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Hedge funds and UK management vehicles: a cheat-sheet for first-time managers

Hedge funds and UK management vehicles: a cheat-sheet for first-time managers

  • United Kingdom
  • Financial services and markets regulation - Hedge funds
  • Investment funds and asset management

21-01-2020

The path to establishing a UK management entity for an offshore fund branches off in all manner of directions. One of the first crossroads faced by the first-time manager is the choice of UK management vehicle. Their decision has significant ramifications, the UK management vehicle will determine commercial structure, regulatory liability and, most significantly, the tax burden. While other options are available, most managers will go down one of two routes: the private limited company (“UK company”) or the limited liability partnership (“LLP”). Both are flexible structures which comply with UK law, but which vehicle suits best will probably depends on its tax profile.

Here is how you get to grips with the options.

LLP

LLPs combine elements from two other vehicles: when calculating tax it is treated as a partnership, but it is considered a company (body corporate) for contractual and commercial purposes. An upshot of this amalgamation is that LLP members can participate in business management without losing limited liability status. That said, the chief appeal of the LLP is its unique tax profile.

Most body corporates (such as UK companies) are treated as “tax opaque”. As such, for some shareholders there can be tax at two levels (i.e. double taxation): once at the company level and then again at the shareholder level when profits are distributed. As explained further below, the aggregate of this double taxation can result in higher overall taxation than operating as a sole trader or through a partnership.

In contrast, LLPs are generally not treated as separate legal entities for tax purposes and are consequently treated as “transparent” for tax purposes. This means that, unlike a UK company, no tax is payable at the LLP level and all income and gains earned by an LLP are attributed directly to its members, who are then taxed according to their applicable tax status and rate. There are a few caveats: LLPs still file a partnership tax return with Her Majesty’s Revenue and Customs (“HMRC”) and are still considered separate entities for VAT purposes. Nonetheless, the transparency of the LLP for UK tax purposes can make this an attractive vehicle for fund managers.

What does this mean from a tax perspective?

UK corporate shareholders will pay UK corporation tax on profits and gains attributed from an LLP (at a current rate of 19%), while UK individual shareholders will pay tax on trading income at an aggregate maximum of 47%, made up of their income tax (up to 45% for additional rate taxpayers i.e. currently taxpayers with income above £150,000) and national insurance contribution (“NIC”) (2%). Note in particular that, subject to anti-avoidance rules discussed below, income received by members of an LLP does not give rise to the 13.8% employer’s NIC charge usually payable on salaries. Therefore, for key individuals that might otherwise have been paid a significant salary by a UK company, the LLP structure can offer further tax savings. Note also that capital gains attributed to UK individual members would be taxed at the lower UK capital gains tax rates.

The case against the UK company

On the face of it there is little to recommend a UK company. LLPs were created, in part, to avoid incurring an additional 19% UK corporation tax on profits. The tax cost to a UK individual receiving a dividends from a UK company is an aggregate tax burden of roughly 49.86%.

However, it is useful to note that this double tax cost does not apply to UK corporate shareholders who, as a general rule, are exempt from tax on dividends received. However, UK company structures still impose certain dividend restrictions – the need for a distributable reserves being one example – which will apply in either case.

This is a pressing issue because for UK companies it is generally more costly from a tax perspective to pay salaries than make dividends. This is because a UK company paying salaries or bonuses to employees and directors must pay a further 13.8% NIC, on top of the income tax and NIC paid by the employee. Therefore, an owner-managed company that is restricted from paying profits in the form of dividends would increase its tax burden by paying salary instead.

The case for the UK Company

So far, so unappealing. However, UK companies can give a real tax advantage where it is necessary to reinvest profit into the business, which is usually vital for a growing business. In these situations, UK companies can give a better tax profile than an LLP since the only tax cost on profits reinvested by a company is the 19% corporation tax charge. Compare this to an LLP, where the profit is directly attributed and taxed in the hands of its members regardless of whether it is actually distributed, meaning profits reinvested by an LLP are effectively subject to tax at rates up to 47%. This broadly means that, after tax, a UK company would have 81% of its profits available to reinvest whereas and LLP would only have 53%.

Further, LLPs have been under attack by HMRC in recent years in an effort to tackle perceived tax avoidance. As a result, the tax treatment of LLPs is generally more complex and difficult to navigate than previously. For example, historically LLPs with mixed memberships (corporate and individual) could take advantage of the lower corporate tax rate by diverting profits they wished to reinvest to corporate shareholders. Following the introduction of the mixed membership rules, this favourable 19% tax on working capital is nearly impossible to achieve with an LLP.

In addition, HMRC has introduced anti-avoidance rules which can – through so-called ‘salaried member’ provisions – reclassify certain members of LLPs as ‘employees’, giving rise to the 13.8% NIC obligation applicable to salaries as described above. This development further blunts the competitive edge previously held by LLPs over their UK company counterparts.

Tailored to the role?

In summary, while an LLP will generally be preferable if you’re aiming for high annual pay-outs, fund managers seeking to re-invest and create working capital may still benefit from a UK Company structure.

How Eversheds Sutherland can help

Our team has been at the forefront of regulatory interpretation and product development for the fund management industry since the 1980s. We advise on all types of fund structures and prepare all documentation necessary to achieve a successful fund launch.

 

For more information contact

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