Incentive Planning for Fund Managers

Tax structuring is coming under scrutiny

FIONA CARPENTER, EMEIA LEADER, GLOBAL HEDGE FUND SERVICES, EY and JAMES STEWART, DIRECTOR, EY

Why is compensation structuring a hot topic? There have been huge changes in the industry from a commercial perspective since 2008. Investors are asking for different things, different types of products, different liquidity and different fee structures. Managers are trying to align themselves with what their investors’ needs are. As a result, the structure of performance and management rewards for new start-up managers is now quite different to some of the older, well-established funds and managers.

There’s a big change in investment asset classes too. Diverse debt strategies and illiquid investments in real estate, shipping and life insurance contracts are all becoming more prevalent. It is quite commonfor a lot of our clients to end up holding some sort of asset that actually is a lot further outside their more typical investment base. These new strategies are driving change in the way the funds as structured.

Evolution of tax legislation
As well as the commercial developments, UK tax law has developed significantly recently, as the government has reacted to the way the market has structured remuneration for portfolio managers and other senior executives across the asset management industry. For example, HMRC has implemented new legislation that means the use of corporate members in partnerships can lead to adverse tax consequences for the individuals, unless these arrangements are structured carefully.

HMRC has also changed the way certain members of Limited Liability Partnerships (LLPs) are taxed on their partnership allocations. HMRC has introduced new rules which seek to counteract members that are admitted to partnerships simply to save their firm National Insurance Contributions at 13.8% on an individual’s compensation. It is worth noting that these rules only apply to LLPs, and not limited partnerships, and that’s because the LLP vehicle allows you to limit your liability to something comparable to being a shareholder in a limited company. By contrast, HMRC seem to take the view that if you’re going to be a limited partner in a limited partnership, you’ve actually got much higher risk and therefore the rules need not apply to you.

Is an LLP still the entity of choice for fund managers?
A lot of questions we receive from the industry are related to whether a limited liability partnership is still the vehicle of choice for an asset manager. Actually the answer to that, particularly for smaller boutique hedge fund managers, is typically yes. The new mixed partnership and salaried members’ rules created a lot of uncertainty for the industry, and we were all very concerned. But it is amazing how it has settled down and life has adapted.

Some LLPs have removed some of their members from the partnership, and those members are now employees. Others are still members, but treated as “salaried members” for tax purposes, with employers’ NIC at 13.8% payable on their remuneration. But most in the asset management industry have been able to demonstrate that their members have sufficient significant influence, or their compensation is sufficiently variable and at risk of forfeiture, to demonstrate that they are true members of a partnership. So, in summary, we still see the LLP as the vehicle of choice for most fund managers in the asset management industry.

Structuring remuneration from the fund
Broadly speaking there are two big themes that you can look at for incentivising your key executives. Is there something you can do at the fund level or the management group level?

At the fund level, the biggest area we keep being asked about is the private equity fund structure model and carried interest. Can hedge funds do it? Can other alternative managers do it? The starting point really is the fund strategy. What sort of income and returns is your strategy delivering?

Impact of fund strategy on compensation structure
The first question is, what is the nature of your fund’s return? If you were, as an individual, to buy and sell the target assets yourself, what would you have? Would you have dividends, interest income and/or capital gains? The taxation of each of those is very different depending on your tax profile. Are you UK resident? Are you domiciled in the UK? If you’re not UK-domiciled, are you on the remittance basis, and therefore potentially able to retain your returns from the fund outside of UK taxation, no matter what the nature of the underlying investment return is? So start by looking at your senior personnel that you want to incentivize.

The fund strategy will be key too. What is the frequency of your transactions? Are you trading every minute, every hour, every week, or monthly? Have you got just 10 core positions that you’re adjusting? These are all really important questions, because they’re shaping what you could potentially receive, and how you could share in the fund’s return using a private equity-style fund, where instead of a performance fee there’s carried interest, and everyone shares in a slice of all the income, gains and losses in that fund.

That’s why those initial questions are really important. How is your fund structured and what can you actually receive from it? If you’ve got a transparent master fund you may well be able to take a slice of all the gains of your fund as an allocation rather than as a performance fee. If you’ve got a corporate master fund, then you could potentially have a preferred share class that delivers maybe a dividend or a capital gain when you sell your investment. But it’s not going to be a share of the underlying gains in the same way as with a transparent master fund.

Relevance of investing versus trading
If your fund structure is suitable, the next consideration is whether your fund is investing or trading for UK tax purposes. If your fund is deemed for tax purposes to be trading rather than investing, then regardless of whether you have realized gains from the sale of investments, you no longer have a capital gain. All of that return that was taxable at capital gains rates now becomes taxable as trading income.

Determining whether a fund is trading or investing relies on case law – something called the “badges of trade”. The most relevant of which in these circumstances is the “motive”. Why is the fund entering into these transactions, what’s your expected holding period, have you covered that trade, have you gone short, and what will be the criteria for disposing of that position?

How are you describing the fund strategy to your potential investors? Are you telling them that the intention is to invest for the long term? For example, a three-year holding horizon over, say, 10 significant names, and the rest of the strategy is just periphery around that: that’s likely to be very supportive of an investing fund as opposed to a trading fund. If, however, you’re telling investors that it’s a very short day-trading strategy, you are more likely to be considered to be trading. But you’ll need to understand the portfolio managers’ rationale for decisions too. Two different types of funds with the same strategy can lead to very different results.

Take, for example, two event driven funds. The first only looks at potential M&A activity. It goes long or short depending on what it thinks is going to happen for that particular party – much more of an investing concept, as it’s buying or selling or going short, based on its view on a particular entity and some actions that might happen. The second event driven fund, however, is buying company X because it thinks it is going to convert into company Y, and it is going short company Y immediately. So straight away it has already closed out its expected exposure to company X if the merger goes ahead as it anticipates. It’s not holding with the long-term perspective.

