Carried interest may be taxed as income: what fund managers should do

New rules will have effect from April 2016 

On 9 December 2015 HMRC published draft rules (Rules) that will have the effect of determining whether carried interest is taxed in the UK as capital gain or as income, by reference to the actual average holding period of assets in the relevant fund. The Rules will apply in addition to the current general rules which determine if carried interest is taxed as capital gains (such as the Memorandum of Understanding agreed between HMRC and the BVCA on the tax treatment of carried interest).

The Rules, if implemented, will apply to carried interest arising after 1 April 2016. There is no grandfathering – in fact the legislation specifies that the rules apply “whenever the arrangements under which the sums arise were made“. 

The Rules were subject to further consultation up to 3 February 2016 and a final version is due to be published after the next Budget (16 March 2016). 

Effect of the changes 

The broad thrust of the Rules is that:

• if the average holding period of assets in a fund is under three years, all of the carried interest will be taxed as income;
• if the average holding period of assets in a fund is over four years, all of the carried interest will taxed as capital;
• there is a sliding scale for funds with an average holding period of between three and four years.

The Rules will generally apply irrespective of the underlying assets held by the fund, although the rules for “direct lending funds” are even stricter. The Rules represent a considerable and (for many) unwelcome restriction on the capital gains tax treatment of carried interest, not only as compared with the current rules but also as compared with the original proposals issued in July 2015. 

How average holding periods are calculated 

The average holding period will be weighted by reference to the amount invested. This represents a doubling of the required holding period to achieve capital gains treatment from that set out in the original consultation document (which had suggested a total holding period of two years with tapering of the amount treated as income occurring after a six month holding period). 

There are detailed calculation rules – such as when disposals of assets are treated as made, how hedging is dealt with, and the circumstances in which carry can be conditionally treated as receiving capital treatment pending further calculation. 

Direct lending funds

Under the Rules, all carried interest arising from a “direct lending fund” will be taxed as income unless it falls within a specific exemption (which requires, amongst other things, that the fund is a limited partnership). 

What fund managers should do 

It will be important for funds and fund managers to review their arrangements before the Rules come into effect so that they are not caught out by the changes – the complex nature of the Rules means that even funds which have a long term holding strategy would be well advised to do so.

Private equity funds making minority investments will need to consider the rules applying to direct lending funds carefully with regard to any loan note funding (although funds making majority investments will probably not be caught as the direct lending fund definition requires the borrowing company to be unconnected to the fund). 

Mis-alignment of interests? 

The Rules, if implemented, may cause a significant tension between the desire to realise assets at the time which is best commercially and the time which achieves capital gains tax treatment for the carried interest holders. 

From a fund manager’s perspective the Rules are an additional blow following changes presented in July 2015 when the ability to “base cost shift” in respect of carried interest was also removed.