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This publication is available at https://www.gov.uk/government/publications/investment-managers-capital-gains-tax-treatment-of-carried-interest-july-2015/investment-managers-capital-gains-tax-treatment-of-carried-interest-july-2015
Summary of legislation - Investment managers: Capital Gains Tax treatment of carried interest. Sections 103KA - KF, Part III, Taxation of Chargeable Gains Act 1992
The Chancellor announced in the Summer Budget on 8 July 2015 that legislation would be introduced with immediate effect concerning the taxation of ‘carried interest’. This is intended to ensure that individuals pay at least the full rate of Capital Gains Tax (CGT) on their economic gain from carried interest. Legislation was published in the Summer Finance Bill 2015 on 15 July 2015.
The legislation will not affect the CGT treatment of genuine investments in funds made by managers on the same terms as third party investors, nor will it affect the treatment of performance linked rewards paid to investment fund managers that are charged to tax as trading income.
Chapter 1 of this guidance sets out the background to the legislation, Chapter 2 runs through the main provisions and effects of the legislation, while Chapter 3 contains further examples.
This note is intended to give guidance to the investment management industry and their advisors and uses terms specific to that industry.
Many of the concepts and terms used in the legislation are based on those contained in the Disguised Investment Management Fees (DMF) rules introduced as new Chapter 5E of Part 13 of the Income Tax Act 2007 (ITA 2007) by section 21, Finance Act 2015 (the DMF Rules). HMRC has published a guidance note on these sections which provides further background and will be relevant in determining how this legislation should apply where common concepts are used (the DMF guidance).
This measure applies to all carried interest arising on or after 8 July 2015, whenever the arrangements under which it arises were entered into, unless the carried interest arises in connection with the disposal of an asset or assets of a partnership or partnerships which took place before 8 July 2015.
Chapter 1: background to legislation
1) The reward paid to many asset managers comprises 2 elements:
- an amount determined by reference to the assets under management or funds invested (often termed the ‘management fee’)
- an amount calculated by reference to the performance of the underlying investments over a given period or the life of the fund (the ‘performance fee’ or ‘performance linked reward’)
2) For some asset managers, the performance linked reward is not structured as a fee. Instead, the individual managers are given a direct participation in the underlying vehicle, generally a partnership. As a result, the manager shares in the profits of the fund once an agreed level of performance has been reached (a ‘performance linked interest’). An example of such a performance linked interest is the ‘carried interest’ awarded to the managers of private equity funds.
3) A statement issued by the British Venture Capital Association (BVCA) with the approval of the then Inland Revenue and Department of Trade and Industry in 1987 1 sets out how carried interest awarded to managers of private equity and venture capital funds is treated for tax purposes under law in force at that time. In parts, this was superseded and supplemented in 2003 by a further Memorandum of Understanding (MOU) agreed between the BVCA and the Inland Revenue 2. While this new legislation changes the technical rules governing how the gain arising to private equity executives in respect of their carried interest is calculated (such that paragraph 4.2 of the 1987 Statement and Guidelines is no longer applicable, as explained below), the general principles set out in those documents are not affected by this legislation.
Previous taxation of carried interest
4) For UK direct tax purposes, partnerships (including Limited Liability Partnerships - LLPs) are generally treated as transparent entities (ie, a partnership has no liability to UK direct tax which is separate and distinct from the liability of its members). This means that sums allocated to partners are treated, for tax purposes, as though the individual and not the partnership had entered into the transactions which give rise to the sums in question.
5) Where a performance linked interest in a fund partnership is awarded to an investment manager (and the relevant performance conditions are met) he or she will become entitled to a share of the underlying profits realised by the fund. If the fund is treated as carrying on investment activity for tax purposes, its profits will generally fall within the CGT rules. In this situation, the sums received by the investment manager in respect of their carried interest may be charged to CGT because the receipts are normally treated as proceeds from the disposal of chargeable assets. (Please note, this will depend on the particular facts and circumstances of any individual and there will be cases where carried interest in a fund carrying on investment activity will, in whole or in part, be charged to tax as income 3.)