Quant funds can be problematic, because in some cases you buy, or you go short, and you know that either it’s going to go up so many basis points, or down so many basis points that it gets sold, but even if it stays flat, it gets sold at the end of the day. In other words, it will be sold, and within a very short space of time. That’s much more akin to trading.

You have to look at the fund in totality. There are indicative factors, but ontheir own in isolation they won’t tell you whether a fund is investing or trading. You can’t take just one transaction and take a view on the fund; you have to look at the core of the portfolio. If the fund is clearly investing, then you could look at replicating more of a carried interest structure and receiving a share of the gains rather than a performance fee.

What are the tax risks associated with a carry structure?
The classification of a fund as investing or trading is also relevant to the UK tax risk for the fund. Funds that are at risk of trading need to avail themselves of the Investment Manager Exemption (IME) if discretionary investment management is performed by a UK manager. Otherwise, they are at risk of being taxable in the UK. One of the key elements within that exemption is the customary rate test that requires the manager be paid a customary rate for the services they’re performing. But how do you meet the customary rate test if you’ve structured your return as carried interest rather than the performance fee and all you’ve taken is a management fee for your services?

The customary rate analysis will be very different from fund to fund. Some funds can point to a mutual fund that does something very similar, and only gets paid 50 basis points for a similar strategy. So in some cases we can argue and demonstrate that the 2% management fee is customary, and there is no need to bring the carried interest into UK tax for the manager’s remuneration to be considered customary. But that’s a really key test.

Remember that if the fund is held to be trading in the UK and fails the IME, then the fund becomes partly taxable in the UK. And as a result that will impact investor returns. So unless you’re definitely investing, we would recommend you consider the IME, and consider this customary rate point as well as the other tests.

Structuring remuneration for members of an LLP
Outside of the fund structure, most UK fund managers are LLPs, and senior personnel receive their remuneration as an allocation of partnership income. There is a risk that these LLP earnings might be re-characterized in some way under the new disguised member and mixed partnership rules. In particular, the mixed partnership rules consider deferred profit allocations and whether or not the member should be taxed on those deferred profit allocations at grant rather than at vesting.

One option, therefore, is to defer when the LLP becomes entitled to its earnings from the fund such that the profits are only recognized by the LLP when the member is to receive their remuneration. One way to do this is to issue contingent shares that are only awarded to the LLP once certain commercial conditions are met. The benefit of this arrangement is that you can go to your investors and you can say that “Our portfolio managers’ commercial risk is really aligned to those of you as an investor, and if these performance targets aren’t met then these units won’t be awarded, and the profits will never come into the LLP and be awarded to those portfolio managers.” That’s great from an investor perspective; whether or not it’s palatable for your portfolio managers is a discussion you have to have with them, because they really are at risk when neither the individual nor the firm have any entitlement whatsoever to these special fund units until vesting once they have met those performance requirements. A second option is to look at replacing part of the performance fee entitlement in favour of some restricted shares in the fund. These shares would have some sort of restriction around, for example, a class that can’t be sold for three to five years. This locks the portfolio manager into the fund and, as such, awards to an LLP member should be taxable at income tax rates on the market value of the shares received. This should include a discount for any restrictions.

Ultimately, the optimum commercial and tax structure for your business will depend upon all the factors discussed: what is the fund strategy, what is the tax profile of your team, how aligned do you want to be to the interests of your investors?

The 2014 UK Autumn Statement
The arrangements discussed are the subject of greater focus. After the conference, the UK government issued draft legislation for consultation on the taxation of fees for fund management services and carried interest returns.

The Chancellor’s 2014 Autumn Statement included an announcement that the UK government intended to introduce anti-avoidance measures to counteract arrangements that avoid amounts arising to investment fund managers for their services being charged to income tax. The publication of draft clauses for inclusion in Finance Bill 2015 on 10 December has provided more details on these measures.

The government’s stated objective is to exclude carried interest and co-investment from these rules. However, there is a very broad definition of ‘management fees’, which includes performance-related incentives and fees, combined with a very narrow safe harbour for carried interest and certain investment returns. The definition of ‘carried interest’ in the draft legislation means that the arrangements employed by many funds would fall outside this exemption, and therefore such investment returns will be charged to income tax and National Insurance contributions (NICs).

The draft legislation’s definition of carried interest requires investors to have all or substantially all of their investment returned to them from the whole fund or the relevant investments (in a deal by deal structure) and each investor to have received a minimum preferred return of 6% per annum. This narrow definition is likely to present a problem for many incentive allocations and carry arrangements.

In addition, the current draft’s safe harbour for co-investment may be seen to be limited to the return of the investment principal, and require any further return to be reasonably comparable to a commercial rate of interest. It would therefore suggest that most shares or interests in funds held by the investment management team may be treated as disguised fees and taxable as UK trading income.

There are further complications for fund managers that conduct some of their activities (such as marketing) offshore. Depending on the circumstances, all profits from these offshore activities could be treated as wholly taking place in the UK, with the consequence that those individuals become liable to income tax and NICs on the entire profits of the business, unless a double tax treaty applies to protect the individual.

It is intended that the final legislation will have effect on all ‘disguised fees’ arising on or after 6 April 2015, whenever the arrangements were entered into.

The investment management industry is invited to submit representations as part of the consultation process. Whilst we will be raising our concerns directly with HM Treasury, we would recommend that those affected consider making similar comments. In addition to feeding into the consultation process, fund managers may wish to review their existing fund structures to determine how they might be affected by the proposed changes.