Much has already been written about the potential impact the Alternative Investment Fund Managers Directive Remuneration Guidelines will have on UK hedge fund managers. To put it simply, UK hedge fund managers could be required to defer between 40%–60% of the variable remuneration of a potentially large proportion of staff. The remuneration would be deferred for a minimum of three years and be subject to vesting and forfeiture conditions.
In the UK, the Financial Conduct Authority (FCA) is now expected to consult with the industry on how it will apply the Remuneration Guidelines in July 2013 (at the earliest). Many think it is unlikely the FCA will be able to apply proportionality to the extent that managers are not subject to mandatory deferral.
The Guidelines state that distributions of business profit in the form of dividends or similar distributions from partnerships are not remuneration but there is an anti-avoidance provision to prevent circumvention of the rules. It is not clear yet how large numbers of hedge fund managers structured as Limited Liability Partnerships (LLPs) will determine what element of LLP profit will represent variable remuneration vs. profit and therefore be subject to deferral.
Deferral by a hedge fund manager organised as a LLP causes a significant tax challenge. Since LLPs are typically tax transparent all the profits of the business are taxable on the partners regardless of whether the profits are actually distributed to them. A mandatory requirement to defer up to 60% of profit can result in a partner being required to fund a cash tax payment to HMRC without receiving sufficient cash from the LLP. This is sometimes referred to as being a ‘dry tax charge’. If the deferred remuneration is clawed back or forfeited in future, the partner will have paid the tax on the amount and no credit will be received.
To date, the Financial Conduct Authority and HMRC have not addressed the fundamental question of how regulatory requirements can work sensibly alongside tax legislation.
Despite the tax challenges a significant number of, but by no means all, UK hedge fund managers already operate some form of deferred remuneration policy for strong commercial reasons, which include meeting regulatory expectations for sound and effective remuneration policies, investor pressure to ensure alignment of interests, and for staff retention purposes. In a practical attempt to address the tax issues, and despite incurring additional cost, complexity and tax risk for themselves and their businesses, many managers have had no option but to use some form of corporate member planning. This can result in a lower overall tax inflow for HMRC since LLP profits often end up being taxed at corporate tax or capital gains tax rates that are lower than the income tax rates which apply to allocation of profits to individual partners.
Despite the genuine commercial reasons for managers to use corporate member planning, HMRC has just published a widely anticipated consultation document which will review the use of corporate members by LLPs. Early reviews of the consultation suggest HMRC is not seeking to limit the scope to aggressive tax planning and that bona fide use of corporate members as a tax efficient means of retaining capital in the business or to enable the deferral of remuneration may also be caught.
Which brings us to the main purpose of this article. That is, how can HM Treasury, HMRC and the FCA, work in partnership and agree a pragmatic solution to this issue?
One solution might be to enable those LLPs that are authorised by the FCA as AIFMs, and therefore subject to deferral, to elect not to be transparent for tax purposes, such that the dry tax charge goes away. The taxation point for deferred remuneration would move to the point of receipt. Whilst this defers the tax paid to HMRC, it would remove the need for many managers to employ corporate member planning, and therefore the overall tax inflow to HMRC would ultimately increase. AIFMs could be required to report details of the profits deferred and the period and conditions of deferral to HMRC, thus enabling HMRC to forecast future tax revenues. HMRC have introduced a cash basis for small business and therefore they may be willing to consider this. It may also be a much simpler way for HMRC to address the issues it sees with certain corporate member planning techniques employed to date.
Alternatively, the FCA could agree that where AIFMs are structured as LLPs and subject to deferral, an adjustment is allowed to the amount subject to deferral reflecting the tax paid. Deferral would therefore be on a post-tax basis. Where amounts are forfeited or clawed back, HMRC would need to allow a tax credit.
These are just two suggestions. There are no doubt other ways to address the issue and, as always, the devil is in the detail. But what seems obvious to many hedge fund managers and their advisors is that there are pragmatic solutions to the problem which would be welcomed by the industry. There are solutions which could be a ‘win / win’ for all and, for many managers, help ease the pain and complexity of compliance with the AIFMD regulations. All that would be required is the collective will of the regulator, tax authority and government to make it happen.