The UK taxation of carried interest will be significantly reformed from 6 April. In this article, Tom Margesson, Tax Partner at Travers Smith, provides an overview of the new regime and considers what asset managers should be doing in preparation.
What’s changing?
Currently carried interest can often be structured as a capital return for UK tax purposes, so that it is subject to capital gains tax (CGT) at 32% rather than income tax at rates of up to 45%.
However, the government considers that carried interest is, in substance, a reward for the provision of investment services, and that it should therefore be taxed as an income. Accordingly, from 6 April, carried interest arising to a fund manager (i.e. an individual who performs any of a wide variety of investment management services) from an investment fund will be taxed as trading income.
The legislation defines “carried interest” broadly, so the new rules are likely to apply to anything that is commercially considered to the carried interest.
How much is the charge?
Although carried interest will be taxed as trading income, a discount mechanism will potentially apply such that only 72.5% of it is taxed. This gives an effective rate of around 34.1% for an additional rate taxpayer (i.e. 72.5% x (45% income tax plus 2% self-employed NIC)). Importantly, this discount will only apply if the carried interest is “qualifying”.
What is “qualifying carried interest”?
The government considers that the benefit of the discounted rate should only apply to funds that carry out long-term investment activity. Therefore, carried interest is “qualifying” provided it derives from a fund that has a weighted-average holding period (AHP) for its assets of at least 40 months. If it has an AHP of more than 36 months but less than 40 months a proportion of the carried interest will be qualifying.
As each injection of cash by the fund is treated as a separate investment, the regime contains special rules (often referred to as “T1/T2” rules) to ensure that AHPs are measured in a commercially realistic way, e.g. to prevent later “bolt-on” acquisitions (relating to earlier main acquisitions) shortening AHPs.
Are non-residents in scope?
Essentially, non-residents will be taxed by reference to the proportion of time, during the period over which the carry accrues (“relevant period”), they spend performing their services in the UK. This involves identifying the total number of applicable workdays (broadly, days in which the individual works for a fund) in the relevant period and ascertaining what proportion of them are “UK workdays” (broadly, days on which they spend more than three hours working in the UK for a fund).
Helpfully, there are relaxations such that what would otherwise be “UK workdays” can, in certain circumstances, be treated as not being so, including if are in a tax year in which the non-resident has fewer than 60 UK workday. Notably, these relaxations only apply to “qualifying” carried interest,
although this is extended in the case of the “60 UK workday” relaxation to also include non-qualifying carried interest to the extent it was reasonable to assume, on the first UK workday in the relevant period, that it would have been qualifying.
Importantly, if the executive is resident in a country with which the UK has a double tax treaty (DTT), relief is likely to be available from the UK charge if they do not have a personal UK “permanent establishment”. Where the individual does have such a UK establishment, HMRC consider that the other jurisdiction is obliged to give DTT relief against its own tax charge. However, we understand that several jurisdictions may not agree with that approach.
How will the new rules impact on different asset classes?
The new regime will apply to all carried interest regardless of the asset class in which the fund invests. However, executives who cannot currently access the 32% CGT rate, such as those working on strategies that generate significant income returns (e.g. real estate funds focussed on receiving rental streams), may find that the 34.1% rate is less than they currently pay.
In addition, many of the “T1/T2” rules are specific to certain asset classes, so the mechanics of the AHP calculation will vary depending on the strategy pursued by the fund. Also, there are some gaps in the “T1/T2” coverage, for instance, they do not work well for multi-strategy funds.
Do the payment on account rules apply?
Since carried interest will be treated as trading profit for tax purposes, it will be subject to the UK’s payment on account (POA) rules, under which self-employed individuals must make advance payments towards their anticipated future tax liability. This is likely to create cash flow issues for executives because carried interest tends to be lumpy and unpredictable.
What should fund management business be doing to prepare?
The new regime relates to the personal tax position of executives, so a key issue for businesses will be how much they look to help those individuals comply with them.
As a minimum, executives will need assistance in relation to calculating AHPs, and so we are seeing businesses starting to stress test their models. In addition, businesses are also likely to want to take steps to educate team members about their personal obligations, including under the POA regime. Bringing executives up to speed with the new rules is particularly important for businesses with non-resident team members, both because they may not be familiar with the UK tax regime and because they may want to reconsider their working patterns and/or put in place appropriate day counting procedures.
By Tom Margesson, Tax Partner at Travers Smith
