Draft Finance Bill 2015: Key Implications for U.K.-Based Alternative Asset Managers and Their Funds
Following not quite so hotly on the heels of the Autumn Statement1 as some would like, the U.K. government has now published draft legislation for inclusion in next year’s Finance Bill.
We have summarized in this alert what we consider to be the key draft legislation potentially affecting U.K.-based alternative asset managers and the funds that they manage.
Investment Managers: Disguised Fee Income
The draft legislation proposes a new chapter be added to the Income Tax Act 2007 (ITA 2007). This anti-avoidance legislation is intended to confirm the treatment of sums received by managers in respect of “investment management services.”
The draft sections prescribe that:
- where an individual directly or indirectly provides investment management services (which is defined widely to include not only discretionary asset management but also fund raising and researching potential investments) in respect of a collective investment scheme (CIS)
- through an arrangement involving one or more partnerships
any sums received directly or indirectly from the CIS for those services may be treated as profits of a trade, unless otherwise charged to income tax.
Her Majesty’s Revenue & Customs (HMRC) state that sums are not intended to be caught by the new rules if they represent a return that varies by reference to profits on funds, or represent a return on investments by the managers. The legislation therefore provides a very prescriptive definition of a “carried interest” that will be outside these draft rules.
As noted in our previous alert, most U.K. hedge fund managers are structured as a U.K. limited liability partnership. However, all fees/allocations are typically already treated as fee income for U.K. tax purposes. Such fees are paid to the U.K.-based manager, calculated by reference to the functions performed, risks assumed and assets used, and are taxed as trading profits. These changes should therefore not be in point in the majority of cases. There are points of detail, however, such as the interaction with the statutory deferral mechanism introduced in response to the AIFMD remuneration provisions, which will need to be worked through with the U.K. tax authorities. We intend to make such representations to HMRC.
Notwithstanding the above, hedge fund managers have been increasingly encouraged to consider “carried interest”/private equity structures in recent times. Those who have opted to implement such a structure should consider this in light of the draft legislation, as “carried interest” has a very specific meaning in the proposed rules. Failure to fall within this definition could mean a hedge fund manager’s “carry” is taxed as trading income and not the desired capital gains. Those in the PE industry may also wish to confirm that what they consider to be carry is similarly within the draft legislation’s definitions. What the draft legislation regards as a carried interest, in particular the need for a certain hurdle, does not mirror the discussion found in the 1987 Memorandum of Understanding between HMRC and the British Venture Capital Association.
Special Purpose Share Schemes
Previously, companies have used special purpose share schemes to offer shareholders the choice to receive either a dividend or to receive a similar amount through an issue of new shares that are subsequently purchased by the company or sold to a pre-arranged third party. HMRC intends for this draft change of law to align the tax consequences of that choice to ensure that all shareholders are taxed as if they had received a dividend.
This measure will have effect for receipts on or after April 6, 2015, and legislation will be introduced in Finance Bill 2015 to include a further charge to income tax on “alternative receipts” offered by special purpose share schemes.
A shareholder will have received an “alternative receipt” if:
- the company has given the shareholder the choice to receive either a dividend or something else,
- the shareholder has chosen to receive something other than a dividend, and
- that receipt would not, apart from this new legislation, have been subject to income tax.
Modernizing the Taxation of Corporate Debt and Derivative Contracts
As noted in our previous alert, the U.K. government wishes to make wide-ranging changes to update, simplify and rationalize the legislation on corporate debt and derivative contracts.
The draft legislation is certainly wide-ranging and covers the following matters:
- The relationship between accountancy and tax will be “clarified and strengthened.” In particular, Sections 307 and 595 of the Corporation Tax Act 2009 (CTA 2009) will be amended to remove the requirement that amounts brought into account for tax must “fairly represent” the profits, gains and losses arising.
- Sections 308 and 597 will be amended to bring the calculation of taxable amounts in line with the usual approach to the computation of profits for both commercial and tax purposes.
- Taxation will be based only on amounts recognized as items of accounting profit or loss, rather than on amounts recognized anywhere in accounts — in reserves or equity, for example. A transitional rule will ensure that this change is broadly tax neutral.
There is, however, no specific mention of amendments to the “bond fund” rules. That said, the draft legislation does include a new regime-wide anti-avoidance rule and so there may be some hope of the bond fund rules falling away. However, the new rule will be introduced into each of Parts 5 and 7 of the CTA 2009, to counter arrangements entered into with a main purpose of obtaining a tax advantage by way of the loan relationships or derivative contracts rules. The bond fund rules reside in Part 6 of the CTA 2009.
The draft legislation is proposed to be effective generally from January 1, 2016; however, certain of the new rules (including the new regime-wide anti-avoidance rule) will take effect from April 1, 2015.
Withholding Tax Exemption for Private Placements
Currently, Part 15 of ITA 2007 requires the deduction of income tax from payments of yearly interest arising in the U.K. Certain exceptions from this obligation are set out in Chapter 3 of Part 15 ITA 2007. Legislation will be introduced in Finance Bill 2015 to amend Chapter 3 of Part 15 ITA 2007 to include an exception from the duty to deduct income tax from qualifying private placements. The legislation will set out certain gateway conditions, including requirements that the instrument must:
- represent a loan relationship of a company
- be issued for a minimum period of three years
- not be listed on a recognized stock exchange.
In addition to setting out these key conditions, the primary legislation will allow for further conditions to be set out in regulations in relation to the security itself and the terms and conditions of its issuance, and in relation to the issuer and holder of the security.
