Management fee rebates to fund investors not annual payments

The First Tier Tribunal has held that “loyalty bonus” payments made by an investment platform to investors were not subject to withholding tax: Hargreaves Lansdown Asset Management v HMRC [2018] UKFTT 127. The payments were, in substance, rebates of fund management charges to investors and as such were not pure income profit. The decision is contrary to HMRC guidance provided in 2013, in which HMRC took the view that such payments were of an income and recurring nature and that investors received such payments without any preconditions or ongoing obligations, such that they were “pure income profit”.

It remains to be seen whether HMRC will appeal the decision, though given the clear position taken in the 2013 guidance an appeal seems very likely.

Background

An “annual payment” is an amount paid under a legal obligation which is capable of recurring and is income in nature. It must also be “pure income profit” in the hands of the recipient so that it is not paid to the recipient in return for any further action by the recipient and the recipient has no expenses or other deductions in earning it. Section 901 Income Tax Act 2007 imposes an obligation to withhold tax on annual payments arising in the UK in certain circumstances.

In 2013, HMRC issued Revenue & Customs Brief 04/13 concerning the tax treatment of payments made to investors in a collective investment scheme, insurance policy or other investment product by fund managers, fund platforms, advisers or any other person acting as an intermediary between the fund and the investor. In particular, it related to “trail commission” paid by the fund manager to other intermediaries which is then paid to (or used to meet the liabilities of or provide a benefit to) an investor. Such payments typically originate from the annual management charge paid out of the assets of the collective investment scheme or other investment product to the fund manager.

HMRC concluded that these payments constituted “annual payments” from which a payer in the UK is under an obligation to deduct basic rate income tax and account for this to HMRC.

Hargreaves Lansdown Asset Management (HL) provided a platform for the distribution to investors of investment products offered by different fund providers. HL was able to negotiate lower annual management charges (AMCs) levied by investment providers for managing investments in a fund for its clients, which were rebated to HL. Typically, before April 2014, HL did not charge its customers a fee but retained a share of such rebated AMCs. In turn, in order to pass on to investors part of the benefit of reduced AMCs, HL would pay to investors a “loyalty bonus”. Following changes introduced in 2014, HL was obliged to pass on the whole of the discounted/rebated AMC to its clients as a “loyalty bonus”, but charged a platform fee based on the value of funds under management.

HMRC contended that the loyalty bonus fell within their R&C Brief as an “annual payment” and that HL was obliged to withhold tax on such payments and assessed HL on that basis. HL appealed.

Decision of the FTT

The question was simply whether the loyalty bonus payments were “annual payments” for UK tax purposes. The FTT noted that the authorities on the meaning of annual payment (which were some fifty years old) indicated that an annual payment must have four characteristics:

• it must be payable under a legal obligation;
• it must recur or be capable of recurrence (though it may be contingent);
• it must constitute income in the hands of the recipient; and
• it must represent “pure income profit” to the recipient.

It was accepted that the payments were income in the hands of investors. In addition, despite arguments to the contrary by HL, the FTT found that the payments were made under a legal obligation and did recur. The decision, therefore, hinged on the question whether the payments were “pure income profit”.

HL argued that the payments were not pure income profit as an investor was required both to do something and forebear from doing something in order to receive them. An investor must both pay the relevant AMC for the month and forebear from selling their investment. The tribunal rejected the general contention that any requirement on an investor would be sufficient to prevent the payments being pure income profit. Whilst it was clear that where a person was required to provide services or do something for a payment, that payment was not pure income profit, it was not the case that any contractual obligation was sufficient to render the payment in return not pure profit. Indeed, the FTT was able to extract from the case law that where a person is required to satisfy an obligation to receive a pure profit payment, it is usually in the nature of an obligation at the very outset (such as transfer certain rights in return for a recurring payment). The fact therefore that in investor must not withdraw his investment to continue to receive the loyalty bonus would not suffice to prevent it being an annual payment. An investor, from that perspective, had done everything needed to be done in substance to receive the payments at the outset by investing.

But what of the requirement to pay the AMCs? On this point, HMRC argued that the AMC is “taken from or paid by” the fund entity and is not paid by the investor. The fund provider might pay a platform provider such as HL an amount which is referred to as a “rebate” of the AMC, but in fact, although calculated as a percentage of the AMC, it is not a rebate but a commission for promoting that fund to investors. HMRC argued therefore that “loyalty bonus” was also a misnomer, as it is actually “trail commission” and not a bonus at all. In contrast, HL argued that there was ample evidence to establish that the AMC was a cost borne by the investor, although the detailed mechanic did not entail paying it as a separate amount. The evidence showed that the bargain presented to investors by HL was that the loyalty bonus would reduce the net cost of the AMC and was therefore entirely dependent on it.

The FTT considered that HMRC’s arguments in relation to this point were “surprising” and that whilst the AMC was not a separate fee paid by an investor, it was a compulsory charge directly borne by an investor. Equally, the loyalty bonus was clearly and consistently presented as a method of reducing that cost. Whilst the mechanism was “far from transparent”, an investor would have understood that the AMC would be charged against his fund investment. The language of the documentation relating to the AMC could only be sensibly be read as indicating that the AMC was an annual charge to investors for investing in a fund.

How did this conclusion affect the question whether the loyalty bonus was pure income profit? The tribunal stated that, “the evidence makes it plain that the nature and quality of a Loyalty Bonus payment is that it is not a “profit” to an investor, but a reduction of his net cost. It is quite unlike an annuity payment or interest in respect of which a recipient need do nothing but sit back and receive the payments”.

As a result, the loyalty payments were not payments of pure income profit, were not annual payments and were not subject to withholding tax.

Comment

The decision of the FTT runs counter to the position taken by HMRC in their 2013 Revenue & Customs Brief and, therefore, it will be surprising if they do not choose to appeal the decision. However, since the decision turns on the meaning of the term “annual payments”, which is not defined by legislation and the meaning of which depends on case law that predates the modern economy, the final resolution of the dispute is far from certain. Indeed, the tribunal itself noted that “given the continuing relevance of the term in modern legislation, it is surprising and by no means helpful, that the most recent of these cases was decided some fifty years ago”.

However, it should be noted that, in any event, there are a number of circumstances in which the withholding tax did not apply:

• Annual payments made by a company, or by a partnership or limited liability partnership of which at least one partner is a company, are exempt from the requirement to deduct tax if the recipient is a UK resident company, the UK trading branch of a non-resident company, an ISA manager, a UK registered pension scheme (including a SIPP trustee) or a UK charity.
• If the annual payment is due from and made by a person outside the UK, that person is not under an obligation to deduct tax (though the payment will remain income of a recipient in the UK). Therefore, where a fee rebate arises under an agreement with a non UK distributor or fund manager, investors did not receive amounts without deduction of tax.
• Payments to investors who are employees or former employers should be treated as part of their employment income and paid under PAYE. Fee rebates made to members of a partnership or limited liability partnership are an application of its profits and taxable as such, with no requirement to deduct tax. These payments were not affected by the treatment set out in the Revenue & Customs Brief.

In addition, the Government later announced that where such payments are made to non-residents fund investors they would be excluded from such treatment: see Statement by the Economic Secretary to the Treasury in respect of offshore investors.