IFM37140 - Overview: Background to the legislation
Background to the legislation
The reward paid to many individuals for performing asset management services comprises two elements:
- an amount determined by reference to the assets under management of the fund (the “management fee”); and
- 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”).
For some asset managers, the performance-linked reward is not structured as a fee. Instead, the individual managers are given participation in the underlying investment vehicle, which could be a partnership or company. 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.
“Carried interest” for these purposes will be the sums arising to the individual fund manager in accordance with ITA07/S809EZC(1) (IFM36520) or ITA07/S809EZD (IFM36540).
Taxation of carried interest prior to 8 July 2015
For UK direct tax purposes, partnerships are generally treated as transparent entities. This means that a partnership, which is separate and distinct from the liability of its members, has no liability to UK direct tax. Therefore, sums allocated to partners are treated, for tax purposes, as though the individual and not the partnership had entered directly into the transactions which give rise to the sums in question.
Where an investment manager has a performance-linked interest in a fund partnership and the relevant performance conditions are met he or she is entitled to a share of the underlying profits realised by the fund. Prior to 8 July 2015, if the fund was treated as carrying on an investment activity for tax purposes, its profits would generally fall within the CGT rules. In this situation, the sums received by the investment manager in respect of their carried interest may have been charged to CGT because the receipts were normally treated as proceeds from the disposal of chargeable assets. However, there were circumstances where carried interest in a fund carrying on investment activity would, in whole or in part, be charged to tax as income. For example, if the investment manager was an employee, the performance-linked interest will have generally amounted to an employment-related security which would be charged as employment income. See ERSM30520 for guidance on restricted securities.
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. Statement of Practice D12 (SoPD12) sets out how the chargeable gains legislation operates in these circumstances. See CG27170 for details of SoPD12.
The application of SoPD12 to carried interest gains, could have resulted in investment managers being charged to CGT in respect of their carried interest gains on amounts which were significantly smaller than their actual economic returns because of “base cost shift” (IFM37160).
Taxation of carried interest from 8 July 2015
TCGA92/S103KA-S103KH
Finance (No.2) Act 2015 introduced legislation in Part 3 of the Taxation of Chargeable Gains Act 1992 (TCGA) which revised the CGT treatment of sums received by managers in respect of their carried interest. This legislation brings into the charge to CGT the full economic return arising to the fund manager after allowing for certain deductions.