Marie Barber, Managing Director of Regulatory Tax services at Duff & Phelps wrote this editorial for HFM Week which was published in issue 392.
The Summer Budget 2015 changed the way dividends will be taxed from April 2016. Although dividends will become a more expensive profit extraction mechanism than profit allocation from an LLP, there remain advantages to operating as a corporate entity such as capital retention and removal of risk of falling foul of the Taxation of Partnerships rules. Additionally, the UK corporate tax rate is dropping to the lowest in the G20.
Targeted at the investment management community, Disguised Investment Management Fee (DIMF) legislation operates from April 2015. DIMF will recharacterize any as-yet-untaxed income arising from investment management activities as taxable to UK income tax, although only where there is a partnership in the structure. Simply having a limited partnership within the fund structure would render this legislation applicable. Furthermore, the definition of investment management extends to the ancillary activities associated with investment management, such as marketing and research. To the extent that all management fees paid by a fund are not taxed to income tax, then potentially DIMF applies. However, carry and co-investment returns in the investment vehicle are not caught by DIMF. Dividends are potentially caught except when an arm’s-length remuneration is paid to the manager.
Diverted profits tax (DPT) also looks at fee flows and where activities are performed. This legislation, commonly referred to as the ‘Google tax’, was not specifically written with the asset management industry in mind, though its reach extends beyond the targeted tech company. Under DPT, taxpayers are required to notify HMRC if they are potentially caught by the rules within three months of the end of the accounting period. Protection under double tax treaties is not available for firms nor is reliance on OECD-compliant transfer pricing policies or documentation. As a result, unless 100% of group profits are taxed in the UK, DPT could be applicable. Previously, partnerships and businesses with UK sales of less than £10m were excluded, but these safe harbors have been removed. An SME exemption remains, but as it is complex to calculate, firms must take caution when calculating this test if they are seeking to rely on it.
There is currently a consultation into the taxation of performance linked rewards, the stated objective of which is to introduce statutory tests to clarify circumstances in which fees may be treated as capital. There are currently two options under consideration: in the first, certain activities will be treated as long term investing activities; in the other, the average time investments are held will be evaluated to determine whether an investing strategy is followed and performance fees may subsequently be treated as capital. HMRC emphasizes that it does not intend the statutory test to impact other areas of taxation such as Investment Manager Exemption (IME) or Reporting Funds Status (RFS), which rely on a distinction between investing and trading. However, firms may have to apply different tests for different regimes, possibly leading to misclassification. We expect to see draft legislation in December 2015 and for the new statutory test to apply from April 2016.
Changes to the non-domiciliary regime, due to come into force on April 2017, would remove the advantages for those individuals who have been a UK resident for more than 15 of the last 20 years. Many individuals operating within this sector are non-domiciled. This is especially true in an industry that is reliant on technology and comprised of wealthy, geographically mobile people.
Given such drastic policy changes in taxation, what should asset managers focus on?
Conduct careful analysis of fee flows around group entities to minimize the risks of being caught by DIMF or DPT. Transfer pricing remains vital, but these two pieces of legislation override OECD principles. Despite having robust transfer pricing, there may remain a residual risk or reporting requirement even if no tax liability arises.
Entity choice should continue to be tabled as a discussion. Although the change in the taxation of dividends has removed the immediate cashflow advantage, there are other commercial considerations such as retention of working capital, return to seed investors and deferral of compensation without up-front taxation.
Watch the outcome of the consultation into the taxation of performance-linked rewards. The investment strategy of the fund could lead to more favorable capital gains tax treatment on performance fees.
Keep under review the intentions of key non-domiciled individuals and consider how the business can move to accommodate any relocation plans. Consider seeking RFS for co-investment vehicles to access CGT rates for UK taxpayers.