment that the individual has made in the scheme. Again, the sum arising must be in relation to an investment that has the same terms as an investment made by an external investor in the same fund.
• Carried interest, in which case it is taxed under the carried interest rules (explained below).
• An amount for which the fund manager has paid market value.
• Already taxed as employment income or trading profits of the individual.
• The sum arises to an unconnected person or connected company (see above), but meets one of two very narrowly defined exemptions, being:

1. that the sum arises to either a UK company and is subject to UK corporation tax or to a non-UK company and is subject to foreign tax at a rate of at least 75% of the UK corporation tax rate; or
2. the sum arises to a company in which the individual personally owns shares.

The two exemptions above do not, however, apply if the structure has a main purpose of avoiding income tax, capital gains tax, corporation tax or inheritance tax.

The carried interest charge applies (instead of DIMF) when the sum arising to an investment manager is considered DIMF, but the carried interest exemption applies. The sum arising must meet the definition of carried interest to qualify, namely:

(i) the structure must be of a standard private equity European waterfall model, whereby investors receive a 6% preferred return and return of capital before carry becomes payable; or

(ii) there was a significant risk when the carried interest was granted to the individual that no sums would subsequently arise to the individual.

If the carried interest exemption applies, then the following rules apply:

• The sum arising is still considered as DIMF (and taxed at 47%) if the sum arising meets the definition of Income Based Carried Interest (‘IBCI’).  The sum is IBCI, broadly, if the investments giving rise to the payment have a weighted average holding period of less than 40 months, subject to various exceptions (NB – the IBCI rules apply only to sums arising from 6th April 2016).
• Otherwise, the carried interest is taxed at 28% (capital gains rates), unless the actual profit is income in nature, in which case it is taxed at income rates.
• Where capital gains rates apply, non-domiciled individuals who file on the remittance basis are eligible to treat a portion of their carry as ‘foreign’ and are therefore taxed only if it is remitted to the UK. There is no fixed rule for calculating the portion of UK taxable carried interest.  The most common method is to apportion the carry based on workdays over the life of the fund, or from the date the individual started working for the fund.  Appropriate bank account segregation is required if the individual wishes to be able to remit the UK portion of the carry to the UK without being deemed to have remitted the offshore portion.
• The opportunity to claim overseas workday relief is very limited if the carried interest is considered ‘IBCI’. This is only available for individuals who were non-UK resident for at least 5 years before their arrival in the UK. The relief is only available for the first 5 years of UK residence in relation to pre-arrival services only.

The DIMF and carried interest rules are extremely complex. However, our team in London have extensive knowledge and practical experience in dealing with HMRC on the matter.

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