6) The size of the chargeable gain or allowable loss that accrues to an individual where a partnership disposes of a chargeable asset is calculated in accordance with the chargeable gains legislation. HM Revenue and Customs (HMRC) has published Statement of Practice D12 (SoPD12 4) which sets out an agreed interpretation of how the chargeable gains legislation operates in these circumstances.
7) The application of the legislation to carried interest, as interpreted by SoPD12, can result in fund managers being charged to CGT in respect of their carried interest on amounts which are significantly smaller than their actual economic returns.
8) This results from what is sometimes termed ‘base cost shift’. In short, this involves individual fund managers becoming entitled to a proportion of the underlying base cost in investments made by a fund which was provided by third party investors. The manager’s chargeable gain, calculated in accordance with SoPD12 is therefore lower than their economic gain. This effect can be amplified by so-called ‘enhanced base cost shift’. Although the gain calculated in accordance with the relevant paragraphs of SoPD12 in both cases is still charged at the full rate of CGT, the gain subject to tax is reduced (which reduces the effective rate of tax paid). Both of these are summarised in more detail in the Appendix.
9) HMRC is also aware that some taxpayers argue that it is possible to ‘cherry pick’ items arising to a fund partnership which are taxed more favourably in their hands than other items, and to allocate these disproportionately to the carried interest holders to further reduce the effective rate of tax they pay. HMRC considers that ‘cherry picking’ is ineffective, being contrary to well-established principles of partnership taxation.
Chapter 2: details of legislation
10) Summer Finance Bill 2015 introduces new legislation in Part 3 of the Taxation of Chargeable Gains Act 1992 (TCGA) revising the CGT treatment of sums received by managers in respect of their carried interest.
11) For this purpose, carried interest will be defined by reference to the DMF rules. This means that carried interest will have a slightly different meaning for the purposes of this legislation than it does in other situations. Instead of referring to the performance linked interest in the fund vehicle, ‘carried interest’ for these purposes will be the sums arising to the individual fund manager in accordance with section 809EZC(1) of ITA 2007. This means that the amounts are by definition excluded from the scope of the DMF rules. The legislation will bring into the charge to CGT the full economic return arising to the fund manager, rather than determining the amount chargeable by reference to the interest in the fund which gives rise to those sums. Further guidance on when a sum will be treated as arising for these purposes can be found below at paragraphs 233 - 255.
12) The new legislation will provide that:
- where an individual performs investment management services for a collective investment scheme or investment trust through an arrangement involving one or more partnerships
- carried interest arises to the individual under those arrangements
then special rules will apply instead of SoPD12 to compute the individual’s chargeable gain. In short, these rules are designed to ensure that individual fund managers are charged to tax on the full economic gain they receive from their performance linked interest, regardless of the nature of the underlying asset to which the gain relates. Base cost shift will no longer be effective to reduce the effective rate of CGT paid by individual fund managers on sums they receive in respect of their carried interest. It will also prevent any argument that cherry picking can be used to reduce the amount of CGT paid in respect of carried interest.
13) The legislation will achieve this by providing that any sums arising in respect of carried interest under the arrangements will, after certain deductions, constitute a chargeable gain and be subject to CGT. This will cover the entire sum actually arising to an individual, regardless of the items notionally applied to fund the carried interest payment at the level of the fund partnership or other entity in the fund structure (and regardless of whether of those items would normally constitute chargeable assets for CGT purposes). Only certain narrowly defined deductions will be allowed in computing the individual’s gain.
Summary of legislation
14) In summary, the amount of carried interest arising will be the amount of the gain, subject only to deductions for cash actually paid by the individual for the right to carried interest, and for amounts charged to Income Tax in respect of the acquisition of those rights. These are expanded upon in more detail below.
15) Similar principles will apply where carried interest arises to an individual where there has been no underlying disposal of partnership assets (such that SoPD12 may not be in point).
16) The measure will not displace any charge to tax other than CGT that arises by reference to the carried interest. In order to prevent double-charging, relief may be claimed for that other tax against the CGT charged under the new provision.
