New government proposals for VAT on fund management fees

VAT costs are an important consideration when structuring fund or asset management
arrangements. However, the current UK rules, which are still based on EU law, are problematic
in two respects:

1. the scope of the VAT exemption for management of certain funds is unclear, with EU
   jurisdictions taking differing views on which types of fund are within scope and it
   being hard to establish whether some services (particularly if outsourced) constitute
   “management”; and
   
   
2. fund managers generally receive a more favourable tax position for making supplies to
   foreign customers than domestic ones. This incentivises the use of non-UK structures.

So, with Brexit giving the UK the ability to set its own rules, this is an area where getting
the answer right would give a competitive advantage over rival European fund centres. It is
therefore unsurprising that when, in March 2020, the government announced that it would
carry out a review of the UK funds regime, this specifically included a review of the VAT
treatment of fund management fees. However, whilst other aspects of the wider review have
made rapid progress (in particular, the new qualifying asset holding company regime due
to come into force next April), up until now, we had heard nothing from the government in
relation to the VAT review (other than confirmations that it was going to go ahead).

The UK takes a narrow view of the fund management exemption that has the effect of
excluding private equity limited partnerships and unlisted unregulated credit funds. Instead,
the UK’s exemption only applies to open-ended authorised UK funds, certain closed-ended
listed funds and UK established defined contribution pension funds.

By contrast, the competitor EU jurisdictions of Luxembourg and Ireland interpret the term
“special investment fund” (the term used in the VAT Directive) more widely, with the effect
that supplies of management to many funds exempt.

If a fund cannot benefit from the VAT exemption, then VAT on its management fees is a real
cost.

However an exemption is a double-edged sword, as a manager making only exempt supplies
cannot recover the VAT charged to it by its own suppliers (“input tax”).

There is also what many see as an anomaly which puts fund managers in a better position
in relation to their foreign supplies than their domestic ones. It arises because of a rule that
allows suppliers to fully recover their input tax in relation to supplies made abroad (and
therefore outside the scope of UK VAT) where the supplies would have been VATable if made
domestically. The narrowness of the UK fund management exemption means that most
supplies by UK fund managers to foreign customers fall within this rule (as they would have
been VATable (and not exempt) if made in the UK). This allows the manager not to charge VAT
whilst fully recovering its own input tax.

Flowchart of current UK VAT position of fund management

This part of the briefing focusses on private equity funds, but the same issues arise for most other unlisted private funds.
As a private equity fund is not within the UK exemption, a supply of fund management to it will be subject to VAT. Without more, this would make UK funds uncompetitive, so instead this VAT is currently mitigated by either:

• locating the fund outside the UK in a jurisdiction with no VAT (e.g. the Channel Islands) or without a VAT exemption that would apply to the fund management supply (e.g. Luxembourg) ; or
  
  
• putting the general partner and the manager into a VAT group, with the effect that the supply of management services is disregarded for VAT purposes.

Whilst a fund manager may not locate a fund offshore abroad just to benefit from advantageous VAT treatment, it is often a factor in deciding where to establish a fund. To many, it has long seemed strange that the UK VAT rules, effectively, incentivise asset managers to locate elsewhere.

VAT grouping approach – no VAT on fund management fee but restricted input VAT recovery for manager

The government has proposed that supplies of fund management be “zero-rated” for VAT purposes. Zero-rating is a particularly beneficial treatment as it means that the customer does not have to pay VAT (as the rate of charge is 0%) but that the supplier can recover its related input VAT (as its own suppliers are technically VATable).

This proposal effectively puts UK fund managers in the same position for their UK supplies as they already enjoy for the foreign supplies, removing the VAT incentive to locate their funds offshore.

The VAT position of a domestic fund structure under the proposals (assuming no VAT grouping)