Tax Matters

ANA WISDELL, THOMAS EGGAR

Traditionally, hedge fund managers have been established as limited liability partnerships (LLP) in the UK. Changes have occurred in recent years making it necessary to re-think whether this is the best option in each case.

These include the introduction of the 50% higher rate of income tax; the FSA Remuneration Code and the impact of the Alternative Investment Fund Managers Directive (AIFMD) will have on the structure and form of remuneration; pension planning; the payment of deferred rights to departing members; and the general shift by Her Majesty’s Revenue and Customs as regards tax planning.

The structure of the management entity is rarely a matter for the individual manager. He is invited to join as a member an existing and well established structure; offered a number of documents to sign and is advised of his personal tax position by the firm’s advisors.

However, his individual position is ultimately derived from and directed by the advice provided to the firmas a whole, rather than at the individual, personal level. The firm’s profits are divided between the members as determined by the partnership agreement and tax is payable by the individual member. The individual member is then left having to bear the tax burden on his individual share, and look for individual means of mitigation.

Tax transparency
Historically, the tax transparency afforded by the LLP has meant that the member was considered as self-employed and this resulted in an overall lower tax burden when compared with payment via corporate structures. The combined burden of income tax and national insurance was lower than that suffered by companies when paying their senior employees and directors.

This was most significant in cases where the manner of remuneration included not only a share in the profits, but also a carried interest in funds, as this meant that the latter enjoyed capital gains tax rates on realisation rather than income tax rates. This continues to be the case where the tax rate differential is now between 50% as the highest rate of income tax and 28% as the highest rate of capital gains tax. In the case of UK-resident, non-domiciled, members the capital gain may be deferred where the proceeds are indeed never remitted.

Alternative forms of tax mitigation
Many newer fund managers are moving on from this model with fewer members enjoying or participating in the carried interest; or indeed the newer members of long-established fund managers do not enjoy the benefits of those founder members. The result is that their remuneration results from the direct profits only and is received as income. The introduction of the higher rate of 50% with the reduction in pension contributions to £50,000 only, has meant that alternative forms of tax mitigation have to be applied.

HMRC opposition to tax planning
Fund managers know and understand risk, and therefore have approached tax mitigation with a better appreciation than most. However, there is a general drive by government to listen to those voices within HMRC that have always been opposed to tax planning of any form, seeing the tax code in simple terms of black and white, and any attempt to arrange one’s affairs so as to reduce one’s tax burden by whatever means, as nothing more than the avoidance of tax.

As many now find themselves, having participated in previous well established and genuine investments, their affairs are not finalised and tax which may be due is not repaid; it has become a war of attrition between advisors and HMRC with the member caught in the middle.

This state of affairs is likely to worsen. The Disclosure of Tax Avoidance Schemes (DOTAS) was introduced in August 2004 and initially included the use of employment-related arrangements or financial products only. This has been extended each year, and now includes a much longer list with continued review and new areas being considered. In addition, in December 2010, the Government appointed Graham Aaronson QC to lead a group to establish whether a General Anti-Avoidance Rule (GAAR) could be framed that would be effective in the UK tax system and, if so, how the provisions of the GAAR might be framed. The group reported as this issue went to press (in late October 2011), but it is understood that the introduction of a GAAR is favoured and model provisions and explanatory notes are expected to be produced.

Such a development could very well result in any form of planning being considered critically and subjectively as regards its purpose; any arrangement entered into would consider not only its legal form and purpose, but its role in the arrangement. Anything that had its main role as the mitigation of tax could result in having its effect nullified. As the manner in which one arranges one’s affairs generally takes tax into consideration, it may well mean that it becomes essential that the primary format, namely as a first step, must be individually catered for, as any subsequent arrangements/ planning will be seen as having no further purpose other then the reduction of tax and, therefore, be disregarded.

Tax differentials under review
It may mean that the “one size fits all” approach will have to be reconsidered and that, as and when a new member is introduced to the LLP, their personal circumstances and needs are considered. This may mean where as some members remain individuals; others are introduced as companies. This introduces personal flexibility as to whether profit is retained and accumulated, subject to the lower corporate rates of 26% and reducing, and how money is withdrawn. The differential between corporate and individual taxation is also under review, with another working party expected to report – possibly yet another consideration to put on hold!