17) Any amount received in respect of the disposal, loss or cancellation of a right to carried interest will also be treated as carried interest arising to the recipient for the purposes of this legislation. If the disposal is otherwise than by way of an arm’s length transaction then transferor will be treated as receiving an amount equal to the market value of the carried interest. For this purpose, the market value will be computed on the basis that restrictions which depress the value of the right to carried interest will be disregarded.
18) As carried interest is defined for these purposes by reference to the DMF rules, the new legislation will not apply to items which are treated as investment management fees by section 809EZA (as ‘carried interest’ is excluded from the definition of management fee under those provisions, a sum taxed under those provisions will not be carried interest and as such will be outside the scope of the new legislation).
19) Furthermore, these provisions will not apply to carried interest (as defined in the DMF rules) to the extent the carried interest is brought into account in calculating the profits of the manager’s trade, profession or vocation for the purposes of Income Tax. This is intended to ensure that fund managers who receive a performance fee which is brought into account when calculating their trading profits do not need to claim relief from the CGT charge under this legislation to avoid double taxation.
20) Any repayment of a genuine co-investment in the fund (that is to say an investment of a kind, and on terms, comparable to those available to external investors), or of an arm’s length return on that co-investment, will not be affected by the new legislation. Again, these terms will be defined by reference to the DMF rules (in particular, subsection 809EZA(2), Income Tax Act (ITA) 2007) and will, in summary, only cover returns on investments made in the fund on substantially the same terms as external investors are participating in the scheme.
21) Where the manager of a fund is not domiciled in the UK, the gain is treated as arising in the UK to the extent that it reflects services that the individual performed in the UK.
22) In addition, legislation was also included in the Summer Finance Bill 2015 to amend the definition of arm’s length return in section 809EZA(2)(b) of ITA 2007 with effect from 8 July 2015, to put beyond doubt that the return on the investment is reasonably comparable to a return to external investors if (and only if):
- the rate of return on the investment is reasonably comparable to the return to external investors on similar investments in the scheme
- any other factors relevant to determining the size of the return are reasonably comparable to the factors determining the size of the return to external investors on similar investments
This change will apply to the DMF rules and will therefore also be relevant to this measure.
Carried interest ‘arising’ to an individual
23) Please note that section 103KF(1) of TCGA provides that a sum ‘arises’ for the purposes of these rules if, and only if, it arises to the individual for the purposes of the DMF Rules. This is designed to tie into the wording in section 809EZC of ITA 2007, such that where a sum is excluded from the DMF rules under that provision, it must necessarily fall within the new carried interest rules. There is no possibility for carried interest to arise to an individual and for it to fall outside the DMF rules but not be within the scope of this measure.
24) This means that carried interest which arises directly or indirectly to the fund manager will be charged under the new provisions (see the interaction of sections 809EZA(1), (3) and 809EZB(1), ITA 2007). Any attempts to interpose a separate entity between the manager and the right to carried interest in order to prevent or delay a charge arising will be ineffective. Further guidance on when a sum will be treated as arising for these purposes can be found in the DMF Guidance (see paragraphs 41 - 51, 141 - 148).
25) A sum that indirectly arises to the manager and does not fall within the carried interest exclusion in the DMF rules will be charged to tax as income under the DMF rules. It is not possible for a sum of carried interest that does not fall within the new measure to be excluded from the DMF rules.
Items chargeable to Income Tax
26) This legislation establishes a minimum level of tax on carried interest rather than a new regime which disregards the underlying receipts to the fund partnership.
27) This means each component of the sum arising is looked at separately when determining whether it is taxed under another head of charge and when determining what relief should be given under section 103KE of TCGA as explained in more detail below.
28) This can be illustrated at best with an example. If a sum of carried interest totalling £2,000 represented £1,000 of debt principal and £1,000 of interest on that debt, the analysis would be as follows:
- the £1,000 of principal is ‘carried interest’ and is therefore charged to CGT at 28% under this measure (£280)
- the £1,000 of interest is also ‘carried interest’ and is also charged to CGT at 28% (£280), there is nothing in the measure to displace the Income Tax charge and so Income Tax at 45% (£450) must be paid, however, the double taxation provision at subsection 103KE of TCGA is designed to allow full relief against the £280 of CGT technically due on the interest income under these rules - the Income Tax payable on the interest would effectively discharge CGT liability on the same sum
- the total tax charge on the 2 amounts is therefore £730 - the difference between £450 Income Tax and £280 CGT cannot be offset against the total amount due
29) Only specified sums will be allowable as a deduction against the amount of carried interest arising to an individual when calculating the chargeable gain. This will ensure that individuals are charged to tax on their true economic profit.
