Technical Spotlight: Taxation of credit fund managers

Individuals in the UK’s asset management industry have been subject to three very significant tax changes in the last 12 months, including, most recently, the further changes to the taxation of carried interest in the Finance Bill 2016.

These changes are primarily intended to address the taxation of amounts arising to individuals in the asset management industry which are not otherwise subject to income tax, either as employment income (in the case of employees) or trading income (in the case of members of an LLP). The new rules address this by effectively:

1. taxing all amounts arising to individuals from the funds they manage as trading income, save in respect of limited categories of co-investment and carried interest. On current rates, this results in an effective rate of tax of 47 per cent (45 per cent income tax and two per cent NICs) on amounts which may previously have benefited from a lower rate of tax, e.g. as a capital gain; and
2. taxing carried interest, which is not regarded as trading income, at a minimum rate of 28 per cent.

Application of these changes to credit funds

The changes apply to asset managers across all asset classes and, in principle therefore, will need to be considered by managers of all forms of credit funds. There are two circumstances in which individuals may be more relaxed about their application:

1. where they already receive all amounts in respect of the funds they manage as employment income or trading income, as those amounts will already be subject to tax at the highest income tax rates, e.g. where those individuals do not have any equity or debt interest in the underlying funds; and
2. where the funds they manage are not a collective investment scheme (CIS), e.g. many funds which are established as non-UK body corporates.

• Recent changes arguably represent the most seismic shift in the taxation of individual UK asset managers in the past 30 years.
• They apply across all asset classes, including credit and debt funds, but generally not to CLOs.
• A general understanding of their scope is critical – and is likely to help shape the structure of carry, co-investment and perhaps even investment strategy.

Many individuals in the CLO industry should not, therefore, be affected by the changes, either on the basis that they do not have any equity interest in the CLO or because the CLO is not a CIS. The changes will, however, be of direct application to managers of credit funds which are established as UK or non-UK limited partnerships.

Implementation – a brief history

The changes have been introduced in three instalments:

1. the disguised investment management fee rules (DIMF Rules), which apply to amounts arising to individuals on or after 6 April 2015;
2. the basic carried interest rules (CI Rules), which apply to amounts arising to individuals on or after 8 July 2015; and
3. the income-based carried interest rules (IBCI Rules), which apply to amounts arising to individuals on or after 6 April 2016;

in each case, largely irrespective of when the fund was established or investments were made. The DIMF Rules and CI Rules apply to asset managers irrespective of whether they are employees or not. Somewhat oddly, the IBCI Rules do not apply to employees and are mainly of relevance to LLP members.

DIMF Rules

The DIMF Rules broadly tax all amounts arising to individuals from a CIS fund (other than defined categories of coinvestment and carried interest) as trading income, i.e. at 47 per cent. UK resident doms and non-doms are taxed in the same way under these rules. Co-investment covers most normal co-investment arrangements, i.e. where individuals co-invest alongside and pari passu with investors, subject to management fee and carried interest waiver, but may not cover other types of more structured co-investment arrangements, e.g. arrangements involving leverage. Carried interest generally includes only carried interest which is profit-dependent and subject to significant risk or carried interest which is subject to a preferred return of at least six per cent.

CI Rules

Under the CI Rules, all carried interest (other than incomebased carried interest – see below) is broadly treated as capital gain and subject to a minimum 28 per cent capital gains tax charge – notwithstanding a reduction in the headline rate of capital gains tax to 20 per cent for other assets. These rules operate in tandem with the existing carried interest rules, rather than replacing them, and so to the extent that any carry payment is made out of dividend or interest income, the higher income tax rates of 38.1 per cent and 45 per cent will apply, with credit for any 28 per cent charge.

UK resident doms and non-doms are taxed slightly differently under these rules, in that a proportion of any capital gain deemed to arise to a non-dom from a non-UK investment will be regarded as a foreign chargeable gain and therefore eligible for the remittance basis to the extent that the relevant asset management services are performed from outside the UK. Non-doms may therefore wish to keep a record of how much time they spend working outside the UK on their funds.

IBCI Rules

Under the IBCI Rules, carried interest which is income-based carried interest will be taxed as trading income under the DIMF Rules at 47 per cent. Again, UK resident doms and nondoms will be taxed in the same way in respect of incomebased carried interest.

Summary

All amounts arising to individual asset managers will be subject to income tax and NICs at a combined 47 per cent, save for:

1. vanilla co-invest; and
2. carried interest which is:
   i. subject to a preferred return of six per cent or significant risk; and
   ii. is not income-based carried interest.

Income-based carried interest

The IBCI Rules take up over 20 pages of Finance Bill 2016. The following paragraphs are not, therefore, intended to be an exhaustive guide to the new rules – rather a summary of some of the key features which may be relevant in the context of credit funds. As noted above, employees are not within the scope of the IBCI Rules so the following is mainly of relevance to LLP members.

The general rule

The basic premise of the legislation is simple – carried interest arising to individuals (other than employees) will be regarded as income-based carried interest and taxed as trading income unless the average holding period of the investments of the fund by value is at least 40 months (assuming a whole of fund carry). A proportion of carried interest will be regarded as income-based carried interest if the average holding period is between 36 and 40 months:

Carried interest, for these purposes, follows the definition in the DIMF Rules. Carried interest which is not income-based carried interest will be taxed under the CI Rules set out above (which will thus result in lower tax rates being payable).

