Finance Bill 2016 summary of key changes for fund managers

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1 Finance Bill 2016 summary of key changes for fund managers On 24 March 2016 the Government published the Finance (No. 2) Bill One of the most relevant aspects of the finance bill for alternative investment fund managers is the revised version of the income-based carried interest rules, which will be effective from 6 April These rules represent the final output from the Government's consultation on Performance Linked Rewards which was undertaken during summer An initial version of the rules was published in December 2015, but the revised version takes into account feedback from PwC and other professional firms as well as industry bodies, and contains a number of improvements on the initial version. The changes are broadly welcome and reflect a better understanding of the practical difficulties facing fund managers applying these rules. Whilst the legislation is relatively long for what is essentially determining a good and bad carried interest scheme by reference to the average holding period of a fund s investments, the Government have in effect created a number of gateway tests that provide fund managers with the opportunity to adopt a simplified approach to calculating this average. Most asset strategies have been accommodated, as set out in this note, with the exception of secondary debt funds which will not have the ability to adopt a simplified approach to determining their average holding period. There are also a number of changes in other areas which can potentially have an impact for the alternative investment fund industry and these are set out in more detail below. One key item is that the headline capital gains tax rate ( CGT ) is to be reduced from 28% to 20% from 6 April However, the CGT rate on carried interest (and residential property) will remain at 28% owing to an 8% surcharge to be levied on these types of gains. Naturally to the extent that any carried interest (as defined by reference to the new carried interest legislation of 8 July 2015) is now IBCI, the effective tax rate on the carried interest will be higher than 28% as any element of the carried interest that is IBCI will be taxable as disguised investment management fees (i.e. 47%). Income-based carried interest ( IBCI ) It is worth initially noting that the exemption from the IBCI rules for carry categorised as an employment related security remains. However, importantly the legislation gives HMRC the ability to quickly remove or restrict the application of this exemption at any point in the future. The average holding period above which carry is not treated as IBCI has been reduced from 48 months to 40 months, which will no doubt be well received by the vast majority of fund managers. The lower end of the tapering, below which all carry is IBCI, has remained at 36 months, and the taper start and end points are, therefore, now concentrated over a 4 month period. As per the table below: Weighted average holding period Relevant proportion taxed as IBCI Less than 36 months 100% At least 36 months but less than 37 months 80% At least 37 months but less than 38 months 60% At least 38 months but less than 39 months 40% At least 39 months but less than 40 months 20% 40 months or more 0% Average holding period Intermediate holdings structures such as Topco- Midco-Bidco in private equity type structures are disregarded for the purposes of calculating the average holding period of an investment scheme. However, an investment is considered to be disposed of if there is a disposal of an intermediate holding structure. This would seem to exclude from the calculation any period where an intermediate holding structure exists prior to the acquisition of an underlying investment. It would also appear to exclude from the calculation any period during which part of the holding structure still exists once an underlying investment has been sold. Importantly it has also been clarified that where carried interest is calculated by reference to the fund as a whole, which we understand to include deal by deal with whole fund clawback, the average holding period will include all investments made by the fund. Where carried interest is calculated by reference to the performance of a portfolio over a given period, the relevant investments will be those disposed of during that period and those which remain held at the close of the period.