30) Deductions will be permitted for such parts of the following amounts as are just and reasonable:
- any consideration actually given by the individual in the form of money (if any) in return for entering into the arrangements under which the carried interest arises (but excluding any genuine co-investment)
- any amounts constituting earnings of the individual under Chapter 1 of Part 3 of Income Tax (Earning and Pensions) (ITEPA) Act 2003 (ITEPA 2003) on entering into the arrangements (for example, where a small capital contribution is required to be made in respect of the interest in the fund giving rise to the carried interest and this is paid by the individual’s employer and gives rise to a general earnings charge)
- amounts counting as income in relation to the individual’s interest in the fund under specified provisions of the employment-related securities regime (these are the same provisions listed in subsection 119A(3), TCGA 1992)
In order for an amount to be just and reasonable in this context HMRC will require that it be closely associated with the acquisition of the right to the carried interest which has arisen, or with the arising of the carried interest itself.
31) Deductions will not be permitted for base cost contributed by other members of the partnership, or attributable to revaluations of the partnership assets, as would be the case where a performance condition is met and the individual fund managers become entitled to an increased share of the partnership profits under the approach agreed in SoPD12 (the ‘base cost shift’ explained in the Appendix).
Disposals of carried interest
32) Where an individual disposes of a right to carried interest in return for consideration, that will be treated as carried interest arising to that individual at the time of the disposal for the purposes of this measure. This will also include where a right to carried interest is lost or cancelled.
33) The general rules in TCGA 1992 which apply to determine whether a disposal has taken place and for what consideration will also apply for this section. In particular, section 17 of TCGA 1992 will apply to treat an individual as having received market value for a right to carried interest when it is disposed of otherwise than at arm’s length (which will be treated as the case, under section 18, in most disposals to a connected party). For the purposes of determining the market value of the right to carried interest, restrictions which reduce the value of the right are disregarded. The relevant restrictions are given in section 103KB TCGA 1992 and correspond to the restrictions defined in relation to employment-related securities in section 423 Income Tax (Earnings and Pensions) Act 2003.
34) So if an individual disposed of their right to carried interest in favour of their child or to an unconnected entity but on non-arm’s length terms (for example, as a gift to a trust structure from which only their adult children could benefit in an attempt to mitigate the impact of the new rules), the amount charged as a capital gain under this measure will equal the unrestricted market value of the right to carried interest at that time.
Relief for payments to acquire rights to carried interest
35) Relief may be claimed where a fund manager pays an amount of money to acquire a right to carried interest from another individual (for example, on joining a fund management team part way through the life of a fund). In this situation, the amount paid may be taken to reduce the amounts of chargeable gains subsequently arising to him or her under the new legislation in respect of the acquired interest.
36) This is a relief that must be claimed and is not provided automatically as a statutory deduction when calculating a gain treated as arising under this legislation.
Foreign chargeable gains
37) A chargeable gain accruing or treated as accruing to an individual in respect of carried interest will be a ‘foreign chargeable gain’ and so eligible for taxation on remittance basis only to the extent that the individual performs the relevant investment management services (that is, those services that give rise to the carried interest) outside the UK.
38) This replaces the normal rule at section 12, TCGA 1992 that defines a foreign chargeable gain by reference to the location of the assets disposed of. Given that carried interest arises in relation to the performance of investment management services, looking to the location where these are performed rather than the location of the assets used to satisfy the carried interest is more appropriate.
39) Where carried interest arises to an individual who performs investment management services both inside and outside the UK, a proportion of the gain accruing under this legislation may be treated as a foreign chargeable gain on a just and reasonable basis. This will depend on the facts and circumstances of each particular instance.
40) HMRC are aware that, for some types of closed-ended funds, carried interest will arise in one year which, in truth, reflects services performed by an individual over a longer period. In such a situation, it may be correct to look at where services have been performed over prior years although, again, this will depend on individual facts and circumstances. An example of such a situation is provided in Chapter 3.
