Seed Investing Series

Seed Investing Series UK IME and other relevant tax considerations for seed capital arrangements By Irina Pisareva, Seda Livian, Miles Humphrey, Dan Thompson and Michael Bolan

This article is the third in a series of articles discussing certain considerations associated with seed capital arrangements. The article focuses primarily on UK tax issues for UK investment managers associated with seed capital arrangements involving non-uk resident seeders and seeded funds, and certain standard pitfalls that can be avoided through diligence and appropriate care and attention. It follows previous articles in the series that looked at the key US tax aspects of seed capital arrangements. The decade after the financial crisis has seen an array of seed capital arrangements proliferating in the fund management sector to provide aspiring investment managers with the start-up capital they need in order to launch their fund management businesses. Although the terms of seed capital arrangements often vary from case to case, the constant theme in all arrangements is the sweetener for seeders to compensate them for the start-up risk to which they are exposed. The article assumes that the reader has a basic level of familiarity with the UK Investment Manager Exemption (IME). In brief, if the IME conditions are met, for both income and corporation tax purposes, an investment manager will not be considered to create a taxable presence in the UK for the non-uk resident fund or the fund s investors. As the IME conditions include, among other criteria, ownership diversification tests, these tests must be carefully considered for all seeded structures. The article does not consider Brexit. As the commercial and regulatory impact of Brexit, if any, becomes clearer over time, organizations will need to address the implications of such changes to their facts and circumstances. UK fund managers a commonly used US-parented structure UK investment managers are often structured as sub-advisors, particularly in the context of US-based asset managers or hedge fund managers that have established a UK management office to serve their client base or assets in UK and European markets. From a structural perspective, UK investment managers usually either take the form of UK private companies or UK limited liability partnerships, with UK-based management either employees or partners of the respective substructure. Investment management services are provided to non-uk resident funds through a sub-advisory agreement with the primary US management entity. Seed capital arrangements the application of the IME s independent capacity test In start-up scenarios, it can often be difficult to evidence that the seeded fund meets the independent capacity test or its diversified ownership component. 1 The interests in the seeded fund may be concentrated between start-up investors, often connected with one another, and therefore, it is entirely possible that five or fewer investors will control an interest of greater than 50% in the fund. It is also possible that a newly established manager would derive more than 70% of its fee income from a seeded fund. The UK tax authorities acknowledge that a fund may need time to establish a track record in order to attract third-party investment. To support this, the tax authorities provide guidance stating that a fund may have an 18-month grace period from the commencement of trading in which to meet the widely held test. As long as a fund can demonstrate genuine attempts to attract thirdparty investment that would adequately dilute the ownership of the fund among investors, it should be possible to demonstrate that the fund is being actively marketed in order to qualify for this condition. In some cases, this would need to include consideration of the specific terms of a seeding agreement, such as the option for the seeder to top up their investment and the capacity to operate the portfolio on the scale needed to achieve the required dilution. 1 UK investment managers must, when acting on behalf of funds, do so in an independent capacity. Provided that such funds are widely held (broadly, no more than 50% of interests in the fund held by five or fewer persons or persons connected to them, or no more than 20% held by a single person or persons connected to that person) or actively marketed to become such, UK investment managers should be considered as acting in an independent capacity. Alternatively, provided that no more than 70% of a UK investment manager s fee income relates to any one fund, this test should also be satisfied. Seed Investing Series 1

Seed capital arrangements the application of the IME s 20% rule Under the so-called 20% rule, the UK investment manager and persons connected with the investment manager must not be beneficially entitled to more than 20% of the fund s profits arising from transactions carried out at the discretion of the UK investment manager, in any period not exceeding five years. 2 In applying the 20% rule, the meaning of the term connected is widely drafted and often costs tax advisors and clients significant time to confirm the relevant connected parties. If the UK investment manager and connected persons do have an aggregated beneficial entitlement to more than 20% of the profits of the fund, a corresponding share of those profits may be subject to UK tax to the extent that they arise from activities carried on through the UK investment manager. However, other profits for which there is no such beneficial entitlement are still protected by the IME if the other conditions are met, even where those profits are generated by the activities of the UK investment manager. One common seed capital arrangement can cause issues with the IME, whereby a seeder fund acquires an equity stake in the seeded investment manager. This may be provided in the form of a partnership interest in the US manager or directly in the UK investment manager. An example of this structure is provided below. Diagram 1: IME 20% considerations Seeder fund fund equity Investment in US or UK manager management team Equity in management structure fund Advisory agreement US manager Sub-advisory agreement Investments UK manager 2 Such entitlement excludes management and performance fees, or other such fees for services rendered, but does include returns on investment due to the investment manager and its connected persons. 2 Seed Investing Series

This particular arrangement can cause problems in relation to the 20% rule, because the equity stake in either the US or UK investment manager creates connections between the seeder fund and the UK investment manager. When such connections mean that the aggregate entitlement of the seeder fund and connected participants to the profits of the seeded fund exceeds 20% (which can often be the case in a start-up scenario), this can lead to a failure of the IME and a potential UK tax exposure for participants in the seeded fund, including the seeder fund. As noted above, in each year, the 20% rule must be met over a qualifying period of up to five years in duration, including the relevant year. Although this provides a period of time over which this condition can be met, often in a start-up scenario, it can be difficult to meet this test, particularly if the performance of the seeded fund is more volatile than expected. The scenario below can be contrasted with the situation where the seeder fund does not hold a direct interest in the manager entity, but rather, this interest is held via a subsidiary entity. Using a subsidiary entity may allow the connection requirements between the seeder fund and the investment manager to be met when applying the 20% rule by effectively breaking this connection. An example of this structure is shown below. Diagram 2: IME 20% considerations subsidiary investment Seeder fund Subsidiary Investment in US or UK manager management team fund equity Equity in management structure fund Advisory agreement US manager Sub-advisory agreement Investments UK manager Seed Investing Series 3

