Effective from April 6, 2015, new rules in the UK seek to tax “disguised investment management fees” as ordinary income (the “DMF Rules”). The trick is to know a disguised management fee when you see one. The DMF Rules may affect not only funds managed or operating in the UK, but potentially any fund that undertakes activities in UK (for example, a representative of the manager meeting with a UK investor). This article serves as a starting point to help readers make sense of the new regime in 10.5 points. 1

1. The DMF Rules apply to all disguised management fees. Any amount “arising” to a management team is treated as a disguised fee unless it satisfies the DMF Rules' definition of either carried interest (carry) or a return on investment (co-invest).


1.5

We note that the rules rest heavily on the meaning of the word “arising,” which is not a defined term. HM Revenue & Customs (“HMRC”), the UK tax authority, has issued guidance that an amount arises when an individual has access to the funds – including where the individual can direct how the funds are used.

2.

The exceptions for carried interest and co-invest reflect an imperfect vision of commercial reality. It is therefore important not to jump to the conclusion that carry and co-invest arrangements are automatically outside the scope of the DMF Rules.


3.

To fall within the carried interest definition, a return must be made out of profits, variable and at risk of not arising. If it is virtually certain that an amount will arise, such amount will not be treated as carried interest.

4.

A carried interest safe harbor applies where returns are made out of profits, after external investors have received back all of their invested capital together with a preferred return of 6% annually compounded interest thereon. In practice, we do not expect this safe harbor to be heavily used, as most carried interest arrangements should fall within the basic definition of carried interest.

5.

Co-investment returns are trickier. The return needs to be an arm’s-length return in respect of an investment made directly or indirectly by a member of the management team. To be arm’s-length, a return must be comparable to the returns of an external investor (although importantly, HMRC has accepted that a co-invest return paid free of management fee and/or carry is still comparable to the return obtained by an external investor).

6.

The difficulty with co-invest stems from the requirement in the DMF Rules that the investment be made by the individual. Although the investment may be made directly or indirectly, indirectly looks vertically down the chain of ownership, not horizontally. Therefore, in a leveraged co-invest arrangement where the general partner obtains third-party financing and invests the borrowed money into the fund on behalf of the individuals, it is difficult to argue that the investment is made by the individuals. This may not be an insurmountable problem, however, as one may argue that any co-invest return flowing to the team in respect of such an arrangement satisfies the carried interest definition in the DMF Rules. In particular, the safe harbor for carried interest may come into play in the analysis.

7.

The application of the DMF Rules to management fee reduction or deferral mechanisms throws up interesting questions. The variety of such mechanisms is so extensive that it is difficult to make generalizations about their treatment under the DMF Rules. We note, however, that mechanisms where there is minimal discretion in the application of the fee reduction – and where the management team takes downside risk in respect of the value by which the management fee is reduced because returns are based purely on the existence of distributable profits – appear to fare better. Again, it is possible that the carried interest safe harbor could prove useful when analyzing these mechanisms.

8.

It remains to be seen how corporate (as opposed to partnership) structures will be treated under the legislation. In particular this is relevant to funds that have a corporate general partner. HMRC has hinted that it will respect genuine corporate arrangements, but where a corporate entity lacks substance it is possible that the arrangement will be open to challenge by HMRC on the basis that an amount has arisen to the management team as soon as money is distributed to the corporate entity. Where cash is not immediately distributed out to the shareholders this could give rise to a “dry” tax charge (without any corresponding cash income), which would effectively prevent pre-tax co-investment programs from working properly.

9.

UK funds are typically structured so that a general partner’s share is paid by the fund to the GP. In the early years when there are no profits this amount is paid as a non-recourse loan. Out of the general partner’s share, it pays the management fee to the manager, and any excess left in the general partner is then distributed to the management team. The distribution is treated as a profit share and therefore, in a fund pursuing a buy out or similar investment strategy, potentially treated as capital gain. For UK taxpayers this distribution is subject to 28% tax, and for non-domiciled UK taxpayers the distribution retains its original source, which may be non-UK. The source is important because UK non-doms pay UK tax only on amounts that are remitted to the UK or which have a UK source. Going forward, these distributions or payments of management fees will be deemed to be UK source and taxable at 47% for UK resident taxpayers.

10.

Technically, the DMF Rules could also apply to non-UK residents to the extent that such persons undertake investment management activities in the UK. Investment management activities are defined very broadly in the DMF Rules and include fundraising activities and research. However, the UK has a very large treaty network; therefore, we would expect the majority of investment managers to benefit from a double tax treaty to prevent any double taxation arising. But those managers relying on a treaty must learn to recognize a disguised fee under the DMF Rules to begin with.

Endnote

1.  Note: For those interested in a more technical analysis of the DMF Rules, Debevoise has published two Client Updates: “Are Your Carry and Co-Invest Returns Safe from UK Income Tax? (Sadly Your Management Fee Probably Isn’t.)” and “More UK Tax? Additional Guidance on the Disguised Management Fee Rules. These updates are available on our website at http://www.debevoise.com/~/media/files/insights/publications/2015/03/
20150325_client%20updateare_your_carry_and_coinvest_returns_safe.pdf
and http://www.debevoise.com
/~/media/files/insights/publications/2015/03/client_update_new_uk_tax_client.pdf
, respectively.