A sigh of relief and a word of caution: disguised investment management fees

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

December's Autumn Statement provoked considerable concern in the real estate investment funds industry. The worry was that fund managers' carried interest and co-investment arrangements might be caught by a legislative attack on the use of certain structures to disguise some fees as capital gains, as opposed to income.

Last month's Finance Act did indeed introduce new rules on sums arising to fund managers after 6 April 2015.

However, most managers can probably breathe a sigh of relief, because the final version of the legislation addressed the worry that many legitimate carry and co-invest structures would inadvertently be caught. The scope of the relevant exemptions was broadened, and arrangements that are common industry practice are now less likely to be affected.

A word of caution nonetheless - the new legislation should be kept firmly in mind when establishing or amending management incentive structures, as the new rules could still affect fund managers whose incentive packages do not fall within specific exemptions for carried interest or co-investment arrangements. We have outlined these exemptions below, and would welcome any queries.

1. Firstly, who is caught?

The new rules broadly target structures through which management fees are paid as a guaranteed profit share to avoid income tax.

The rules seek to tax sums arising to investment fund managers that are paid through a partnership unless they are already taxed as income (disguised investment management fees) or fall within an exemption.

The exemptions are where sums are:

(a) carried interest;

(b) repayment of investment made by management; or

(c) a commercial return on such investment,

((b) and (c) provide the exemption for co-investment arrangements).

There are no grandfathering provisions for existing arrangements. The new rules apply to any sums arising on or after 6 April 2015 regardless of when the arrangements were established.

2. Carried interest exemption

Broadly, the legislation considers carried interest to be a profit-related return. In particular where:

(a) sums arise to management only if there are profits (realised or unrealised);

(b) such sums are variable "to a substantial extent" by reference to those profits; and

(c) returns to external investors are also determined by reference to those profits.

There needs to be "significant risk" at the time management become party to arrangements, or material changes are made to the arrangements.

In the original draft legislation, carried interest was much more narrowly defined as sums arising on a realised basis (i.e. only after investors received all or substantially all of their investment) with a preferred return hurdle of at least six per cent per annum. This definition has been retained as a pure safe harbour test.

3. Co-investment exemption

Co-investment arrangements are exempted from the new rules if the returns to management represent an arms' length return.

An arms' length return is a return which is reasonably comparable to the return received by external investors.

Again, this is a welcome change from the original draft of the legislation, which limited the exemption for co-investment only to the extent that returns represented a commercial rate of interest. The amended legislation is much wider and should permit most co-investment arrangements to fall outside the new rules.