41) Please note, these rules do not displace the general rule in section 2(1), Taxes and Capital Gains Act (TGCA) 1992 that non-residents are not charged to CGT (save in relation to certain types of residential property and the disposal of assets used in a trade carried on in the UK through a branch or agency).
Prevention of double taxation
42) If an individual has paid any other tax in relation to the carried interest charged under these rules, then the individual may make a claim for any necessary adjustments to be made to the CGT charged in order to avoid a double charge.
43) If tax has been paid on amounts which are then treated as permitted deductions in computing the chargeable gain then no relief is available against CGT in respect of that tax under this provision.
44) The value of the adjustments made will not exceed the lesser of the:
- CGT charge in respect of the carried interest under the new legislation
- other tax paid
45) The other tax in respect of which an adjustment is sought must have been paid by the individual. It is not sufficient that the sum is charged or may be chargeable to another tax. Often, this other tax will have been paid by the time the individual files his or her tax return for the year in which the carried interest arises: a claim under these rules for an adjustment should then be made in that tax return. Please note that, where a sum of carried interest is charged to CGT under this measure but is also charged to Income Tax in the same tax year (for example, where the sums represent interest or dividend income to the underlying partnership), such that there are 2 charges in respect of that carried interest, a claim can be made in the appropriate tax return without the need to discharge both tax liabilities. HMRC will treat the Income Tax as having been ‘paid’ by the payment made alongside the tax return for the year in question. It would not be necessary to pay both the Income Tax due and CGT charged under this measure at the same time before requesting a repayment.
46) Where, however, another tax is paid after the CGT charged under the new rules has been paid, the individual will be able to make a claim to avoid double taxation through an amendment to their tax return (where possible) or by other means and regardless of normal time limits.
47) As explained above in paragraph 27, this legislation establishes a minimum level of tax on carried interest rather than a new regime which disregards the underlying receipts to the fund partnership. This means each component of the sum arising is looked at separately when determining what relief should be given under section 103KE. Where a sum comprises a series of items, double taxation relief will be given on an item by item basis (ie, it will only be possible to set the other tax due on a particularly component of the sum arising against the CGT due on that component, rather than the CGT due on the sum as a whole). This is the only approach which will be considered ‘just and reasonable’ in accordance with section 103KE(3) by HMRC.
48) Using the same figures as the example in paragraph 28, section 103KE would work as follows, the:
- £1,000 of principal is ‘carried interest’ and so is charged to CGT at 28% under this measure (£280)
- £1,000 of interest is also ‘carried interest’ and so charged to CGT at 28% (£280), Income Tax at 45% (£450) must still be paid
Section 103KE will allow full relief against the £280 of CGT technically due on the interest income under these rules. The Income Tax payable on the interest would effectively discharge CGT liability on the same sum. However, the Income Tax due on the interest income cannot also be set off against the CGT due on the principal. The Income Tax arises in relation to the interest and so can only be relieved against the CGT due on that interest, and not against the CGT due on any other item which is represented in the sum of carried interest.
49) The legislation will include a provision that will prevent arrangements being put in place that have the purpose of securing that the legislation does not apply to the individual, or to the individual and others, or to any part of an amount of carried interest arising.
50) Where any carried interest holder enters into arrangements on or after 8 July 2015 which have the effect of reducing his or her liability to tax, HMRC will investigate the circumstances closely and robustly challenge any attempt to circumvent this legislation using the anti-avoidance rule in section 103KE, other anti-avoidance provisions and, where appropriate, the General Anti-Abuse Rule (GAAR).
