IFM37160 - Carried Interest: Overview: Base cost shift

Base cost shift

Base cost shifting was widely utilised prior to the introduction of the carried interest provisions within TCGA92/S103KA-KH. From 8 July 2015 the carried interest rules remove the ability to use base cost shifting.

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 HMRC’s interpretation of the capital gains tax legislation embodied in Statement of Practice D12 (SoPD12). For further guidance please search for “Statement of Practice D12” on the website.

For individual fund managers, base cost shift occurs when they are allocated a share of the base cost of underlying investments held by a fund partnership, which is derived from contributions made by other investors and greater than the sums the fund managers themselves contributed. Consequently, this results in their gain for capital gains tax purposes being lower than their economic gain. The gain charged to tax is therefore reduced, although the rate of tax applied remains the same.

How it works in practice

Under paragraph 1 of SoPD12 each of the partners are 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 SoPD12 paragraph 4 is that these acquisitions and disposals are generally treated as occurring on a “no gain/no loss” basis.

In summary, this results in the partner whose profit share increases taking over some of the other partners’ base cost in the underlying assets. The effect of this is that when that asset is disposed of, the partner’s gain, for tax purposes, is lower than their economic gain. This occurs because they were entitled to deduct an additional portion of the base cost. As noted above, that part was originally funded by someone else (i.e. the partner whose entitlement was reduced), not by the partner now claiming the deduction.

Base cost shift is a consequence of the treatment described in SoPD12 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

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 SoPD12 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.