HMRC has published a technical note which sets out its proposals for the additional conditions mentioned above, which, if adopted in the proposed form, would materially limit the scope of the exemption. For example, HMRC proposes that the exemption should only apply to issuances of between £10 million and £300 million by “trading companies” and would not apply where the holder is connected to the issuer or where the holder is not resident in a “qualifying territory” (broadly, a territory which has a double tax treaty with the U.K. that contains a non-discrimination article). The technical note also outlines several other proposed conditions that relate to the terms of the notes and the holder of the notes and confirms that the regulations will include an anti-avoidance provision.
The technical note can be found here.
Diverted Profits Tax
As announced during the Autumn Statement, legislation will be introduced in Finance Bill 2015 for a new tax on “diverted profits,” which will take effect in relation to accounting periods beginning on or after April 1, 2015. The tax will apply to arrangements that erode the U.K. tax base by the:
- avoidance of a U.K. permanent establishment, or
- transfer of profits to entities that pay low amounts of tax in situations where there is a lack of economic substance.
Where it is in point, the tax will apply at a rate of 25 percent on the diverted profits and will be payable within 30 days after the issue of a charging notice by a designated HMRC officer.4
While the measure will have effect in respect of taxable diverted profits arising on or after April 1, 2015, it will not apply to profits arising from arrangements that only involve loan relationships.
As noted above, the first rule is designed to address arrangements that avoid a U.K. permanent establishment. This rule can have effect if a person is carrying on activity in the U.K. in connection with supplies of goods and services by a non-U.K. resident company to customers in the U.K., provided that other detailed conditions are met.
It is also worthy of note, as HMRC states in its policy document, that it is only targeting “large” multinationals. As such, the first rule only applies where the U.K. person and the foreign company are not small or medium-sized enterprises5 (SMEs). The first rule will also be subject to an exemption based on the level of the foreign company’s (or a connected company’s) total sales revenues from all supplies of goods and services to U.K. customers not exceeding £10 million for a twelve-month accounting period.
The second rule will apply to certain arrangements that lack economic substance involving entities with an existing U.K.-taxable presence. The primary function is to counteract arrangements that exploit tax differentials and will apply where the detailed conditions, including those on an “effective tax mismatch outcome”, are met. It is also necessary, for the second rule to apply, for the two parties to the arrangements not to be SMEs (whereby the SME test will apply to the group).
With the above in mind, U.K.-based alternative asset managers will be all too aware of the need to avoid creating a U.K. permanent establishment of the non-U.K. funds that they manage. Such managers will therefore welcome a safe harbor contained within the rules regarding U.K. agents of independent status (including pursuant to the Investment Manager Exemption). However, with the first rule, in particular, in mind, U.K.-based alternative asset managers should still consider the possible impact on their management and/or fund structures, not least where, for example, alternative arguments have been relied upon to conclude that a U.K. permanent establishment does not exist.
Capital Gains Tax (CGT): Non-U.K. Residents and U.K. Residential Property
While this measure was not included in the Autumn Statement, having been announced early, draft legislation was published on December 10, 2014. This measure will impact non-U.K. resident persons that own U.K residential property, in particular:
- non-U.K. resident individuals
- non-U.K. resident trusts
- personal representatives of a deceased person who was a non-U.K. resident; and
- non-U.K. resident companies controlled by five or fewer persons, except where the company itself, or at least one of the controlling persons, is a “qualifying institutional investor”.
It may also affect some U.K. resident individuals disposing of properties overseas, or who spend part of a tax year abroad.
This measure will have effect on and after April 6, 2015. Legislation will therefore be introduced in Finance Bill 2015 to amend sections 1 and 2 of the Taxation of Chargeable Gains Act 1992 and insert new sections to bring non-U.K. residents within the charge to CGT when they dispose of a U.K. residential property interest.
Non-resident institutional investors that are diversely-owned, and companies that are not controlled by five or fewer persons will be exempt from the charge. Companies that are within the new charge and part of a group may treat the assets of the group on a “pooled” basis, with gains and losses of different non-resident group members being offset in year, unrelieved losses carried forward, and transfers within the group on a tax-neutral basis.
The legislation will also make clear that the CGT charge will be due to be paid within 30 days of the property being conveyed, unless the person has a current self-assessment record with HMRC when payment will be at the normal due date for the tax year in which the disposal is made.
Capital Gains Tax: Changes to the Threshold Amount for ATED-related CGT
While also not featured in our Autumn Statement alert, we wanted to flag this draft legislation as it impacts, amongst others, managers of collective investment schemes which own residential property worth over £500,000 that does not form part of a genuine commercial activity or is not used to house employees of that activity.
The draft legislation is a technical change so as to reduce the threshold on the proceeds of the sale of a residential property above which capital gains tax is payable, where the annual tax on enveloped dwellings (ATED) has been paid on the property. HMRC considers that the measure ensures that a seller’s liability to CGT when they dispose of a property continues to be linked to their previous liability to ATED on the same property. In HMRC’s opinion, this improves the fairness of the way property is taxed.
The measure will have effect in two stages. The threshold amount for consideration received will fall from £2 million to £1 million for disposals on or after April 6, 2015, and then to £500,000 for disposals on or after April 6, 2016.
If you have any questions regarding this alert, please contact the Akin Gump lawyer with whom you usually work or
2 Including explanatory notes, but excluding guidance and policy statements.
3 With the likelihood that a shorter Finance Bill will be introduced in March 2015, containing those matters that are to receive Royal Assent before the General Election.
4 The draft legislation does contain a “consultative” process through which the taxpayer has the ability to challenge HMRC’s assertions that the rules apply, and the extent to which they do so.
5 Based on the EU definition (2003/361/EC), as adapted for U.K. tax purposes.