The Investment Manager Exemption Review

Finding a safe harbour

Originally published in the September 2007 issue

Over the past 12 months the UK’s Investment Manager Exemption, (‘IME’), has generated a lot of press coverage. It has been reported that changes, which HMRC has suggested, had the potential to drive investment managers and in particular hedge fund managers offshore from the UK and to seriously impact on the hedge fund investment management industry in London.

What is the IME and why have these proposals generated so much controversy?

In order to understand the IME, it is necessary first to understand the nature of the UK’s involvement in the hedge fund industry. Despite frequent comment, not least by the industry itself, that London is a leading hedge fund location, this is in fact not correct and potentially misleading. The vast majority of the world’s hedge funds are not located in the UK, but in Cayman, Ireland, Luxembourg and a small number of other centres, which specialise in providing efficient structures for international investment funds. The investment managers, providing advice to these funds, are in turn found in only a small number of other locations, the primary ones being London and Connecticut. Whereas the investment managers are liable to tax on their investment advisory fees in the UK, or the US, the funds themselves, (as is the international norm), are tax free in their own jurisdictions. Investors, who receive income, or gains from such funds also pay tax in their countries of residence.

The tax problem and the exemption

So why could there be a tax issue for the funds, if the funds are tax free and service providers and investors pay tax in their home countries? This arises because of the way in which entities which cross jurisdictions are normally taxed. If a fund, for example in Cayman is trading through a UK based investment manager, under normal tax rules, because that fund has an agent in the UK and that agent can give rise to a taxable permanent establishment in the UK, the income of that fund would be taxable in the UK. The UK tax authorities would deem the fund itself, via its agent to have acquired a taxable presence in the UK and to be liable to tax on the investment income arising from the decisions of its agent. The reason this does not happen is because such an occurrence is specifically exempted under UK rules. These rules, which were originally set out in 1995 and amended in 2001 are called the UK Investment Manager Exemption. The IME provides an exemption from UK tax for non-residents trading in certain investments in the UK where that trade is carried on through an investment manager acting as an independent agent. Due to the complicated nature of the area, in 2001 HMRC issued Statement of Practice 101 (‘SP101’), to explain their interpretation of the relevant legislation, contained in the Finance Act 1995, as amended.


In order to avail of the IME, the following conditions are set out:

  • The manager must act in the ordinary course of its business
  • The manager must act in an independent capacity, (Independence Test)
  • The manager and connected parties must not be entitled to more than 20% of the fund profits, (20% Test)
  • The manager is not entitled to receive more than a customary rate of remuneration, (Customary Rate Test)
  • The fund must not otherwise trade through the manager in the UK
  • The exemption applies to investment transactions only

The Independence, 20% and the Customary Rate Test have proven the most important of these conditions. In addition, because of the continually changing nature of the investment market, industry has been most concerned that the definitions of ‘investment transactions’ applied by HMRC would not be too narrowly construed. Originally, HMRC set out a list of circumstances, whereby if any one applied, the Independence Test was fulfilled. These included: where less than 70% of the investment manager’s income was from any one fund, where the funds were listed on a recognised stock exchange and where the fund was widely held, (by more than 5 investors, no one holding more than 20%). However, the legislation was silent on the Customary Rate Test and historically HMRC have given little guidance on this, although they appear to have been guided by typically reported hedge fund rates, (such as 2% fee and 20% of outperformance).

HMRC review

In October 2006, HMRC announced a review of SP101, with a view to issuing a revised statement of practice. It stated that the review arose from a requirement to remove areas of significant doubt, which were causing uncertainty. HMRC also stated that whilst they were not out to tax offshore funds, they could do so where people were ‘being unco-operative’.

Specialists from HMRC’s international CT section met with industry participants and representatives. A draft revised statement was issued and a period of consultation with industry was announced. Reaction to the draft varied. Whilst some elements of the draft provided more certainty, others appeared to regress on the certainty provided by the original statement. Specifically, the draft guidance stated that the Customary Rate Test was to be considered using the arm’s length principle of the OECD’s transfer pricing guidelines. In relation to the Independence Test, recourse was again made to OECD documentation concerning the definition of an independent agent. What concerned the industry most, however, was HMRC’s new policy of looking at all the facts of each case, whereas previously passing one of the independence tests was sufficient.

Consultation summary

On 29th March 2007, HMRC published a summary of its consultations. As anticipated the Independence Test now included not ‘any one of’, but a hierarchy of tests. The Customary Rate Test was now also to be based on net rather than gross fees, a significant change. HMRC also announced that the scope of investment transactions was to be increased with CDSs now falling under the IME and also carbon emission credits to be included by legislation. Further discussions were held with industry in the period to June 2007.

Revised SP101

On 20th July, HMRC issued the revised statement, in which they appear to have listened carefully to the views of industry. However, whereas more clarity seems now to prevail, some ‘safe harbours’, (such as having a fund quoted on a recognised stock exchange), have gone – although there will be a transition period of up to 31 December 2009 to ensure that an alternative ‘safe harbour’ can be found.

The definitions of investment transaction have been broadened and clarified; significantly HMRC have confirmed that minor, or inadvertent non-qualifying transactions, will not generally cause the IME test to be failed. While the net fee approach has been retained for the Customary Rate Test, the use of rebated, reduced, or zero fee arrangements with unconnected parties, will not in themselves cause the test to be failed. The revised statement has immediate effect, but the old 2001 version may be relied on until 31st December 2009, to enable managers to become compliant.

While industry has generally welcomed the new SP101 as helpful in maintaining the competitive position of the UK based investment management industry, participants need to be aware that the old ‘check the box’ regime has now been replaced. HMRC has stressed that appropriate documentation and evidence will be required to support arm’s length fee arrangements.

In consultation prior to the final revised statement, HMRC indicated that, whereas in the past, it has not had the practice of raising assessments on investment managers for breaching the IME, failure to comply with the rules going forward may cause such assessments to be raised. This would particularly be the case, where an investment manager had failed to take proper advice.