Direct lending fund rules

The general rule is supplemented by a number of different regimes for different types of fund. In respect of direct lending funds, the default position is that all carried interest constitutes income-based carried interest. A direct lending fund is a fund which is not subject to one of the other fund regimes under these rules and in relation to which it is reasonable to suppose that, when investments cease to be made, more than 50 per cent of the investments made by the fund will have been direct loans. A direct loan for these purposes is an advance of money to any person at interest or for any other return determined by reference to the time value of money and, importantly, includes any loan acquired by the fund (on syndication or in the secondary market) within 120 days of being made. Generally, therefore, credit funds which intend to undertake direct lending will typically fall within these rules, whereas credit funds which intend to invest in the secondary market outside of the 120 days will typically not. Credit funds which take equity stakes as part of their investment strategy may fall within one of the other fund regimes and should consider their position carefully.

The exception

The presumption that carried interest in respect of a direct lending fund is income-based carried interest is disapplied where:

1. the fund is a limited partnership (or equivalent formed outside the UK);
2. the carried interest is subject to a preferred return of at least four per cent; and
3. it is reasonable to suppose that, when investments cease to be made, at least 75 per cent of the direct loans (calculated by reference to value) will have been qualifying loans.

Qualifying loans are arm’s-length loans made to unconnected borrowers with fixed and determinable repayments, a fixed maturity and a relevant term of at least four years (the relevant term is the period from when money is advanced until the time by which at least 75 per cent of the principal must be repaid under the terms of the loan). The fund must also have the intention to hold the qualifying loan to maturity.

Many direct lending funds are now being established as limited partnerships and, in principle therefore, will be able to benefit from this exception. The requirement that at least 75 per cent of the investments of the fund need to have been qualifying loans may present difficulties where the fund expects to syndicate some or all of its loans, however, because to be a qualifying loan the fund must intend to hold it to maturity. Any syndication policy should therefore be considered very carefully by any direct lending fund which hopes to fall within the exception.

Where a fund falls within the exception, the extent to which any carried interest in respect of that fund constitutes income-based carried interest will be determined by the general rule, i.e. by reference to the average holding period of the investments in the fund.

Average holding period

The calculation of average holding periods is clearly critical to the determination of income-based carried interest and is broadly determined by reference to when amounts are invested and when the investments funded by those amounts are disposed of. Large investments, follow-ons, part disposals and syndications may therefore have a disproportionate effect on the average holding period of investments in a fund.

Syndication

In a credit funds context, therefore, any syndication strategy needs to be considered very carefully. Certain part disposals/syndications can be disregarded where, among other things, the “unwanted investment” is disposed of within 120 days of acquisition and does not constitute more than half of the original investment but we recommend that, at least initially, this is reviewed on a case-by-case basis.

Early repayment of principal

The early repayment of loans may also have a disproportionate effect on average holding periods. In recognition of this, the IBCI Rules provide that, in the context of a direct lending fund, where the principal amount of a qualifying loan (see above) is repaid within 40 months of the loan being made, the whole loan will generally be deemed to have been held for 40 months provided it is reasonable to suppose that the borrower’s repayment was not concerned with the application of these rules. This deeming provision is, however, limited to qualifying loans only.

Conclusion

Application

Individuals managing credit funds which are established as collective investment schemes (e.g. limited partnerships and open-ended fund vehicles) are likely to be affected by some or all of the rules described above. In analysing their position, the starting point is that they should expect to pay tax at 47 per cent on all amounts arising to them from those funds which are not otherwise
subject to employment or trading income taxes, except to the extent that those amounts represent returns on a vanilla co-investment or carried interest which is profit-dependent and subject to significant risk or subject to a six per cent preferred return.

In addition, those individuals who are not employees will then also need to consider whether any carried interest arising to them (which is not otherwise taxed at 47 per cent) is income-based carried interest and therefore also subject to tax at 47 per cent. This will depend on whether the fund is a direct lending fund and, if it is not a direct lending fund or falls within the exception for direct lending funds, on the average holding period of investments in the fund. In either case, carried interest which escapes the 47 per cent charges above will be subject to a minimum 28 per cent capital gains tax charge. If the carried interest is entirely funded out of capital or capital gains, there is no further UK tax to pay. However, there will be additional tax to pay at the appropriate dividend and interest rates if the carry is funded out of income.

Finally, non-doms may benefit from the remittance rules in respect of part of their carried interest under these rules if it relates to a non-UK investment and the individual performs some or all of their services outside the UK.

Practical points

The application of some of the rules set out above depends in part on the investment strategy and profile of the fund. It may therefore be sensible to include reference, where appropriate, to anticipated holding periods in prospectuses and information memoranda. Syndication strategies should be considered very carefully because this could have a disproportionate effect on the average holding period of investments in the fund.

Direct lending funds which intend to take advantage of the exception to the default position on direct lending funds should ensure that 75 per cent of their loans will meet the qualifying loan test. None of these sets of rules impose employers’ NICs. Thus, even where the above rules apply, it may still be worthwhile for employers to give equity interests to employees rather than pay them bonuses. Non-doms may wish to record time worked outside the UK on their funds to benefit from the remittance basis under the carried interest rules.

Finally, any credit fund managers should approach any structuring around these rules with caution; there are targeted anti-avoidance rules in each of these regimes and the current environment is not at all sympathetic to what might be perceived as aggressive tax planning.

_{This article is part of our latest edition of Credit Fund INSIGHT. To download a PDF of the full publication, please click here.}