General interaction with DMF rules
51) As referred to above, the key concepts in this legislation will come from the DMF rules in Chapter 5E of Part 13 of ITA 2007. Where common terms and concepts are used, they will have the same meaning across both pieces of legislation. It is envisaged that the DMF rules together with the new legislation will work together as a comprehensive regime to cater for the 2 types of reward an investment manager can receive from a fund, while also catering for any co-investment they make. Going forward an individual performing investment management services in respect of arrangements involving at least one partnership will be taxed as follows:
- the management fee they receive will be charged to tax as income - planning designed to prevent this will be rendered ineffective by the DMF rules
- to the extent their performance linked reward is not charged to Income Tax as trading income, this new legislation will ensure that the fund manager is charged to CGT on the full amount of their economic gain
- any genuine co-investment made by the individual fund manager on terms which are reasonably comparable to investments made by external investors and the return on such co-investment will fall outside both the DMF rules and this new legislation and will be taxed in accordance with general principles
Chapter 3: examples
Example 1 - private equity manager receiving carried interest
A Capital LLP manages a private fund, A Capital Fund I LP. It has 3 individual members, A, B and C. A Capital LLP is paid a management fee equal to 1.75% of funds commitment to the fund partnership by investors (please note this is extracted from A Capital Fund I LP by way of a priority profit share to its general partner. The general partner on-pays this sum to A Capital LLP as a fee). The individual members are also entitled, between themselves, to carried interest in the fund. This entitles them to 20% of the ‘super’ profit of the fund, once a preferred return has been paid to investors equal to an annualised rate of interest of 7%. A B and C are also required, following negotiation with investors, to make an investment equal to 4% of the total sums committed to A Capital Fund I LP. This investment is made on the same terms as investments made by the external investors, although it is free from the obligations to pay the priority profit share to the general partner or bear the cost of the carried interest.
Going forward, the management fee is charged to tax as trading income in A Capital LLP and thus on A, B and C. To the extent structures are employed to try and divert a portion of the priority profit share away from the fee paid to A Capital LLP and instead for that sum to arise directly or indirectly to A, B and C in such a way that it is not charged to tax as trading income, the DMF rules will apply. The management fee will not, however, come within the definition of carried interest for the purposes of this measure,
A repayment of the co-investment made by A, B and C will not be charged to tax under the DMF Rules or this measure. The return on that co-investment will also fall outside the DMF rules and this measure as it will amount to an ‘arm’s length return’. The return on the co-invest to A, B and C is exactly the same as that return on investments made by the external investors in A Capital Fund I LP apart from being carry and management fee ‘free’. However, as this is designed to prevent A, B and C paying money to themselves, the return on their co-invest will still be reasonably comparable to that flowing to external investors such that it will still be an arm’s length return.
In respect of their carried interest, this measure will change the position. Historically, A, B and C would have benefited from base cost shift when the performance hurdle was met and their carried interest began to share in the profits and gains of A Capital Fund I LP. This will no longer be the case, and all the sums arising to A, B and C will constitute chargeable gains and be charged to tax at the full rate of CGT. A, B and C did make a nominal capital contribution to A Capital Fund I LP in respect of their carried interest. They may be entitled to deduct this (although its impact will be insignificant) on a just and reasonable basis in calculating their chargeable gain under this measure.
Example 2 - private equity manager receiving carried interest within employment-related securities rules
In this example the facts are the same as in example 1 and the treatment of the management fee and co-invest remains the same.
However, in this situation C is an employee of A Capital LLP who became entitled to carry some time after A Capital Fund I LP had closed and the underlying investments were beginning to perform well. C was assigned some of the carried interest previously held by A and B. C did not pay any consideration for the assignment nor did she make an election under section 431, ITEPA 2003. C was charged to employment Income Tax, however, under section 62, ITEPA 2003 on the then market value of the carried interest she acquired. This figure was lower, however, than the value that would have been given if various restrictions (as defined in section 423, ITEPA 2003) had not been attached to that carried interest.
Subsequently, those restrictions fell away. This is a chargeable event for the purposes of section 427, ITEPA 2003 and C is charged to employment Income Tax in accordance Chapter 2 of Part 7, ITEPA 2003 (the restricted securities rules).
Subsequently the performance hurdle is met and C begins to receive sums in respect of her carried interest. In computing her chargeable gain under this measure, C is allowed to deduct the amount which was charged to tax as employment earnings when she acquired the carried interest, as well as the amount which counted as income under the restricted securities rules when the restrictions fell away. Both permitted deductions are allowed on a just and reasonable basis.