2 Unwanted assets One key practical point raised by PwC as part of consultation on the draft rules was how unwanted assets would act as a drag on the weighted-average holding period of a fund. Industry practice in a number of areas (including real estate) is to buy a package of assets which might include assets which are not desirable or require syndication to prevent the fund breaching its concentration limit. It is common, therefore, to buy a group of assets, but then to sell on the unwanted assets (which would thus have given a very short holding period). The new exemption allows such unwanted asset sales to be excluded from the holding period calculation in certain circumstances. Availability of the exemption requires any resulting profit from the disposal to have no bearing on whether carry arises, which is unhelpfully worded given such sums would typically still form part of the cash waterfall which dictates when carry becomes payable. There are also time limits within which the unwanted assets must be sold, depending on the type of assets land (12 months), securities in unlisted companies (6 months), certain types of direct loans (6 months) and qualifying loans for the purposes of direct lending funds (120 days). A fund will no longer be able to disregard unwanted assets if it becomes reasonable to suppose that 25% or more of the capital of the investment scheme will have been invested in unwanted short-term investments. The 25% is cumulative and does not refresh as unwanted short-term investments are disposed of. Conditionally exempt carried interest ( CECI ) The conditionally exempt carry rule was aimed at situations where carry is received early in the lifecycle of the fund and, therefore, likely to be IBCI, but if re-tested later in the life-cycle it would be reasonable to suppose it would not be IBCI. However, in the initial draft the application of CECI was very restrictive as it only applied for carry received in the 4 years from the start of the fund investing. Given the investment period of funds this was unrealistic and the rules have now been helpfully extended to cover 10 years, provided carry is paid on a realisation model (which requires external investors to receive full repayment ahead of any carry arising on either a whole fund or deal by deal basis, although there is no requirement for a performance hurdle). As before if at a later relevant time the CECI does not meet the holding period requirements it would fall back into IBCI and essentially be treated as if it had always been so. Private equity funds For private equity funds which invest in trading companies and/or trading groups there are three relevant categories, all of which have a simplified weighted-average holding period calculation, whereby subsequent investments are effectively back dated and disposals are ignored (subject to conditions). Significant interests Broadly, a significant interest is where a fund has a controlling interest (i.e. 50%) in a trading company or group etc. and disposals are ignored until the fund s holding falls below 40% (this is basically unchanged from the previous draft Finance Bill). Controlling equity stake funds Broadly, this is a fund where it is reasonable to suppose, as determined at the time the fund starts to make investments, that over the life of the fund more than 50% of the investments made by the fund will be controlling interests (i.e. 50%) in trading companies or groups etc. and more than 50% of the investments made by the fund will be held for at least 40 months. Where a fund holds a 25% interest in a trading company or group, any subsequent investment made by such the fund is treated as being made at the time the fund acquired the 25% interest in the company. Thereafter, any disposal is ignored until fund s interest in the company falls below 25% (this is basically unchanged from the previous draft Finance Bill). A fund cannot meet the conditions of a controlling equity stake fund if it is a significant equity stake fund or a venture capital fund (see below). Significant equity stake funds The test is similar to the controlling equity stake fund apart from the requirement for the fund to initially only hold a 20% interest in a trading company or group etc., and only after the fund s investment falls below 15% would it trigger a disposal for the purposes of these rules. However, to contrast to the controlling equity stake fund rule, a significant equity stake fund must be able to appoint a director to the investment company (or a company which controls the company) and that director must be entitled to exercise certain enhanced rights in respect of the company (the scheme director condition ). This test also considers whether the company is likely to be listed in the relatively near future, or whether there are firm plans in place for it to be listed at some point. A vague expectation of future listing is not sufficient. The scheme director condition and the listing condition should not be problematic for most private equity funds.

3 Venture capital funds The Finance Bill allows for a simplified weightedaverage holding period calculation to apply to venture capital investments whereby subsequent investments are effectively back dated and disposals are ignored until the fund has disposed of more than 80% of its investment in the company, or it ceases to meet the scheme director condition. It would appear that the venture capital fund definition should only apply to those funds making investments in genuine start-up companies. Whilst the level of investment required to be qualifying is much lower than other funds types, being either 5% of the company in which the investment made or 1 million, the definition of what constitutes a venture capital investment is more restrictive. This requires at least 75% of the investment to be made in newly issued shares, that the investment is used by the company to support its growth or development, the company has been trading for less than 7 years and that the fund appoints a director to the company (with associated conditions applying). Further, there is a condition that when the investment is made, the company is unlisted and likely to remain so (as described above). Due to the above there may be a perceived gap in the specific regimes between start-ups and established companies, where the controlling stake rules could start to apply, meaning companies that are seeking second-stage investment may now be less attractive to funds. Real estate funds Whilst many real estate funds are typically operated in a manner similar to private equity funds and often have a long-term investment strategy, the definition of controlling and significant equity stake funds only applies to investments in a trading company, which would otherwise exclude most real estate investments. The Finance Bill specifically defines a real estate fund, broadly meaning a fund that invests 50% or more of its value in land. Where the definition is met, a simplified weighted-average holding period calculation will apply, under which the disposal is treated as being effective when more than 50% of the value of land is disposed. This applies where a fund has a major interest in land (broadly, this is an interest exceeding 21 years in England & Wales or not less than 20 years in relation to Scotland) and when calculating the average holding period it ignores the corporate envelope. It would appear that many of the concerns raised by the industry group and PwC have been addressed in the majority of situations, both through the specific definition of real estate in the legislation, specifically the clarifications to hedging and financing arrangements and the treatment of unwanted investments which are perhaps more common to real estate funds. Fund of funds Fund of funds typically invest in third-party managed funds. The Finance Bill clarifies that the requirement to disregard intermediate holding structures does not apply to fund of funds; in effect, this means the relevant investment is the thirdparty managed fund, therefore reducing the challenges in obtaining additional data on each underlying investment. Broadly, the definition of a fund of funds should apply where the fund has at least 75% external investors and predominantly invests in other funds, holding less than 50% of those underlying funds. Certain anti-avoidance provisions also apply. A simplified calculation methodology, similar to controlling equity stake funds (see above), has also been introduced to situations where the fund of funds has a significant investment in an underlying fund. This is defined as an investment of at least 1 million or 5% of the underlying fund. In addition, a fund of funds will fall outside the scope of the applicable definitions where a person provides investment management services to both the fund of funds and the underlying fund. These clarifications are likely to be welcome by the fund of funds industry following representations from the industry body and PwC. However, fund of funds managers may still face some challenges where they hold a greater than 50% interest in the underlying fund, potential pitfalls could be dedicated feeder vehicles for the fund of fund, or its own parallel investment vehicle. In such cases, the fund of fund may not benefit from this simplification. Moreover, whilst we were concerned that the fund of fund itself would need to be widely held, the test included that requires 75% external investors could also create an issue for some fund managers with managed account strategies if there is a requirement to have more than one external investor (i.e. investors ). These issues are also relevant to underlying fund managers because they will potentially impact on their own fund structures. Additionally, there is specific provision for the subsequent acquisition of adjacent land to be considered as part of the original land acquisition.

