The DIMF rules have applied to ‘disguised fees’ arising to investment managers since 6th April 2015. The rules have often been overlooked, falling between the two stools of corporate and personal tax advisors. The impact of the regime is so potentially adverse that many have put their heads in the sand and hoped it will pass over them. As one would expect HMRC has now commenced enquiries into the application of the DIMF rules for 2015/16 onwards and it is important for advisors to be able to identify clients at risk and to be in a position to deal with the demanding factual and technical aspects of the rules if faced with HMRC enquiries.
Co-authored by Michael Beart and Francis Fitzpatrick QC this article was first published in the May 2019 edition of the Tax Journal
The DIMF rules were inserted as Income Tax Act 2007 ss809EZA-EZH by FA 2015 and apply for years of assessment 2015/2016 onwards. The declared purpose of the rules was to tax, as income, remuneration received by an individual for providing investment management services. Initially, and to the relief of many, carried interest (‘carry’) was exempted from the rules, but FA 2016 brought one type of carry, ‘income based carried interest’ (‘ICBI’) within the rules. As will appear, and as one might expect, the rules are complex, broadly drawn and require a close factual examination of the structure in question.
By way of example, Diagram A details a classic start-up structure adopted by many UK hedge fund managers established in the last 10-15 years with a simplified fund structure. Whilst we look at hedge fund structures here, the DIMF rules potentially apply to all investment management structures.
Investment Manager Ltd is engaged under an investment management agreement (‘IMA’) to provide investment management services to the investment vehicle (the ‘Fund’). Tax is suffered at the portfolio level and at the investor level, therefore to prevent a third layer of tax the Fund would typically be located in a low tax jurisdiction, with the Cayman Islands being the most popular location predominantly as a result of US investor preference. Fees under the IMA follow the 2% and 20% model (albeit this is often reduced under negotiation), charging a 2% management fee on assets under management per annum and a 20% performance fee on gains in the portfolio. Sub-Investment Manager LLP, based in the UK, is delegated all or most of the day-to-day investment management activities by Investment Management Ltd under a sub-IMA. The principal(s) behind the business (the ‘Founder(s)’) are typically the majority owners of Investment Manager Limited, partners in Sub-Investment Manager LLP, and are usually the individuals who undertake the discretionary investment management activity. From a UK tax perspective, the Founders are often UK resident, but non-domiciled, filing on a remittance basis and travelling extensively to meet with investors outside the UK.
Where all of the functions, assets used and risks assumed are in the UK, then in theory, 100% of the management and performance fees should flow first to Investment Manager Ltd and then to the Sub-Investment Manager LLP. However, in practice for various reasons this is not always the case, for example where: the directors in Cayman are undertaking investment management decisions; or the capital raising function was performed outside the UK often prior to establishing the business in the UK; or part of the performance fee may be allocated directly to the Founders from the Fund for US tax purposes.
Over time, as both the industry and managers evolve, the structure launched at start-up becomes more complex, as detailed in Diagram B. Managers may have established multiple new offices across the globe focused around financial centres in the US, Hong Kong or Switzerland staffed by teams of investment professionals. Funds are often now based in jurisdictions such as Luxembourg or Ireland which are increasingly desirable for large institutional investors. The Founders may also have established offshore trusts to hold the business, especially if they are now deemed domiciled from a UK tax perspective. Established managers will often employ co-investment and deferral remuneration structures in line with investor and regulatory expectations and as part of a longer-term retention strategy.
Pre-DIMF tax treatment
Prior to the introduction of DIMF, the 2% would normally be taxed as income as a payment for the investment management services provided by managers. In a typical open-ended hedge fund structure, the 20% performance fees would crystallise annually and be taxed as income. Whereas in the traditional close-ended private equity structure the 20% performance fee was given by way of participation in the fund, structured as carry only arising when the investment portfolio was realised at the end of the fund term. If the fund was carrying on an investment activity, its profits and so the 20% share could fall within the scope of capital gains tax rather than income tax, but potentially were kept outside the tax net altogether. The original focus of the DIMF rules was to tackle structures attempting to recharacterize fees taxable as income into capital and base-cost shifting in the private equity industry. However, the legislation evolved quickly into a far wider ranging piece of anti-avoidance which, as it will be seen, potentially strips away all corporate layers to tax an entire asset management business as if it were a single transparent partnership.
Before turning to the legislation, it is worth noting the position regarding HMRC guidance. Guidance was originally published in a Technical Note ‘Investment Managers: Disguised Fee Income’ dated 29 March 2015. A later draft revised version of the Technical Note was circulated in October 2016 and it was expected that a final version of the Note would be published within a reasonable period thereafter, but no such final version has been published as yet. In any event, useful and informative as HMRC guidance is, it is the legislation which advisers must start with as recent case law shows that it is difficult to hold HMRC to the views expressed in their guidance.
