Disguised Investment Management Fees (DIMF) and carried interest – In search of guidance?
By Michael Beart, Larkstoke Advisors
Published: 22 March 2021
My last article for the AIMA Journal on the UK’s disguised investment management fee (DIMF) and carried interest legislation was featured back in Edition 111, where I described the rules as “a riddle, wrapped in a mystery, inside an enigma”. Whilst little has changed since then in terms of the legislation, in that article I noted that we were due updated guidance. Finally, in October 2020, HMRC published the aforementioned updates to their guidance in the Investment Funds Manual, a five-year gap after the rules came into force in 2015. Whilst draft versions of the guidance had been in circulation since October 2016, the extended wait before official publication hints at the level of subjectivity involved and the deliberations as to how the legislation could or should be interpreted. In the absence of any case law on the subject the guidance has been widely welcomed.
By way of recap, the legislation seeks to ensure that remuneration from funds attributed to individuals as a result of investment management services being performed in the UK is taxed as either employment income or trading income, unless those amounts relate to carried interest. Amounts categorised as carried interest are then taxed at either special capital gains tax rates or (if they are determined to be income-based) at the standard income tax rates. Traditional management and performance fee models will typically see all receipts from the fund treated as fee income.
The legislation is complex, being updated twice in the year of its release, meaning some managers either misunderstood or overlooked the rules when first implemented. The revisions, which the guidance discusses in detail, mean that any arrangements (structural or otherwise) that sit between the fund and the individual may be disregarded. Furthermore, income and gains that may otherwise be regarded as outside the UK may be deemed to be UK-based or UK-situs respectively. The result is that the individual providing those investment management services in the UK is required to consider what obligation they have personally to report a charge under the legislation.
Similar to other anti-avoidance legislation in the UK, the rules require personal tax advisors to understand and analyse the corporate structure through which an individual (who is providing investment manager services) is remunerated. This requires a significant level of investigation and a level of detail that the individual taxpayer may not readily have available. Logically advice at the corporate level often focuses on fee flows and tax liabilities recognised in the financial statements, therefore the potential for the topic to fall in a gap between personal and corporate advisors is high.
Complicating matters further, the rules potentially cut through personal planning that individuals may have undertaken as part of becoming deemed domicile in the UK. Taxpayers acting in good faith hoping to fall within the carve-outs afforded by the UK Government may be inadvertently caught out by the rules. Additionally, if there is any non-compliance pre-April 2017 then the UK’s requirement to correct legislation could lead to some particularly costly outcomes for taxpayers.
Another angle to consider is the fact non-residents can also be caught by the legislation. Whilst occasional visits to the UK should not lead to a tax liability, frequent visitors or those establishing a pattern of behaviour that could be regarded as trading from the UK will have an exposure. Double tax treaties do provide some protection, but those individuals with a UK focal point to their work or seeking to manage their UK day count in order to stay non-resident should review their position carefully. If they personally create a permanent establishment as a result of their UK activities then the business profits articles typically found in double tax treaties will not provide protection.
Increasingly, individuals in the asset management sector are finding that their tax position is being scrutinised in detail by HMRC, usually as a result of declaring income out of a non-UK vehicle, e.g. dividends / partnership allocations. What starts as a relatively benign round of questions can escalate into an enquiry that spans the corporate structure and other individuals in the business. Naturally, inconsistencies between the filing positions adopted by taxpayers will lead to tensions between the parties, noting there may be a divergence in the advice received at a personal and corporate level, or indeed between different advisors. Such tensions can only compound the alarm that unexpected enquiries, tax bills and advisor fees will raise.
The newly released guidance addresses the key changes introduced on 22nd October 2015 that impact the taxation of most management and performance fee structures. This clarification, as it was positioned at the time, advanced the already complicated rules to the status of weapons-grade legislation, stacking the deck clearly in favour of HMRC. Specifically, from this date certain ‘enjoyment conditions’ were imposed (borrowed from some of the UK’s other anti-avoidance legislation) to attribute fees directly to individuals, thus creating a ‘deemed trade’ in the UK.
Whilst exemptions exist to disapply the enjoyment conditions, there are also barring conditions that disapply the exemptions. The exemptions are barred when (a) it is reasonable to assume that, in the absence of those arrangements, amounts would have arisen to the individual performing the service or an individual connected with them; and (b) it is reasonable to assume that the arrangements have as their main purpose, or one of their main purposes, the avoidance of tax.
When analysing clause (a) HMRC guidance sets out a long list of things to consider, including fund structure, tax advice received, management company structure, the size / international spread of the management team, whether it operates on a commercial basis and if the individual receives an arm’s length rate of remuneration. It also cites the need to have sufficient economic substance to support the arrangements in place, an area that many jurisdictions have had to focus on in recent years. Importantly no one factor is deemed to be decisive as the analysis depends on the facts and circumstances.
The point of contention when interpreting this rule is whether an individual in an owner-managed asset management business is entitled to be able to treat their remuneration for services rendered separate from the return they may receive as an equity owner in the business. The argument made by equity owners is that they should legitimately be able to expect an equity style return on surplus profits (i.e. after remuneration) without sums being recharacterised as trading income. Whilst there is clear logic in this argument, a wholly UK business operating as an LLP would not be afforded such treatment as the mixed membership rules essentially force 100% profits that individuals can ‘enjoy’ to be taxed as trading income.
For clause (b), tax avoidance includes the avoidance of a liability to pay UK income tax, capital gains tax, inheritance tax, or corporation tax. However, the most contentious and notable feature of this test is the fact that fees re-invested back into a fund will automatically be regarded as meeting this requirement. Given that co-investment is often viewed by investors as somewhat of a mandatory requirement such a clause seems entirely at odds with the commercial position.
In essence, the legislation creates a higher threshold in compliance terms for individuals working in asset management than any other industry in the UK (a fact that many in the general public may not appreciate). Conceptually that in itself is not a concern, indeed some would argue that it was necessary to rebalance the relationship after HMRC continuously found themselves one step behind the industry. However, for others the level of uncertainty surrounding the application of the legislation is a deterrent, acting as a potential barrier for those seeking to move to the UK, and also a catalyst for them to leave.
Such concerns come into sharp focus at a time when UK competitiveness is under increased scrutiny, particularly around financial services, as such the release of the guidance now can only be viewed as a good thing. Furthermore, HMRC are increasingly supportive of helping taxpayers outside of the standard self-assessment regimes, an approach that is actively encouraged, either directly through non-statutory clearance procedures, or more commonly indirectly through advisors. The message from inside the corridors of power is clear: “We are here to help”. How the relationship between asset managers and HMRC evolves on this topic will be key to driving sentiment across the industry. Historically taxpayers have been reluctant to actively engage so this is a change in mindset. Greater transparency needs to be rewarded with greater certainty, although some would argue the reverse. Either way, trust has to be earned.