On 13 October 2020, HMRC published its long-awaited updated guidance on the application of the Disguised Investment Management Fees (“DIMF”) and Carried Interest rules. We have reviewed the updates made since October 2016 and considered the potential impact for clients.

By way of background, the DIMF rules effective from 6 April 2015 were introduced to target amounts received by individuals that are, in substance, management fees and so ought to be subject to tax as trading income regardless of the underlying nature of those amounts at the fund level (income tax at a max. rate of 45% and Class 4 NIC at a max. rate of 2%). Defined carried interest and co-investment arrangements were carved out from the rules. From 8 July 2015, holders of carried interest no longer became entitled to reduce their capital gains arising through ‘base cost shifting’ and the Finance Act 2016 brought a type of carried interest, ‘Income Based Carried Interest’ (“IBCI”) within the DIMF rules. The rules are highly complex and widely drawn which explains why we have come across a number of different interpretations to the rules.

The original guidance to these rules was set out in HMRC’s Technical Note ‘Investment Managers: Disguised Fee Income’ dated 29 March 2015 and a later draft revised version was circulated in October 2016. However, no further guidance has been released until  13 October 2020. The updated guidance can be accessed here. 

1. DIMF Rules

The updated guidance broadly remains the same as the previous guidance (most changes relate to presentation) however, we note the following substantive changes made by HMRC:

• Broadening of the definition of what they consider to be a ‘management fee’

In the updated guidance, HMRC state that in a typical model, management fees are due irrespective of how well an investment fund performs. In earlier guidance, they state that management fees are strictly calculated by reference to the sums committed by investors to the fund, even before those sums have been drawn down.  

In the updated guidance, they state that the DIMF rules apply regardless of how a sum is described or if the legal form of the fee is not that of a payment for services i.e. amounts described as partnership profit shares or advances in anticipation of expected future profit shares. The previous guidance did not mention advances in anticipation of expected future profit shares.

They have included a new section on the background of a limited partnership fund where they describe how in the early period of a fund’s life, the investors or the fund vehicle will typically advance the general partner (“GP”) money from the fund’s capital reserves so that the GP can pay the management fees as per its contract with the fund house. These management fees are usually known as ‘advance profit shares.’ They acknowledge that the limited partnership agreement will usually recognise that the GP has been advanced monies to settle the management fees and guarantee that the GP gets allocated a share of any profits before limited partners and this is known as ‘guaranteed profit share’ or ‘priority profit share’ where it typically matches the accumulated ‘advance profit share.’ In the previous guidance, the only type of profit share mentioned was the priority profit share.

The changes made to the guidance reflect HMRC’s acknowledgement that fees provided to individuals can in substance be management fees regardless of how they are determined, described, written in legal form, etc. which appears to broaden their definition of what they consider to be a management fee.

• Limiting the meaning of ‘Condition 1 - performance of investment management services’

One of the conditions to fall within the DIMF rules is that the individual must perform investment management services. Much of the new guidance in relation to this condition remains the same as the previous version but it further clarifies that if it can be demonstrated that shares or an interest in an asset manager firm have been awarded solely to incentivise executives and the award is not made in relation to the performance of the fund, then the DIMF rules may not apply. If however, the award has been made as part of a wider remuneration scheme to avoid the application of the DIMF rules, then the amount may still be charged as income. HMRC makes clear that all facts and circumstances must therefore be taken into consideration in order to evaluate whether the DIMF rules apply.

Elsewhere in the guidance, they clarify that the DIMF rules were not intended to introduce a different or more onerous basis for taxing fund managers than applies to individuals who receive similar benefits but who work in other industries i.e. a share scheme designed to incentivise a firm’s workforce linked to the performance of the firm or wider group, as opposed to the performance of investment funds managed by that firm or wider group.

Such clarifications appear welcome because the interpretation of DIMF in relation to the acquisition of such awards is not immediately clear. It is important to ensure that any awards made to individuals performing investment management services are reviewed on a case-by-case basis to determine whether they fall within the DIMF rules or outside.

• Inclusion of additional examples in relation to DIMF, carried interest and co-investment.

Additional examples are added by HMRC on the application of DIMF (in relation to the enjoyment conditions), what constitutes ‘arm’s length’ for co-investment purposes and what would meet the ‘significant risk’ condition for carried interest under the DIMF rules.

 2. Carried Interest Rules

Please note that the updated guidance reviewed in relation to these rules do not include IBCI – guidance on IBCI is still in the progress of being completed. But similar to the updated guidance on the DIMF, the changes are limited.

HMRC has added a section on ‘low tax jurisdictions.’ They clarify that the correct proportion of carried interest applicable to UK taxation will not be affected by the attempt to disguise the legitimate underlying investment management services – services based in low tax jurisdictions may be labelled as marketing services, investor relations or other vague descriptions seeking to disguise the real contribution of value by the management team in the offshore financial centres where they are normally based.

In relation to the updated guidance on both sets of rules, we consider that the changes from the previous guidance are limited. We were hoping to see clarification to the DIMF rules particularly in relation to where sums are paid by way of genuine loans with commercial terms however we have seen no such guidance. The rules remain highly complex and widely drawn.

How can A&M Taxand help?

At A&M Taxand we can help you navigate through the complex DIMF and carried interest rules and guidance to help you understand what these mean for you and your investment structures. If you would like to discuss this or would like to discuss your structures more generally, please feel free to get in touch with your usual A&M point of contact, Daniel Parry, Orion Ganase, Louise Jenkins or Shirley Ly.