Example 3 - private equity manager in receipt of carry comprising capital and income items
In this example the facts are the same as in example 1 and the treatment of the management fee and co-invest remains the same.
However, this example seeks to illustrate how the new provisions will work when a private equity executive receives a sum in respect of their carried interest which represents a mixture of receipts to A Capital Fund I LP.
A, who is not within the employment related securities rules receives a sum of £4,000 in respect of her carried interest. This represents, for tax purposes, the following receipts:
- £1,000 of debt principal repaid on the disposal of a company
- £1,000 of accrued interest on that debt (none of which was subject to a corresponding adjustment)
- £1,000 of base cost (using the methodology set out in SoP D12) in respect of shares in the company disposed of
- £1,000 of gain on those shares
As explained above, these rules do not establish a new regime for the taxation of carried interest which wholly disregards the underlying receipts to the fund partnership. In particular, it does not replace an Income Tax charge on items which represent income with a charge to CGT at a lower rate. While those items will also be charged to CGT under this measure, relief will generally be given under section 103KE.
On these facts, the tax position would be as follows. A is an additional rate taxpayer:
- the £1,000 of debt principal amounts to ‘carried interest’ in these measures, and is charged to CGT at 28% (£280)
- the £1,000 of interest is also carried interest and charged to CGT under these rules (£280), however, there is nothing in the legislation which displaces the Income Tax charge and so Income Tax at 45% must also be paid (£450)
- the £1,000 of base cost is charged to CGT as carried interest at 28% (£280)
- the £1,000 of gain would be charged to CGT at 28% under general principles (£280) and so these rules do not change the position
In respect of the £1,000 interest received, the double taxation provision at subsection 103KE is designed to allow full relief against the £280 of CGT technically due on the interest income. This would effectively discharge CGT liability on the same sum. In total A will be liable to pay tax of £1,290 on the total receipts of £4,000. This equates to an effective rate of tax of 32.25%. Please note that Section 103KE of TCGA looks at the items comprising a sum of carried interest individually. On these facts it is only possible to relieve the £450 of Income Tax due on the interest against the CGT also due on that interest. No part of the £450 can be relieved against the tax due on other items, such as the debt principal and base cost. Any other approach would not meet the ‘just and reasonable’ requirement in section 103KE(3) of TCGA.
Section 103KE of TCGA intentionally uses the term ‘paid’ in respect of another tax for which relief should be given. Where 2 charges arise on carried interest in the same tax year a claim can be made in the appropriate tax return without the need to discharge both tax liabilities (ie that the other tax will have been ‘paid’ for these purposes). So, if the £1,000 of interest in the above example was received on 1 September 2015, in the individual’s 2015 to 2016 tax return they would be able to claim relief for the £450 Income Tax charged on the interest against the £280 of CGT technically due. It would not be necessary to pay £280 of CGT on the interest at the same time as the Income Tax and then request a repayment.
Before the introduction of these rules, the debt principal and base cost allocated in respect of carried interest would not have been charged to tax in A’s hands. A would have been liable to pay £450 on the interest element and £280 of CGT on the gain realised on the shares giving a total tax bill of £730 (which would have given an effective rate of tax of 18.25%). In short, this measure stops A receiving £2,000 of his or her carry in tax free form and ensures that the entire sum is charged to tax at a minimum rate of 28%.
Example 4 - hedge fund manager receiving performance fee
C Capital LLP manages a hedge fund based in the Cayman Islands. C Capital LLP is rewarded for its management services via 2 routes:
- an annual management fee based on assets under management
- a performance fee equal to 20% of the increase in value of the assets managed during the year
Both of these fees are brought into account when calculating C Capital LLP’s trading profits.
Going forward there will be no change to the tax treatment adopted by C Capital LLP and its members.
As the management fee is charged to tax as trading income it is not ‘untaxed’ for the purposes of the DMF rules, such that the DMF rules do not apply.
As the performance fee is also charged to tax as trading income it is not ‘untaxed’ for the purposes of the DMF rules and it will be expressly excluded from this measure to avoid the need for the members of C Capital LLP to claim relief from double taxation.
Example 5 - non-UK services
D Capital LLP manages various alternative investment funds, including private equity funds. It has management teams located in various jurisdictions, including the UK, but is headquartered in New York.
