IFM36420 - Co-investment: Arm's length returns

Arm’s length returns

ITA07/S809EZB(2)-(4)

A return is an arm’s length return if:

  • the investments made by the managers which result in the return are of the same kind as investments which are made in the scheme by external investors (or reasonably comparable to those investments);
  • the return is reasonably comparable to the return realised by external investors; and
  • the terms governing the return are reasonably comparable to the terms governing the return to external investors.

These requirements are purposefully strict to ensure that only genuine co-investment returns are excluded from being treated as disguised fees under the disguised investment management fees (DIMF) rules and not any other method of providing management fees by way of investments only available to managers.

Example: Excessive return on a co-investment

Jane is a fund manager, but she also has a personal investment in the fund that she manages. Jane receives a return 2% greater than all the external investees who have invested in the same fund.

The evidence suggests that Jane is receiving enhanced benefits in the form of an excessive return. This takes the whole return on the co-investment outside the exclusion from being disguised fees as the arm’s length test is not met.

An agreement that gives the manager of a fund enhanced benefits or enhanced upside / downside exposure does not meet the arm’s length test.

‘Reasonably comparable’

When considering if a return is an arm’s length return, the return is reasonably comparable if:

  • the rate is reasonably comparable to the rate given to external investors on the same investments; and
  • any other factors relevant to determining the size of the return on the investment are reasonably comparable to the factors used to determine the size of the return to external investors on the same investments.

Returns to internal and external investors will not always be identical. This could be the case where an individual invests in a fund on the same terms as external investors but is not liable to the management fee (or carried interest) in respect of that investment. HMRC accepts that this will still meet the definition of ‘reasonably comparable’ in the arm’s length test described above.

Broadly where there are genuine commercial reasons for a difference in internal and external investors’ returns, but these differences do not materially affect in substance the return received by managers compared to that of external investors, the co-investment can still be considered to be reasonably comparable. The classification of the investment however will ultimately be based upon the relevant facts and circumstances.

Co-investments awarded at a discount

A fund manager may be awarded a co-investment at a discount (or for no consideration). Where the discounted amount has been fully charged to income tax and national insurance contributions as employment income, or is subject to the employment related securities rules, the manager is required to consider if the return on the discounted investment is reasonably comparable to investments held by external investees. When making this comparison it is important to include the amount charged as employment income.

Example: Co-investment awarded at a discount

An individual receives co-investment valued at £100 but only contributes £20 with the remaining £80 being funded from sums which have been taxed as employment income.

Although the fund manager has only contributed £20 in monetary terms they are in the same position as for example a colleague who had contributed £100. To determine if the investment is at arm’s length, the value of the investment used for the comparison should be that of the full £100 including the discounted amount. Similarly, the full £100 should be used for the purposes of determining the return of the investment made. 

Loans to service co-investments

Where an individual receives a loan at arm’s length terms to invest in a capital scheme the resultant return may still be classified as a co-investment.  The arrangements under which the loan is provided may mean that the loaned amount is treated as a disguised fee. However, the fund manager must not gain an advantage over and above the return which external investors receive.

Occasionally an entity (i.e. company or partnership) comprising of a fund management team is used to acquire a loan from a third party to meet co-investment commitments of the managers. The loan (including amounts returned for the loan) is then repaid from the sums returned on the investment in the fund. This arrangement may still come within the exclusion of being a disguised fee, provided that the return is reasonably comparable to that of external investors.

If however the entity used is leveraged in such a way that the fund managers effectively get a deduction for the interest costs of the third party loan, this would no longer be comparable with the return to external investors. 

Absence of comparable funds

Where an investment is entirely ‘in house’ it may have no external investors. In these situations it is necessary to identify a fund of a similar nature which does have external investors and take into account all relevant factors when making an arm’s length comparison.