4 Secondary funds In addition to a fund of funds there is also a definition for secondary funds. It is not readily apparent why HMRC have sought to include a specific definition for a secondary fund where the conditions are so similar to that of a fund of funds. Whilst there are some slight differences in terms used, it would appear that HMRC are only recognising situations where a secondary fund acquires limited partner interests in an established fund, and it is likely that the fund of funds definition may also apply. Secondary funds should not disregard intermediate holding structures in respect of their investments. A similar simplification of the weighted-average holding period calculation also applies. Direct lending funds With one exception, the default position is that the whole of the carried interest on a direct lending fund is subject to income tax, no matter how long the average holding period. A direct lending fund is one where the majority of its investments are direct loans and it is not one of the four funds with a simplified regime (a venture capital fund, significant equity stake fund, controlling equity stake fund or real estate fund). A direct loan is one where money is advanced at interest or for any other return determined by reference to the time value of money. The exception is aimed at primary debt funds and applies where the fund is a limited partnership, at least 75% of the loans are qualifying loans and the preferred return on the carried interest is at least 4%. These are loans where: (a) money is advanced under a genuine commercial loan agreement negotiated at arm s length to an unconnected borrower, (b) repayments are fixed and determinable, maturity is fixed and the fund has the positive intention and ability to hold the loan to maturity, and (c) the term of at least 75% of the loan is four years or more. Where these conditions are satisfied the normal rules for calculating the average holding period apply but with one favourable exception. This is that any part of the loan that is repaid early is treated as having been held for 40 months. This is designed to ensure that carried interest can still qualify for the capital gains tax treatment even if a borrower decides to repay the loan early. The restriction of acquiring loans within 120 days of when first issued is still a condition for qualifying as a direct lending fund, which effectively restricts secondary debt funds from benefiting. Aggregation of parallel funds The Finance Bill has introduced rules which allows investments held through parallel investment schemes to be aggregated where the same or substantially the same individuals provide investment management services to the parallel investment schemes. The aggregation is permitted where the underlying investments are substantially the same; and the parallel investment schemes act together in relation to all or substantially all of the investments. This is an important amendment from the original draft as it should now allow funds to aggregate their investments for the purposes of calculating the average holding periods under the significant interests test, the significant and controlling equity stake fund tests and the venture capital fund test. IBCI: persons coming to the UK There is welcome news for internationally mobile executives that are non-uk domiciled UK residents, but only for the first four tax years after their arrival in the UK. Provided that they have previously been non UK resident for at least 5 consecutive tax years or more and have no break in UK residence between arrival and year of receipt of the carried interest they will be able to claim the remittance basis on IBCI to the extent that it is attributable to services they performed outside the UK before coming to the UK. Disguised Investment Management Fees ( DIMF ) The Finance Bill includes a number of important changes to the DIMF legislation, all of which apply for sums arising on or after 6 April An individual does not have to perform investment management services in the year to potentially have a disguised investment management fee as the legislation has been broadened by applying to an individual where at any time the individual performs or is to perform investment management services, thereby capturing joiners and leavers. The individual no longer has to supply investment management services to the investment scheme that is generating the potential disguised investment management fee, merely the provision of investment management services is sufficient to taint the amount in question. The legislation has also been clarified to deal with arrangements associated with the investment scheme, which in effect clarifies whether parallel co-investment or co-investment structured through a nominee arrangement are within the rules. Moreover, the definition of investment scheme has also been amended to accommodate alternative investment structures whereby external investors do not invest directly through the investment scheme.