Establishing whether the DIMF applies
In order for the legislation to apply, there must be a ‘disguised fee’ which ‘arises’ to an individual from an ‘investment scheme’. If this is the case, then the individual is liable for income tax in respect of the disguised fee as if: the individual were carrying on a trade for the tax year in the UK (to the extent that the individual performs the relevant services in the UK); the disguised fee was the profits of the tax year; and the individual was the person receiving or entitled to those profits, ITA 2007 s809EZB. The crucial point to note here is that as the trade is deemed to be carried on in the UK, the remittance basis will not apply so that non-domiciled but UK resident managers are within the scope of the charge – a point that is often overlooked in the personal tax analysis, also meaning structures held within so-called ‘protected trusts’ by those deemed domicile are not necessarily protected.
To understand what is meant by a ‘disguised fee’, it is first necessary to understand what is meant by a ‘management fee’ as the former is defined by reference to the latter. A ‘management fee’ means any sum (including a sum in the form of a loan or advance or an allocation of profits) except in so far as the sum is: a repayment (in whole or in part) of an investment made directly or indirectly by the individual in the scheme (co-investment); or an arm’s length return on an investment made directly or indirectly by the individual (return on co-investment); or ‘carried interest’ which is not IBCI, see ITA 2007 s809EZB. The last item, IBCI, was added by FA 2016 with respect to sums of carry arising on or after 6 April 2016. It is this FA 2016 amendment which brought income based carry within the scope of the DIMF rules for the first time.
‘Carried interest’ is defined as a sum which arises to an individual under the arrangements by way of a profit-related return, see ITA 2007 s809EZC-EZD. IBCI is defined by reference to an investment scheme’s average holding period (‘AHP’), which is determined by the average length of time for which investments are held for the purposes of the scheme and by reference to which carried interest is calculated, see ITA 2007 s809FZA-FZZ. The amount of the carried interest which is IBCI is zero if the AHP is above 40 months and then increases gradually to 100% where the AHP is less than 36 months. There are further detailed rules that apply to determine what is IBCI, depending, amongst other things, on the nature of the assets held. The key point here is that initially annual performance fees earned by hedge fund managers were not caught by the DIMF legislation, but from 6 April 2016 they were brought within scope, along with short-term returns made by private equity managers.
If it has been established that a ‘management fee’ has been paid, then in order to decide if this amounts to a ‘disguised fee’, this requires 3 further questions to be answered positively.
(1) Has the individual performed investment management services for the scheme?
First, has the individual at any time performed or is the individual to perform investment management services directly or indirectly in respect of the scheme under the arrangements? The scheme in question is an ‘investment scheme’ defined as a collective investment scheme (‘CIS’) or an investment trust, ITA 2007 s809EZA(6). Whilst CIS bears its normal definition as having the meaning given by s235 FISMA 2000with some important extensions under ITA 2007 s809EZA(7).
(2) Does a fee ‘arise’ to an individual from an investment scheme?
Second, under the arrangements, does a management fee ‘arise’ to individual from an investment scheme? Originally there was no definition of ‘arises’ in the legislation, but an extensive definition was added as ITA 2007 s809EZDA-EZDB by F(No2)A 2015 with effect in relation to sums arising on or after 22 October 2015. It is this statutory definition of ‘arises’ which gives rise to the most difficult problems in applying the DIMF rules. It is also the aspect that has been most widely overlooked in the marketplace and which is discussed in detail in the revised yet unpublished HMRC guidance. As will be apparent, the definition of ‘arises’ is drawn in part from notoriously wide ranging and open-textured anti-avoidance provisions such as the transfer of assets abroad provisions.
In the simplest case, a sum will arise to an individual (‘A’) if it is paid to him. A sum will also be treated as arising to A if: a sum arises to a company connected with A or a person not connected with A; any of the enjoyment conditions is met; and the sum does not otherwise arise to A, ITA 2007 s809EZDB.
The enjoyment conditions repay careful study and are that:
- the sum is so dealt with by any person as to be calculated at some time to enure for the benefit of A or a person connected with A;
- the arising of the sum operates to increase the value to A or to a person connected with A of any assets which A or the connected person holds or are held for the benefit of A or the connected person;
- A or a person connected with A receives or is entitled to receive at any time any benefit provided or to be provided out of the sum or part of the sum;
- A or a person connected with A may become entitled to the beneficial enjoyment of the sum or part of the sum if one or more powers are exercised or successively exercised. This is clearly aimed at discretionary trust arrangements, as where part of a management fee is paid not to the individual but to a discretionary trust of which the individual is a beneficiary; or
- A or a person connected with A is able in any manner to control directly or indirectly the application of the sum or part of the sum.