Mr F is based in the US, and his primary responsibilities are in relation to D Capital’s US buy-out funds, although Mr F does provide limited advice and support to management teams throughout the world. After some years providing investment management services to D Capital’s current US buy-out fund, he is transferred to their London office to support a business expansion. He retains his carried interest in the US buy-out fund, and continues to provide some limited support to its remaining management team, but his future focus will be on various European funds (in which he will be given carried interest).
The US buy-out fund has performed well and the performance hurdle is hit immediately after Mr F moves to London and becomes resident for tax purposes in the UK, over the following years he receives sums in respect of his carried interest in the US buy-out fund.
These sums will amount to ‘carried interest’ for the purposes of this measure. Mr F is also performing investment management services in the UK during the period when they arise and so is potentially within the scope of these rules. Furthermore, during the years when he receives carried interest the vast majority of his fund management activities are performed in the UK.
This does not mean, however, that his carried interest will be charged to UK tax under these rules. Depending on the extent of support given to the US buyout funds after he became UK resident, the correct conclusion on a review of the all facts may be that none of carried interest relates to Mr F performing services in the UK. This is because it arises in respect of services Mr F performed outside the UK, even though it arises to him after he has become UK resident.
Appendix - ‘base cost shift’
1) ‘Base cost shift’ involves individual fund managers becoming entitled to base cost in underlying investments held by a fund partnership which is derived from contributions made by other investors. When calculating their chargeable gains, the individual fund managers are therefore entitled to deduct a greater amount of base cost than the amount they themselves actually contributed to Fund LP. This results in their gain for CGT purposes being lower than their economic gain. The gain charged to tax is therefore reduced, although the rate of tax applied remains the same.
2) ‘Base-cost shift ‘occurs where the profit sharing ratio of a partnership changes such that a member participates in the profits of a partnership in relation to an asset or assets to a greater extent than before. This treatment follows from the agreed interpretation of the CGT legislation embodied in SoP D12.
3) Under paragraph 1 of SoP D12 each of the partners is treated as owning a fractional interest in the underlying assets of a partnership. Where the capital profit sharing ratios in relation to such an asset are changed, the partners are treated as making an acquisition and disposal (as appropriate) of their interests in those assets. Provided there has been no revaluation of that asset in the partnership accounts and no consideration moves between the partners, the effect of SoP D12 paragraph 4 is that these acquisitions and disposals are generally treated as occurring on a ‘no gain/no loss’. In summary, this results in the partner whose profit share increases taking over some of the other partners’ base cost in the underlying assets. When that asset is disposed of the partner’s gain, for tax purposes, is therefore lower than his or her economic gain (as he or she was entitled to deduct a portion of base cost originally funded by the partner whose entitlement was reduced).
4) ‘Base cost shift’ is a consequence of the treatment described in SoP D12 paragraph 4 but its operation in the context of carried interest can result in individual fund managers paying a lower effective rate of tax.
‘Enhanced’ base cost shift
5) So-called ‘enhanced’ base cost shift attempts to multiply this effect by revaluing the assets held by the fund limited partnership in its accounts immediately prior to a change in the profit sharing ratios. Under paragraph 5 of SoP D12 this results in an even greater base cost being transferred to the individual fund managers in respect of their carried interest and so a lower effective rate of tax being paid.
Memorandum of Understanding between the BVCA and Inland Revenue agreed on 25 July 2003 on the Income Tax treatment of Venture Capital and Private Equity Limited Partnerships and Carried Interest of which a copy is available at HMRC manual ERSM30530. ↩
For example this will not necessarily be the case where the investment manager is or was an employee, where the performance linked interest will generally amount to an employment related security for the purposes of Part 7, Income Tax (Earnings and Pensions) Act 2003 which sets out a special regime for the employment tax treatment of such rewards. For the carried interest awarded to private equity fund managers, the 2003 MoU referred to above sets out an agreed interpretation of the restricted securities provisions to carried interest. There will also be situations where carried interest awarded to an investment manager who is not an employee should be charged to tax as income but such situations will either fall outside this legislation or the manager will be able to claim relief, as described below. ↩