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Out-Law News 2 min. read

New rules ensuring 'disguised' investment management fees will be taxed come into force


Rules designed to ensure that investment managers pay income tax on certain fees and other payments received as remuneration for investment management services have come into force.

The change, which came into force as part of the 2015 Finance Act, is designed to ensure that sums received by individuals who are partners in firms that manage investments pay income tax rather than capital gains tax on  amounts which are  "disguised" investment management fees. The change was made to target structures used by private equity firms, in particular, where annual fees were paid as priority partnership shares to avoid an income tax charge on the fees.

Corporate tax expert Tom Cartwright of Pinsent Masons, the law firm behind Out-Law.com, said that the legislation was "much more targeted" than what was originally proposed as part of December's Autumn Statement. The final rules specifically exclude carried interest and coinvestment returns received by the investment manager, he said.

"The fear in the industry was that the changes as originally drafted were far more extensive than they were purported to be," he said. "However, HMRC has taken on board the majority of comments made to try to make the measure much more targeted at the mischief they perceive from untaxed management fees being paid to managers through the use of certain types of structure."

Carried interest is the share of the profits realised from a fund's investments that is paid to executives of a private equity fund. Such executives also sometimes have coinvestment rights to invest directly in the company in which the private equity fund is investing. A Memorandum of Understanding agreed on 25 July 2003 between the Inland Revenue and the British Venture Capital Association (BVCA) sets out the circumstances in which carried interest will be subject to capital gains tax rather than income tax.

The new rules will affect fees which are paid to individuals who have provided investment management services directly or indirectly to an investment scheme involving at least one partnership, where at least some of the fee is not subject to UK income tax. They will ensure that where part of a general partner's priority profit share (PPS) is used to compensate a fund manager for investment services either in a non-taxable form or as a capital gain, this will be treated as an investment management fee and taxable as income.

The original draft of the legislation contained very narrow definitions of both carried interest and coinvestment, requiring a minimum preferred return of 6% and a coinvestment return at a rate "reasonably comparable" to a commercial interest rate to prevent these payments from being treated as earned income. Both of these definitions were widened in the final legislation to address industry concerns that the rules would otherwise catch genuine carried interest and coinvestment arrangements that did not fit within the narrow definitions.

The final rules no longer require qualifying carried interest to carry a minimum preferred return of 6%. The final definition of coinvestment focuses on an arm's length return that is "reasonably comparable to the return to external investors", which should ensure that genuine arrangements where a fund manager is required to invest some of his or her own capital into the scheme are not caught by the changes, Cartwright said.

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