AIFMD restrictions
The structure of remuneration had been an area which caused some serious concern until December 2010, when the FSA set out their proportional approach to the implementation of their Remuneration Code. This has meant that many fund managers are not caught by the more restrictive requirements applying to remuneration. However, in July, the EU published the Alternative Investment Fund Managers Directive (AIFMD), whose provisions are to be implemented by 2013. The AIFMD imposes many restrictions on the structure and form of remuneration, much of which mirrors that already present in the FSA Remuneration Code. Consultation is to take place as to the implementation, so we will have to wait as to the outcome. It could well mean that some form of deferment may still ultimately be implemented.

Generally speaking, the taxation of profits follows the accounting treatment. Should deferred remuneration be introduced, in order that members are not taxed on profits until they are distributed, or able to be drawn-down, it will be necessary for not only a new remuneration structure to be introduced, but also one which defers the tax point until such time as the earnings are paid/received. Although this is an issue primarily for the fund manager and its advisors, it is something that each individual member should be concerned with, as ultimately how and when he is credited with his taxable profits is directly linked to how, when, and how much tax he pays.

This raises the issues of how a departing/retiring member receives and is taxed on his deferred share. There remains a conflict between the individual no longer being a member of the LLP, being due the profit share that has accrued to date, the payment of that profit share and how it complies with the terms of any deferral that is required.

Restructuring deferred payments
Some fund managers already have arrangements in place, which defer the payment of any performance fee until such time as the fund matures. This ensures that the ultimate performance fee realised reflects the true performance, and is not simply paid on a year-on-year basis. This requires some restructuring of how deferred payments become due, so that post cessation profit shares can be allocated to departed members, deferring the tax liability until receipt and being regarded as an allocation of profits, not an expense, as far as the LLP is concerned. This is to the benefit of all members continuing and past.

From 2011, the ability to contribute to and obtain tax relief for, pension contributions is severely curtailed. Considering that we are considered to be an ageing population and how we are all likely to fund our retirement is becoming a current topic, regardless of age, it has become a critical issue. The announcement in December 2010 of the disguised remuneration provisions, has meant that unapproved pension plans are caught up. The provisions do not apply to the self-employed, but would apply to a corporate member. It has also meant that the non-registered pension market is in a hiatus, while it finds its place in this brave new world.

Deferring contributions
Since 2003, tax relief for contributions tonon-registered pension schemes was deferred until such time as the member drew a chargeable benefit. This remains the case. For this reason, contributions to such schemes had fallen out of favour. Such contributions, particularly where made by the member, out of already taxed sources, or out of sources standing in a tax neutral position, to a non-registered scheme, are not subject to either the annual or lifetime allowances. To not consider such options, simply because there is no immediate tax relief on contributions is short sighted, as the schemes remain a tax effective method of pension savings. When structured effectively, tax savings can be maximised.

To date, the norm has been that the fund manager seeks the legal and tax advice for itself and this has generally been seen as advantageous and efficient for the individual member. However, the changes on the horizon mean that this may no longer be the case and it will become prudent for the member to seek his own personal advice. It is not generally the case that the needs of the fund manager are in conflict with those of its members, but the reality is that the needs of no two members are the same. It is this that is the conflict. It is not the fund manager’s position to structure and plan for each individual member, but it is possible for the variations to be explored and recognised and possibly a menu of options to be available.

The situation is no different than that found in the corporate world, where the needs of individual director/shareholders are separate and distinct. The model for the company, its business decisions and advice is tailored to meet its commercial imperatives and requirements. However, where a business is sold, the shareholders are generally advised independently as ultimately what suits them may not suit the company; in many situations it can be accommodated and results in benefits for both the shareholder and the company.

This same principle applies to the fund manager and its members. The industry is very much in its infancy, the LLP Act being just over a decade old and the oldest LLP not yet 10. There is much expertise out there, but it is very much concentrated in advising the fund manager. The members should now look to recognise that there are a number of solutions to any problem, and possibly some input from their personal advisors may be necessary. The original fund managers have given rise to a new wave. Similarly many advisors within the acknowledged industry leaders have broken loose to set up independently or band together in new smaller outfits. These advisors are well placed to see the alternatives.

Ana Wisdell is partner with Thomas Eggar. The firm offer a comprehensive range of legal services to private clients and commercial organisations. Widell has extensive experience in advising on UK residence and domicile issues, and complex structures to assist individuals and entrepreneurs.