The legal challenge brought by Hargreaves Lansdown against HM Revenue & Customs (HMRC) over the tax treatment of fund rebates has finally been brought to a close.
Last month a tax tribunal ruled in favour of HMRC, and Hargreaves has decided not to appeal.
Had the ruling gone the other way, Hargreaves had hoped for a total of £15m to be returned to 150,000 customers.
Instead, this ruling has effectively closed the door on the prospect of annual management charge (AMC) rebates being paid to investors tax-free by platforms.
So how did we get here? And what was the rationale behind the latest ruling in favour of HMRC?
The background to the case
This legal challenge has been a long-running one, with the case first brought by Hargreaves in September 2013.
The case centres around whether certain payments – which Hargreaves terms ‘loyalty bonuses’ – made by the platform to investors were annual payments for tax purposes.
These loyalty bonuses represent a rebate of part of a fund’s AMC, and initially Hargreaves made these payments free of tax.
But in April 2013, HMRC deemed rebates of AMC charges as taxable.
As a result, basic rate income tax of 20 per cent must be deducted by the platform and the client/investor must declare this as income, with further tax payable if they are 40 per cent or 45 per cent taxpayers.
The case was originally heard at the First Tier Tribunal Tax Chamber, and it wasn’t until March 2018 that the first ruling was made.
Judge Thomas Scott found that an annual payment has four characteristics:
1) It must be payable under a legal obligation.
2) It must recur or be capable of recurrence, although the obligation to pay may be contingent.
3) It must constitute income and not capital in the hands of the recipient.
4) It must represent ‘pure income profit’ to the recipient.
The judge concluded that Hargreaves’ rebate payments didn’t meet the fourth characteristic – that of being a ‘pure income profit’ to the recipient.
At this point, it’s worth explaining these loyalty bonus payments are only paid where an investor both does something and is prevented from doing something.
In this situation, the investor must pay the AMC and must also not sell his or her investment before the end of the month.
While HMRC argued loyalty bonuses were essentially trail commission payments, the First Tier Tribunal concluded that loyalty bonus payments represent a reduction of the investor’s net cost, rather than a profit to an investor.
As a result, it ruled these payments were neither annual payments or taxable. So, first round to Hargreaves.
But as the Lenny Kravitz song goes: “It ain’t over till it’s over.”
HMRC appealed the decision, with the appeal heard in the Upper Tribunal Tax and Chancery Chamber in April this year. The judgement then followed last month.
HMRC appealed on the grounds that the investor doesn’t pay the AMC, and that payment of the rebate is negotiated between Hargreaves and the fund manager.
It argued Hargreaves is only entitled to the rebate, and that other than invest in the fund and pay for their units, the investor doesn’t have to do anything else in return for receiving the loyalty bonus.
The Upper Tribunal analysed the situation based on the contracts, and found “there is no contractual link between the payment of the loyalty bonus and the amount of the AMC”.
The payment of the loyalty bonus did not result in a reduced AMC payable by the fund, but rather this was partially rebated to the investor, tearing through the net cost argument of the First Tier Tribunal.
The decision in favour of HMRC was made on the pure income profit issue, with the final ruling being that loyalty bonus payments are both annual payments and taxable.
What all this means now is following its decision not to appeal, Hargreaves will continue to tax loyalty bonus payments, unless the underlying investments are held in a tax wrapper such as an Isa or a Sipp.
There are relatively few assets paying AMC rebates on the Nucleus platform.
That said, if HMRC had ultimately lost this case, significant sums of money would have been returned to investors, and across all platforms.