There is specific provision that in determining whether any of the enjoyment conditions are met ‘regard must be had to the substantial result and effect of all the relevant circumstances’, ITA 2007 s809EZDB(5)(a), a very strong steer to a court to apply a substance test.
The ‘out-in’ exemptions
The potentially extremely wide breadth of these provisions is tempered in two respects. First, the enjoyment conditions in (b)-(d) are not met if they would be met only by reason of A holding shares or an interest in shares in a company. The ‘only’ is important as if A could benefit otherwise than through holding shares (such as where there is a wider arrangement under which A may benefit), then the exemption is not available. Second, the enjoyment conditions in (a) and (e) are not met if the sum arises to a company connected with A and A is liable to pay corporation tax on its profits and the sum is included in the computation of those profits, or the company is a controlled foreign company (‘CFC’) and the exemption in Chapter 14 Part 9A TIOPA 2010 applies (which applies where the local tax amount is at least 75% of the corresponding UK tax) or the company is not a CFC but, if it were, the exemption would apply for that period. This is the ‘out’ part.
However, that is not the end of the story as it is possible to fall back ‘in’ to the regime. There is an anti-avoidance provision to prevent the insertion of corporate entitles between managers and the management fees in order to circumvent the legislation. Both of the exemptions will not apply if it is reasonable to assume that: in the absence of the arrangements the sum or part of the sum would have arisen to A or an individual connected with A; and the arrangements have as their main purpose or one of their main purposes, the avoidance of a liability to pay income tax, capital gains tax, inheritance or corporation tax, ITA 2007 s809EZDB(8). The inclusion of inheritance tax is important as for non-domiciliaries, it has been standard IHT planning to use off-shore vehicles to hold shares or other interests in UK entities to ensure that the estate comprises excluded property for IHT purposes. As such the classic Cayman structure in Diagram A could arguably fall foul of this provision. This latter requirement is deemed to be met in a case where the sum is applied directly or indirectly as an investment in a CIV meaning that a co-investment by an entirely UK business could be caught which is arguably one of the most painful and commercially naïve aspects of the legislation.
Determining whether or not in the absence of the arrangements, the sum would have arisen to A is a difficult counter-factual exercise. HMRC in its draft guidance posits a spectrum from a multi-national asset management group which employs thousands of people (where it will be obvious that in the absence of the arrangements the sum would not have arisen to the A) to an individual manager imposing a corporate vehicle to receive their carry and which has no substance (where it will be equally obvious that A would have received the sums in the absence of the arrangements). The problem is to apply the test in cases between those two extremes where it will be necessary to consider all of the circumstances and also, presumably, whether the remuneration received directly by A was commercial and arm’s length.
(3) Some or all of the management fee is ‘untaxed’
The third condition is that some or all of the management fee is ‘untaxed’. The fee will be ‘untaxed’ to the extent that: it is not charged to tax under ITEPA 2003 as employment income of the individual for any tax year; or it is not brought into account in calculating the profits of a trade of the individual for the purposes of income tax for any tax year, see ITA 2007 s809EZA(4). It is important to note that the fact that the fee is charged to corporation tax will not prevent it being ‘untaxed’ for these purposes – again meaning an entirely UK business can be caught by the legislation. It is important to note the use of the word ‘any’ before ‘preceding tax year’ as this small inclusion fundamentally underpins co-investment deferral planning.
Other tax provisions
It is worth noting that these structures raise a number of other tax issues including: transfer pricing, diverted profits tax; profit fragmentation; transfer of assets abroad; ; investment manager exemption; disguised remuneration (‘DR’) and double tax treaty issues. How these other provisions interact with the DIMF regime is not straight forward. HMRC has indicated on occasion that if a structure is not subject to DIMF, then it should also not be subject to some of the other anti-avoidance provisions, but why is unclear. In cases where there has been an under declaration of tax with an offshore element, it may also be necessary to consider the impact of the requirement to correct (‘RTC’) legislation.
Action points given that HMRC is now actively pursuing DIMF enquiries
It is crucial for advisers to:
- Identify structures that may be within the scope of the rules, developing a structure chart which identifies the residence of the relevant individuals and entities;
- Draw up a table showing the destination of the sums arising to the investment manager and the timing given various significant changes to the legislation since its enactment;
- Clarify whether and how the DIMF rules apply;
- Establish what returns, if any, have been made with respect to the DIMF rules;
- Liaise closely with advisers from other jurisdictions and consider double tax treaty reliefs;
- Establish how matters will be managed and co-ordinated between the personal and corporate advisors.
- Consider potential exposures under RTC.