UK investment managers paying fee rebates, loyalty bonuses or similar payments to UK investors and certain non-UK investors in collective investment schemes should note recent case law developments regarding the tax treatment of such sums. In short, in allowing the appeal of HM Revenue and Customs (HMRC) in Revenue & Customs Commissioners v Hargreaves Lansdown Asset Management, the Upper Tribunal held that loyalty bonuses paid by Hargreaves Lansdown (Asset Manager) were “annual payments” for income tax purposes and should have been paid to UK investors subject to 20% withholding.

Background

Contrary to the then-market understanding, in 2013 HMRC announced that fee rebates (and other similar payments to fund investors made by persons other than the fund itself) constitute annual payments for income tax purposes and, in the case of payments made to UK investors and certain non-UK investors, should be paid subject to 20% withholding in respect of basic rate income tax.

In brief, annual payments are sums payable under a legal obligation, which: are recurring or capable of recurrence; constitute income in the hands of the recipient; and are received as "pure income profit" (meaning, broadly, that they are received without the recipient having to do anything in return, over and above the making of an investment).

The Hargreaves Lansdown Case

The Asset Manager argued that HMRC’s approach was “an unnecessary and unwarranted attack” on investors, and so challenged HMRC’s position in respect of “loyalty bonuses” paid by it. The Asset Manager was successful at the First Tier Tax Tribunal, but on 9 August, the Upper Tribunal overturned this decision, concluding that the First Tier Tax Tribunal had erred in law in deciding that the loyalty payments did not constitute annual payments.

In summary, the First Tier Tax Tribunal had concluded that the loyalty payments were not annual payments because they were not “pure income profit” in the hands of the investors, as investors were required to pay ongoing management fees with respect to their investment in order to qualify for the loyalty bonuses. However, on a close reading of the contractual relationships, the Upper Tribunal determined that it was the fund entity (and not the investor) that had the liability to pay the ongoing management fees. The Upper Tribunal further determined that the loyalty bonus was paid by the Asset Manager, not by the fund or the fund manager. In the Upper Tribunal’s view, although the Asset Manager chose to market the arrangements on the basis that payments of the loyalty bonuses reduced investors’ management fees, the correct characterisation of the loyalty bonus was that the investor received a further income distribution in respect of its investment in the fund as a result of its continuing investment. As such, the payments were pure income profit because, in order to receive the loyalty bonus, the investor did not need to pay the management fee, but needed only to remain invested in the fund.

Further, in the view of the Upper Tribunal, the fact that the investors ultimately suffered the management fee (in the sense that this fee reduced the distribution of income to them or the value of their investments in the fund) did not allow the investors to treat the management fee as an expense that could be deducted in computing the amount of tax payable by them on the loyalty bonus.

Consequences

The Upper Tribunal’s decision reinforces HMRC’s position regarding the treatment of fee rebates, loyalty bonuses, the passing on of trail commissions and similar arrangements. UK managers making, or considering making, such payments to UK investors and certain non-UK investors should be aware of the strict contractual interpretation applied by the courts in this context, and should consider whether a withholding obligation applies in respect of such payments. Since HMRC will look to recover any uncollected withholding from the payer of annual payments, advice should be taken where necessary, and appropriate reserves should be put in place in the case of any uncertainty.