26 March 2015

UK changes tax rules on "disguised fees"

Last week's UK budget was interesting more for its political content than its tax reforms.  With an election just a few weeks away, most of the concrete announcements were designed to appeal to wavering voters – although there were one or two measures that the venture capital sector could welcome, including generous extensions to the Enterprise Investment Scheme and Venture Capital Trust rules, especially for investments in "knowledge intensive" companies.  (Click here for our full summary of last week's announcements.)

The private equity and venture capital sector has, though, been more interested in the detail of the Finance Bill, which was published on Tuesday this week and is now all but on the statute books.  That is because, in December last year, the government announced that it would change the way that it taxed certain sums arising to investment fund managers so that they would be treated as trading income subject to UK income tax and social charges.  And although the government made clear at the time that it did not want to include genuine carried interest or co-investment within these new rules – whose existing tax treatment it wanted to preserve – the draft legislation it published last year would have inadvertently included some of those payments within its ambit.  The detail of the final rules was therefore crucial.

At the time of last week's budget the government said that, following consultation, it had revised the rules to better reflect industry practice, but the industry had to wait until this week to see the detail of the law – and the inevitable accompanying guidance notes.  The new rules are indeed much more reflective of industry approaches to carried interest and co-investment schemes, and while not every such arrangement will fit within the government's definitions, the vast majority will (including those where the carried interest is not subject to a preferred return, which had previously been excluded). On the other hand, most structures which might previously have enabled some portion of the management fees earned by a general partner to be converted into investment returns are affected, including waiver of the management fee in return for funded co-investment, or streaming the fee through a tax transparent vehicle such as a limited liability partnership. And, as usual, not everything is completely clear: for example, one area that may cause some head scratching is whether reallocations of valuable carried interest in existing funds, including to new joiners, could trigger income tax charges under the new rules.

The final legislation includes wide anti-avoidance provisions that seek to bring other "unacceptable" structures within the scope of the income tax charge.  This, coupled with the ability for the government to change key exclusions by regulation, means that structuring which works 'technically', but undermines the key aim of the rules, is unlikely to work.  This should encourage the industry to play by the spirit of the government's rules when setting up new structures.

Refinement of the legislation, and helpful guidance on the extent of the exception for genuine carried interest and co-investment, is appropriate and welcome.  But the fact remains that the approach taken, which is to push everything into the income tax net and then define the exceptions for carry and co-invest, means that the statutory definitions – and the way they are interpreted in practice – will take centre stage.  These new definitions will dictate some of the commercial terms that will be offered by managers, and constrain the ability of funds to innovate new structures which might have been preferred by investors.  And it is also significant that the tax treatment of carried interest is, for the first time in UK law, dictated by a clear statement in primary legislation.  The longer term impact of that innovation remains to be seen.  

At a seminar in London on 26 March 2015 we explored the detailed impact of these changes.  Please contact us if you would like more information on the impact they may have on your management fee, carried interest and co-investment structures.

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