5 Businesses required to publish tax strategy The Finance Bill introduces a requirement for large businesses to publish a tax strategy in relation to UK taxation. These new measures are specifically aimed at qualifying partnerships, companies, groups (including UK sub-groups or companies of multinationals) with over 200m of turnover or a balance sheet over 2bn as measured in the previous financial year. Multi-national enterprises with some form of UK establishment and a total turnover of 750m are also required to publish a tax strategy. This legislation will apply for the financial year commencing 1 January Qualifying businesses must publically publish a tax strategy on the internet, free of charge and for at least one year, before the end of each financial year. The tax strategy document must cover the approach, attitude and level of risk taken in relation to UK taxation and their approach to dealings with HMRC. Incremental penalties may apply for nonpublication or inadequate disclosure. The tax strategy does not need to include capital gains tax for individuals. Although funds structured as an English Limited Partnership and used in transactions are typically non-trading limited partnerships, large funds with balance sheets above 2bn are expected to be caught by this legislation and have a reporting requirement. Large general partners, investment management or advisory partnerships trading as LLPs may also be caught as well as where organisations with consolidated turnover and balance sheet of a corporate group, excluding partnerships, breach the thresholds. The UK definition of a group (excluding the OECD Multi National Enterprise ( MNE ) definition) does not aggregate partnerships or holdings by partnerships, which could result in several entities in an organisation required to publish a tax strategy. Funds holding 51% or more of equity in UK groups or UK companies in their portfolio will need to consider whether the qualification test thresholds have been met. Unlike the UK definition, the OECD definition of a MNE group is extremely wide and can aggregate holdings via partnerships considering collections of enterprises related through ownership or control. There is a risk that UK based funds are required to aggregate the whole of the enterprise including underlying investments and any entities controlling the fund (the GP/investment manager). There will be a requirement to monitor the position by an organisation going forward into the next financial year. Cash extraction - changes to transactions in securities provisions and introduction of a targeted anti-avoidance rule ( TAAR ) for liquidations Within private equity backed companies and corporate structures more generally, funds are returned to investors in a number of ways, including repayments of share capital or share premium, buying back shares or liquidation distributions. The transaction in securities provisions have been around for some time and broadly seek to counter any income tax advantage for individuals in situations where HMRC perceive that individual to have transformed an income return into capital in a close company. The scope of these provisions has been widened and with the reduction in the headline CGT rate to 20% and the increase in the effective dividend tax rate for additional rate tax payers to 38.1%, we expect the provisions to be one of a number of areas of HMRC focus. A liquidations TAAR will also broadly seek to tax capital returns as dividends if at any time within a period of two years beginning with when the liquidation distribution is made, the individual carries on a trade or activity which is the same as, or similar to, that carried on by the liquidated company. It is clear that future returns to individuals will need careful consideration as the changes potentially have a wider impact than HMRC intended and could result in an unexpected tax treatment on returning funds to individuals. Investors' relief ( IR ) The Budget introduced a new relief for those investing in newly issues shares in unlisted trading companies for at least 3 years. Those individuals can benefit from a reduced rate of capital gains (10% vs. 20%) on a subsequent qualifying disposal up to a 10m lifetime allowance. There is no 5% test as with entrepreneurs' relief ( ER ) however, the investor cannot be, nor be connected with an officer or employee of the group they are investing in. The ER lifetime allowance is independent of IR. Therefore, an individual qualifying for ER in one investment could also benefit from IR in another independent investment. The provisions are designed to attract new capital to a business and there are a number of anti-avoidance provisions seeking to capture situations where individuals try to transform an existing investment by recycling capital into an IR qualifying investment.

