IFM36531 - Carried interest and profit related returns: The "no significant risk" test: Overview

The “no significant risk” test

ITA07/S809EZC(3)-(8)

For a sum arising to be carried interest under the definition at ITA07/S809EZC (and therefore subject to capital gains tax instead of the disguised investment management fees (DIMF) charge), it must meet the three profit-related return conditions (IFM36300), and also pass an assessment of risk which this guidance refers to as the ‘no significant risk’ test.

‘Significant risk’ is not defined in legislation, but the intention is to only capture disguised fees; that is, sums which are highly likely to arise. Passing the ‘no significant risk’ test means that there must be significant risk that the sum will not arise. The intention is that, any attempt to make a fee appear as if it is linked to profits while actually being fixed in substance, will be ineffective.

Purpose of the ‘no significant risk’ test

The intention of the “no significant risk” test is to ensure that sums awarded to individuals, which in reality are highly likely to arise, are not categorised as carried interest. Instead such sums should be caught by the DIMF rules and charged to income tax. Whether the sum is likely to arise will depend on the facts and circumstances of each case.

Example

Ayo, an individual providing investment management services is due to be paid £1m, or £1m plus 10% of profits if the fund profits exceed a certain level.

The £1m is not carried interest as it does not vary by reference to profits and there is not a significant risk that it will not arise. The 10% of profits above a certain profit level could be carried interest as the amount appears to vary. We still have to be mindful that the three profit-related return conditions of ITA07/S809EZC(2) (IFM36300) are met and the requirements of the “no-significant risk” test are fulfilled. For instance, the profit level may have been set at an unrealistically low level where there is no significant risk that it would arise, this could mean that the “no significant risk” test would not be met. Whether the amount meets the profit-related return conditions or the “no significant risk” test will depend on the facts and circumstances at the time.

In practice it should be clear to fund managers, through management agreements entered into whether sums arising to them represent their fixed management fee as opposed to carried interest. This test is intended to catch all amounts which, viewed realistically, represent a largely fixed entitlement based on the amount of assets under management. HMRC may challenge any attempt made to circumvent this test or any of the profit related conditions of ITA07/S809EZC(2) (IFM36300).

Where arrangements do not meet the “no significant risk” test, the sum arising to the fund manager is not carried interest even if the three-profit-related conditions are met.

Application of the “no significant risk” test to the arrangements

The no significant risk test applies to sums arising to an individual under arrangements by way of a profit related return, not to the investments made by the fund.

Example

Fund A invests in risky investments but puts arrangements in place which provide a certain payment every year to the fund managers. Fund B invests in relatively safe investments but set a high hurdle rate that must be exceeded before any carried interest was paid.

Despite the nature of the investments, Fund A may not meet the significant risk test, and therefore the fees would be caught by the DIMF rules. Should it be the case that in Fund B it was by no means guaranteed that a manager would ever receive carried interest this may pass the significant risk test despite the less risky investments held.

A history of good performance (e.g. 5 out of 6 previous funds have delivered high returns) does not in itself mean there is no significant risk attached to the sums arising to the fund manager. If funds have to deliver a high enough performance to repay loans to external investors and meet the hurdle rate before any carried interest is paid, it is likely that at the outset there would be a significant risk that carried interest would not be paid. This is not an automatic qualification however and whether the “no significant” risk test has been met would have to be based on the facts and circumstances at the time.

Practical application

For each sum that arises two amounts are compared:

The sum of the amount which did arise and any other sum which may have arisen, and

Any amount which was certain to arise (i.e. there was no significant risk of it not arising). That is called the minimum amount.

Consider sums arising individually and then together.

Compare the amounts described in the two bullet points above with the sum that actually did arise. The amount which is certain to arise (the minimum amount) is not carried interest, and is therefore a disguised fee. The remainder of this sum is carried interest (provided the other conditions are met).

Example

Dipti, an individual providing investment management services is to receive £1m if there are no profits, and 20% of any profits above £50m. There is a 30% chance that profits will exceed £50m.

If profits are £60m, Dipti receives £3m. There is no risk attached to the £1m fee but there was a risk that the extra £2m may not have arisen. £2m is considered carried interest and the £1m fee is a disguised fee charged to income tax.

If the profits were instead £45m, then no additional sum arises. The carried interest is nil and the disguised fee is £1m.

The consideration of the sums together is not intended to catch normal diversification arrangements by funds as it is not unusual for funds to spread investments to give a safer return overall. Sums taken together would only be applicable if avoidance arrangements are in place to give investment managers disguised fees where there was no significant risk.