Investment manager performance linked rewards: draft legislation
By Martin Shah, Partner, Tax, Simmons & Simmons
Published: 18 December 2015
The UK Government has released draft legislation to implement the Summer 2015 Budget proposals to restrict the capital gains tax treatment of carried interest and other performance linked rewards received by fund managers.
Following on from the surprise consultation released in July 2015 as part of the Summer Budget, a consultation response document and draft legislation released on 9 December 2015 as part of the draft Finance Bill 2016 confirms that new rules will considerably widen the imposition of income tax on performance linked rewards received by investment managers.
HMRC has been open in confirming the intention that any return received by an investment manager which is calculated by reference to the performance of the underlying investments over a given period, or the life, of the fund should as a starting point be taxed as income, however it is structured. It is no surprise, therefore, that the legislation in the draft Finance Bill clauses makes it clear that the exceptions to income tax treatment will apply very narrowly and only where a fund has a long term investment profile, excluding a significant number of funds, even where they are currently “investing” rather than “trading” for tax purposes.
Investment managers affected by the provisions, which will come into force from 6 April 2016, should carefully consider whether any changes to their structures are advisable as a result of these changes.
Not content with the recent changes to the taxation of salaried members, mixed membership partnerships, disguised investment management fees (DIMF) and carried interest, the Summer Budget saw the release by HMRC of a consultation on the taxation of performance linked rewards.
The consultation arose from concerns on the part of HMRC that investment managers outside the private equity and venture capital spheres were widely using carried interest and other arrangements to derive performance linked rewards as a return from the fund. Provided that the underlying fund vehicle is investing rather than trading for tax purposes, the performance linked interest in these circumstances would give rise to capital receipts charged to capital gains tax rather than income tax, reducing the amount of tax paid. In addition, amounts could be received as lower taxed dividend income, or potentially in untaxed form. A particular concern noted in the consultation was where such arrangements replaced performance fees that were previously taxed as trading income.
The consultation proposed a specific tax regime for performance linked rewards payable to individuals performing investment management services (using the wide definition in the DIMF rules). The measures would only apply to those individuals, and would not affect the treatment of the fund or its investors, or indeed “genuine” co-investment by the individuals. The default position under such a regime would be that rewards would be charged to tax as income.
However, the consultation contained two proposals that sought to maintain the current capital gains treatment for “private equity carried interest”. The first proposal was for a “white list” of activities that would be regarded as long-term investment activities. The second proposal instead focused on the average length of time for which a fund holds investments, with the proportion of the performance linked reward that would be taxed as a capital gain increasing in a series of 25% steps from 0% where the average holding period is less than six months to 100% where the period exceeds two years.
Draft legislation, together with a consultation response document, has now been released to implement the new tax regime for performance linked rewards as part of the draft Finance Bill 2016, with a commencement date of 6 April 2016. As feared by many in the industry, the draft legislation providing for the exception to the imposition of income tax on performance linked rewards will be tightly defined and difficult to meet.
The draft legislation confirms that the Government will adopt a version of “option 2”, providing an exception to the rules based on the length of time underlying investment are held, but in a much more onerous form. The Government has decided that the proposed holding periods set out in the consultation were too short and has considerably extended the holding periods required for the retention of capital gains tax treatment.
Under the new legislation, carried interest or other performance linked rewards received by investment managers that is not already taxed as trading or employment income will be subject to income tax treatment, unless it arises from assets held by a fund with an average holding period for its assets of at least three years. Where the holding period is more than three but less than four years, a sliding scale will determine the proportion of the return subject to income tax. Only if the average holding period is at least four years will capital gains tax treatment apply in full.
For these purposes, the average holding period will be based on the average holding period by the fund of investments held for the purposes of the scheme and by reference to which the carried interest is calculated. In turn, this is calculated on an investment by investment basis using the amount originally invested at the time the investment was made. The calculation is made at the time the carried interest arises. In this way, the legislation uses an average weighted holding period to determine the tax treatment of performance linked rewards such as carried interest.
In general, TCGA principles will be followed to identify whether and when a disposal of investments is made, including the reorganisation rules, but the share pooling rules will be disapplied and a “first in, first out” (FIFO) basis will be used. This means that each holding will be made up of the most recently acquired instruments, making it very difficult to meet the four year holding period where there is any turnover in shares. Indeed, a large sale even if made for sound investment principles will have a negative effect on the fund’s average holding period.
An exception is, however, made for an investment amounting to an increase in a controlling interest in a trading group, where the investment will be treated as made at the time the controlling interest was acquired. The BVCA has already indicated that it will be lobbying for more protection for the venture and growth capital sectors where minority stakes are the norm.
The consultation document does hold out the promise that HMRC will be “willing to discuss other situations where the provisions could be said to misrepresent the average holding period of a particular type of fund and to explore any unintended consequences”.
“In particular, the government understands that the investment model used by many venture capital funds may result in the above test producing a shorter average holding period and income tax treatment even where the fund is undertaking long-term investment activity. HMRC is keen to engage with industry representatives so as to ensure the average holding period test accurately reflects the activity undertaken by venture capital funds.”
For the purposes of determining the investments against which to measure the holding period, the legislation provides for intermediate holdings or holding structures to be disregarded. The definition of what amounts to an investment for these purposes is wide, but excludes cash awaiting investment or cash disposal proceeds that are to be distributed to investors as soon as reasonably practicable. Derivatives are included, although separate rules determine the value invested in a derivative. “Direct lending funds” are specifically excluded from capital gains tax treatment, unless additional strict conditions are met as to the composition of the fund’s loan portfolio.
This method of calculation would, of course, mean that for new funds the first performance linked rewards would prima facie be taxed as income as the holding period will be less than three years. However, the legislation allows conditional capital treatment to be applied from the outset where it is reasonable to suppose that the conditions for the exemption would be met at the relevant later time. This will, at least, allow funds which do have clear long-term investment objectives (such as real estate and some private equity funds) to obtain capital gains tax treatment from the outset.
Finally, the legislation includes the obligatory anti-avoidance provision which provides that any arrangements which have as a main purpose the reduction in the proportion of carried interest which is subject to income tax treatment are to be disregarded.
The draft legislation makes it clear that very few hedge funds or other funds, except for private equity, real estate or infrastructure funds, will be able to qualify for continued capital gains treatment on carried interest or other performance linked rewards.
Even where funds do have a long term holding strategy sufficient to fall within the exception to the legislation, it will be necessary to consider whether the possible advantages outweigh the costs of a more complex structure, more difficult compliance and the risk that investment decisions will remove the advantage anyway. There is, in addition, the risk that managers may find themselves in a position of conflict, between maximising their investors’ returns and seeking capital gains tax treatment.
The draft provisions will now undergo a further period of consultation leading up to Royal Assent of the Finance Act 2016. It is at least welcome that the consultation response document shows that HMRC is open to further discussion on the detailed calculation of the average holding period.