Impact of Permanent Establishment Reform for Credit Funds

On 28 April, the UK Government produced draft legislation for consultation as the latest step in the reform of UK rules on transfer pricing, permanent establishments and diverted profits tax. 

From an asset management perspective, the most controversial part of the reform is the change to the UK domestic definition of a permanent establishment. This definition is important because, outside the real estate context, non-resident companies are only subject to UK tax if they are trading in the UK through a UK permanent establishment. The first question LPs ask is whether an investment in a fund could subject them to local tax filing or payment obligations. If there is no permanent establishment (or no trading) a clean answer can be provided.

The concern raised with the changes at the policy consultation stage is that they could create uncertainty for non-UK clients of UK asset managers as to whether they might become taxable in the UK as a result of using the asset manager’s services. The absence of this concern has been a longstanding plus for the UK asset management industry.

The main reason for this concern is that under current legislation in order to create a dependent agent permanent establishment the agent must have (and exercise) authority to do business on behalf of the company. It is proposed that this will change such that playing the principal role leading to conclusion of contracts is the test. Interestingly the HMRC consultation document takes the view that the new test is no broader than the old one.

The proposed permanent establishment definition does include the updated dependent agent features that had caused this concern to be raised. However, the government has also proposed an overhaul of the investment manager exemption (IME) to address the concern. This exemption prevents the activities of UK investment managers from creating a taxable permanent establishment for their clients.

Private equity style funds do not usually use the IME as their primary defence. Typically, they will argue, in order: 1) the fund is not trading, 2) the UK manager/adviser is an independent agent for domestic purposes, 3) the UK manager/ adviser is an independent agent for treaty purposes, and 4) the IME applies to confirm independent agent status for the relevant transactions.

The primary argument, not trading, is unchanged by the proposed reform. There is only really genuine doubt on this point for credit funds, so the remainder of this post focuses on those.

So does the enhanced IME compensate for the dependent agent changes?

There are many positives. It is made (fairly) clear that the IME can apply to investment advisers as well as investment managers. The categories of transactions that can qualify for exemption now cover everything an investment fund does other than certain transactions in real estate and commodities (and in the context of fees related to debt I think this change goes further than the proposed revisions to the statement of practice allow). The puzzling 20% condition D is removed. The permanent establishment elements of the DPT are repealed. It is clarified that the customary rate test does not require a transfer pricing study.

So far so good, but there is quite a big but. The new IME would only apply to the transactions of an investment fund, in this context defined as an AIF or a CIS- both by reference to UK regulatory rules. This is a new limitation. Currently the rules apply to specific transaction types, but are not limited to regulated funds.

You can see why this might be a problem in a traditional asset management arrangement where a client appoints a discretionary asset manager without the interposition of a fund vehicle, but why is it an issue in our credit fund context?

The reason is that most of the actual transactions, and therefore the trading risk, are not undertaken by the fund itself. Instead they are typically undertaken by an asset holding company established by the fund. Sometimes this will be an AIF (for example Lux SCAs are currently popular), in which case no problem, but often it will be a regular company or a securitisation vehicle. The revised IME wouldn’t apply to transactions carried out by unregulated asset holding companies.

Asset holding companies are typically in treaty jurisdictions and so are likely to still be able to rely on treaty protection (HMRC has indicated that the proposed changes to the domestic permanent establishment definition will not necessarily be followed in its treaty negotiations). However, given that many fund documents require clean advice on this point, this is an area where a simple and clear exemption, such as it looks likely will now be provided for the funds themselves, will be very beneficial. Ideally this can be resolved in the consultation process.

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