Complex payment flows and netting arrangements are a critical part of any structured finance transaction.  Weaving together fees, investments, inducement payments and rebates into the closing arrangements for a financing deal is part of the modern lawyer’s toolkit.  However, a decision in August 2019 of the United Kingdom’s Upper-tier Taxation Tribunal illustrates the importance of understanding the legal relationships which form the bedrock of any payment netting arrangement.

Hargreaves Lansdown Asset Management Limited (HL) offered retail investors the ability to use its “platform” to make and manage investments.  The platform allowed HL’s retail customers to buy and sell investments in various funds (the Funds).  The retail customers were not charged a fee for the use of HL’s platform.  Rather, the retail customers paid an amount to the Funds, which the Funds used to pay an annual management charge (AMC) to an asset manager.  The asset manager, in turn, then used the AMC to pay a “rebate” to HL for HL agreeing to make the Funds (managed by that asset manager) available for investment to the retail customers on the HL platform.  HL retained an amount from the rebate to operate the platform and make a profit, with the balance being paid to the retail customers as “loyalty payments.”

The retail customers were informed by HL in various marketing publications that they would be required to pay the AMC to invest in the Funds listed on the platform.  The customers were also informed that they would be entitled to the loyalty payments provided they invested in, and held their investments through, the HL platform.

The question before the UK’s tax tribunals has been whether a withholding tax should be imposed on the loyalty payments to the retail customers.  In March 2013, an HMRC publication stated that payments of “trail commission” by fund managers, fund platforms, advisers, or any other person acting as an intermediary between the fund and the investor, were subject to a withholding of income tax at 20 per cent. as being “annual payments.”  One of the reasons for this was that HMRC viewed the “rebates” paid to investors as being economically similar to additional distributions from the funds being invested in.  If HMRC was correct, HL would be required to withhold and pay 20 per cent. of the loyalty payments to HMRC, thereby reducing the amount received by the retail customers.

For UK tax purposes, a payment has to satisfy a number of requirements to be an annual payment.  In addition to a payment being of an income nature and payable annually (or by reference to a year on a recurring basis) under a legal obligation, an annual payment must also be “pure income profit.”  This means that an annual payment by its nature must be pure profit in its recipient's hands, without permitting tax deductible payments to be set against it.

The First-tier Taxation Tribunal decided in 2018 that the loyalty payments were not pure income profit.  The basis for this finding was that because the retail customers held investments through HL's platform, AMCs were paid with respect to their investments. Accordingly, the retail customers obtained the right to loyalty payments through agreeing, in a broad commercial context, to fund the payment of the AMCs.  The loyalty payments were therefore not “pure income profit” – the costs of the AMCs could be set against the loyalty payments.  The First-tier’s approach accorded with the commercial dynamics of the relationship between the retail customers, HL and the operation of the platform.

Before the Upper-tier Tribunal, however, HMRC argued that the legal detail of the contracts under which the loyalty payments were made to the retail customers should be given greater weight.  Such arguments had been advanced by HMRC before the First-tier Tribunal, and had been rejected.  The Upper-tier Tribunal was far more receptive to HMRC’s arguments, and noted that the Funds, and not the retail customers, were contractually obliged to pay the AMCs to the asset manager.  The amount of the rebate was negotiated between the asset manager and HL only, without the retail customers ever being involved.  Only HL was entitled to the rebate, and the loyalty payments were made monthly by HL to the retail customers under a binding contractual obligation agreed between HL and the customers.

The payments by the retail customers to the Funds did not, the Upper-tier Tribunal held, produce a deductible expense for the retail customers against the receipt of their loyalty payments.  The retail customers did nothing to receive the loyalty payment, except continuing to invest on the platform.  Memorably, the Judge stated that “the term Loyalty Bonus is therefore a correct description; the payment does what is says on the tin – it rewards loyalty.”  The loyalty payment stood alone as a contractual payment, and was not, as a contractual and legal matter, paid as a result of the network of other contractual relationships in the wider arrangement under which the platform operated.  Any marketing literature which conflated the loyalty payments with the payments made by the retail customers to the platform was not determinative, and did not have a bearing on the legal characterization of the payments being made. 

The decision of the Upper-tier Tribunal is an important reminder of the need to carefully examine the network of payment flows in modern structured finance transactions.  Frequently, payments in financing transactions will be netted off against each other, combined and fitted into complex transaction flow spreadsheets.  For the commercial viability of transactions, and sometimes for accounting purposes, such blending of payment flows is highly useful.  However, looking at the commercial product of such netting arrangements is not, as the Upper-tier Tribunal have found, the correct method of discerning the taxation treatment of the payments being made.