Seed capital arrangements received through fund vehicles We have observed that seeder funds are frequently compensated by being offered a reduction in management fee allocations to increase their share of a seeded fund s income. Alternatively, seeder funds may receive a payment from a seeded fund equivalent to a certain percentage of the investment management fees charged to the seeded fund. Such arrangements may have relevance from a UK perspective to the extent that a seeder fund receives such allocation, where the seeder fund has individual investors that are UK tax residents (regardless of whether connected to the UK investment manager). The precise impact will depend on the entity classification of the seeder fund itself. From a UK tax perspective, payments to UK tax resident persons may be treated as either income or capital gains, the characterization of which may have a significant impact for UK individuals in particular. There has been recent UK legislative activity with respect to the UK tax treatment of compensation and allocations paid to UKbased individuals, with the intention of appropriately taxing as income fees or returns derived from investment management activity and making certain that payments only receive capital gains tax treatment on returns that are capital returns based on the appreciation of the seeded fund s portfolio. The precise treatment for UK purposes will be dependent on the specific terms of any allocation. Detailed advice would need to be sought by seeder funds concerned about the UK tax treatment associated with receiving such returns. The UK tax effect of any payments or allocations that reduce management fee returns to UK investment managers would also need to be considered to validate that the returns to such UK investment managers remain appropriate from both a transfer pricing and diverted profits tax (DPT) perspective. We consider the DPT in further detail below. Again, any effect will be based upon the specific terms of the allocation arrangements in place. Finally, we note that in reduced fee arrangements it will be necessary to consider the impact of such arrangements on 20%- rule calculations for IME purposes (as discussed above) and whether there are any other UK tax implications, such as UK withholding tax on rebates from UK managers. As above, any effect will be contingent upon the specific terms of the arrangements. Additional considerations In addition to the IME-related seed capital arrangement considerations discussed above, sometimes the seeding arrangements involve the seeder fund assisting the investment manager with infrastructure and operational support, for example in legal, operational and administrative matters. Where such support is provided to a UK investment manager, it will be important to confirm that such support does not lead to the creation of a UK taxable presence for the seeder fund. This risk may be accentuated should an employee of the seeder fund perform their employment duties while in the UK working with the UK investment manager. Further, to the extent non-uk tax resident individuals take business trips to the UK to support a UK investment manager, it will be important to ascertain the UK individual tax issues associated with such trips so that such individuals do not foot-fault and create UK domestic residency for income and social security-type tax purposes. Double tax treaties can come into effect to help determine residency issues in more complicated scenarios. The UK also has certain shortterm business visitor agreements that UK entities can enter into with the UK tax authorities to verify the reporting of such visitors to the UK is appropriately recorded. Although not specific to seed capital arrangements, as noted above, it is worth mentioning in passing that the UK has introduced a new tax, the DPT, with effect from 1 April 2015. In summary, the DPT can potentially apply in relation to profits that are regarded as having been diverted from the UK (either in an avoided private equity scenario or in scenarios that seek to under-allocate profit to the UK for services provided) at 25%, compared to the current corporation tax rate of 20%. Where a UK investment manager can rely on the IME in respect of advice provided to an offshore fund, the DPT should not apply to the activity of the UK investment manager. The practical effect of this new legislation is to make it all the more important to verify the IME is met with respect to the activity of a UK investment manager to any offshore funds it advises. 4 Seed Investing Series

In conclusion In summary, where seed capital or start-up capital arrangements involve a UK-based investment manager, it is important to consider the UK tax implications associated with such arrangements, both on an ongoing basis and for exit tax purposes. UK tax costs associated with poorly planned structures can make such costs prohibitive to the overall strategy of the seeded manager. The tax implications of seed arrangements will depend on the specific facts and circumstances at hand, and will need tailored advice. Where seed arrangements involve a seeder fund taking an equity stake in the investment manager, this can lead to difficulties in meeting the conditions of the UK s statutory safe harbor for investment management services, the IME. With appropriate planning and advice, such risks can be significantly reduced.

EY contacts EY Assurance Tax Transactions Advisory Seda Livian +1 212 773 1168 seda.livian@ey.com Seda is a partner in the Wealth & Asset Management Tax practice and a co-leader of the Seed Capital Services group at Ernst & Young LLP (US). Irina Pisareva +1 212 773 9349 irina.pisareva@ey.com Irina is a partner in the Wealth & Asset Management International Tax Services practice and a member of the Seed Capital Services group at Ernst & Young LLP (US). Miles Humphrey +1 212 773 1425 miles.humphrey@ey.com Miles is a partner in the International Tax Services, EMEIA Financial Services Desk at Ernst & Young LLP (US). Dan Thompson +44 20 7951 0144 dthompson2@uk.ey.com Dan is a partner in the UK Wealth & Asset Management Tax practice and Co-leader of the hedge fund practice in London at Ernst & Young LLP (UK). Michael Bolan +44 20 7951 9614 mbolan@uk.ey.com Michael is a senior manager in the International Tax Services, EMEIA Financial Services Desk at Ernst & Young LLP (UK). About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. EY is a leader in serving the global financial services marketplace Nearly 43,000 EY financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, EY is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Organization today includes more than 6,900 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. EY professionals in our financial services practices worldwide align with key global industry groups, including EY s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industryfocused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, EY s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. 2016 EYGM Limited. All Rights Reserved. EYG no. 03628-161Gbl 1610-2085669 BDFSO ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com