6 Employee Shareholder Shares ( ESS ) On disposals of ESS shares relating to employee shareholder agreements entered into post 16 March 2016, the level of exempt gains will be capped at a lifetime amount of 100,000 per individual. Although the amount of exempt gains has reduced, an issuance of ESS still presents an opportunity to agree a tax valuation up-front with HMRC before shares are issued. Businesses and management teams will have to weigh up the certainty offered on the valuation for tax purposes against the limited amount of exemption. Hybrid mismatch arrangements Background The Finance Bill proposals in relation to hybrid mismatches originate from the G20/OECD Base Erosion and Profit Shifting (BEPS) project completed by the OECD in October A hybrid payment is generally where there is either a tax deduction with no corresponding taxation on the income, or where two tax deductions in different territories can be achieved for a single payment. In the UK, anti-arbitrage laws have been in force since 2005, however, the purpose of these changes is to make the rules consistent with those agreed on a global basis in the BEPS project. The new rules will apply for payments made after 1 January 2017 (so if payments are accrued in accounts prior to 1 January 2017, but are still paid after, the new rules will apply). Draft legislation was published in December 2015 for consultation. As a result, there have been a number of changes from the proposals outlined in December. Purpose of the hybrid rules Driving tax payers towards less complicated and more transparent structures; Targeted at related parties and structured arrangements only; No motive test defence; The rules include primary response (to deny tax deductions for hybrid payments), defensive rule (to tax income from hybrid payments) and then third, indirect, imported mismatch rule to ensure hybrid effect is neutralised (to deny tax deductions for payments made to fund hybrid payments); Application to hybrid debt in private equity structures To fall within the rules, one of the following persons must be within the charge to corporation tax: Company making the hybrid payment (primary rule); Company receiving the hybrid payment (secondary rule); Company making a payment which funds a hybrid payment (imported mismatch rules); The rules do not apply to individuals and corporates who are only within the charge to UK tax through income tax; and The rules only apply to related party transactions (25% investment) or structured arrangements where an outcome is specifically designed for an investor. However, investors which invest through a partnership will generally have their interests pooled to determine if the 25% test is met. The key risk areas where we expect to see interest deduction denied in the UK in private equity structures are as follows: Where corporate structures have been disregarded for US tax purposes through check the box elections so the interest income is not taxed (or if the payment is taxed in an intermediate jurisdiction, an onward payment to US investors is disregarded; The use of preferred equity certificates and profit participating loans where investors treat the instruments as equity. Although these instruments do not generally create a hybrid if held or issued directly by the UK, there could still be an imported mismatch into the UK if a UK debt instrument funds payments under a hybrid instrument issued between two other countries which have not implemented these rules; Interest payments to or from permanent establishments which are not fully subject to tax; and Specific provisions will mean that UK LLPs will not be treated as transparent for UK tax purposes if they have income falling within the rules (generally, where the members of the LLP are not taxable because under their tax rules the LLP is viewed as opaque). Such structures could include LLPs that are reverse checked for US tax purposes.

7 The rules are not intended to impact mismatches that do not rely on a hybrid element e.g. tax havens (though extra analysis is required for exempt bodies such as pension funds and sovereign wealth funds); and Pure timing differences are not impacted where it's "just and reasonable" for the income to arise in a later period. This will be area where hopefully we will receive more clarity from the guidance. Key changes The December draft of the Finance Bill included a concept of a permitted reason which meant the rules did not apply where there was a hybrid but this was as a result of the recipient either (1) having sovereign immunity; (2) not being subject to tax under the law of any territory; (3) not being subject to tax on income sourced outside of its territory or (4) met certain offshore fund rules. This concept has now been deleted from the current rules. To determine whether a tax exempt body such as pension funds or sovereign wealth funds fall within the rules, it is now required to test whether the income would be subject to tax at the full marginal rate to a fully taxable person. If it is a hybrid for a fully taxable person, it will be a hybrid even if the recipient is an exempt body. Conclusion Having been trailed in December, the inclusion of the hybrid legislation was no surprise. The rules as drafted could have an impact for UK interest deductibility for financing expense on private equity investments and could have a distortive effect on how investments are made. Funds with partnership structure on top could be disadvantaged compared to corporate funds under the related party rules. Also the use of no/low tax jurisdictions would seem to provide a better answer than some territories which tax income but then provide for reliefs or exemptions for certain investors. The deletion of the permitted reasons test is particularly disappointing as companies will not only need to know how they are actually taxed, but also how exempt companies would be taxed if they were a fully taxable entities in their jurisdiction. This will add further complexity to rules which were already drafted to be some of the more complex pieces of legislation in UK tax law. There has been a welcome relaxation (so the rules are now consistent with the OECD rules) for tax transparent structures such that if an investor is subject to full tax on the income of an subsidiary entity, then a full tax deduction can be offset for a payment against that income in the subsidiary state even if it is not taxed. New restrictions are provided for the following structures relating to permanent establishments: Where there is a tax deduction for a payment or deemed payment between the permanent establishment and the head office which is not taxed in the head office; and Where the income allocated to the permanent establishment by the tax rules of the head office state (and not taxed there) are then not fully taxed in the jurisdiction of the permanent establishment. There is a new general anti-avoidance provision for taxpayers who deliberately structure outside of the rules in a way which is not consistent with the policy of the rules.

8 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers CI LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers CI LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers CI LLP which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.