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Summer Finance Bill: Carried interest

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The changes to the taxation of carried interest have sent shock waves through the private funds industry. Following on so soon after the disguised investment management fee (DIMF) rules effective from 6 April, together they represent something of a double whammy for private equity executives.  
While certain of the changes counteract the anomalous tax outcomes resulting from the existing rules (and so are difficult to take issue with), there are other aspects of the changes which go beyond that and which impact the attractiveness of the UK as a centre for the private funds industry.  
Before setting out the carried interest changes in detail, it is helpful to have a recap of the DIMF rules, as the new carried interest rules have their source in those rules.   
For UK tax resident individuals (whether UK domiciled or not), the DIMF rules tax as earned income all cash flows arising directly or indirectly to an executive from a fund he or she works on, unless the amounts are either carried interest or co-investment returns (ITA 2007 ss 809EZA and 809EZB inserted by cl 40 of the Bill). 
In its related guidance, HMRC states that the effect of the ‘directly or indirectly’ language is that a DIMF tax liability arises when relevant amounts arise to a structure interposed between the individual and the cash flow; however, it seems to accept that investment management companies and other entities of substance can break the chain.  
For the purposes of the DIMF rules, carried interest is defined widely and includes almost all types of performance award structured in equity or partnership interest form (ITA 2007 s 809EZC). While the wide definition of carried interest and its exclusion from the DIMF rules was welcomed at the time, seasoned observers worried that a definition of carried interest provided an easy basis for HMRC to change its tax treatment. So it has proved.  
Previous carried interest rules: Under the law before 8 July, carried interest holders in partnerships did not pay tax based on their economic profit, but instead based on the underlying profits allocated to them by the fund. This had a number of consequences.
First, a distribution of cash to a carried interest holder following the disposal of an investment by the fund would not have been matched by an allocation of the same amount of profit, as part of the cash amount would have represented the cost of the relevant investment to the fund. For example, if a fund bought an investment for 100 and then sold it for 200 at the time the carried interest holders participated in proceeds, only 50% of the cash received by the carried interest holders would have been taxable and the remainder would have been tax free. This was known as the ‘base cost shift’.
Second, to the extent that cash received by a carried interest holder is matched by profits, the tax payable depends upon the nature of those profits. If the profit is capital gain, the tax rate is 28%; however, if the profit is, say, interest income, the profit is taxed at 45%. Some managers sought to optimise their tax position by seeking to allocate lower rather than more highly taxed profits in satisfaction of carried interest (so called ‘cherry picking’).
Finally, for non-domiciled executives, it was possible to structure the holding of carried interest in such a way that they were subject to UK tax on the remittance basis, save to the extent that the carried interest comprised UK source income.
Changes in the Bill: From 8 July 2015, the taxation of carried interest will not be solely dependent upon the underlying nature of the profits arising to the fund and allocated to the carried interest holders.
Instead, all carried interest arising to a UK tax resident individual (less certain permitted deductions, such as acquisition cost) is treated as capital gain, accruing at the time the carried interest arises directly or indirectly to the individual (TCGA 1992 s 103KA).
Furthermore, that gain is treated as UK source to the extent that the individual performs his or her investment management services for the relevant fund in the UK (TCGA 1992 s 103KC). This means that, to the extent of their UK activities for the fund in question, UK resident non-domiciled individuals will be subject to 28% tax on carried interest, whether or not remitted. 
In the related guidance, HMRC states that the extent of pro rating will depend upon the facts and circumstances and seems to suggest that it is a qualitative not a quantitative analysis. Some clearer guidance is needed, as well as clarification on how these rules will interact with the remittance and mixed fund rules. Hopefully, HMRC will allow non-domiciliaries to remit the taxed element of carried interest before the untaxed element. 
The main point to note with the new rules is that they supplement, rather than replace, the existing rules. For example, if any part of the carried interest is satisfied by an allocation of UK source interest income, the carry holder will be subject to 45% tax on that item of cash flow, not 28%. As almost all private funds give rise to income after the hurdle, the effective tax rate for most carried interest holders under the new rules will be over 30%. This is internationally uncompetitive.
Another big issue is for US citizens working in the UK. Put simply, these individuals will have to pay US tax on carried interest (at generally lower rates than the UK’s) on a deal by deal basis, even for a fund as a whole carried interest. However, these individuals will now have to pay a higher rate of UK tax on the same commercial profits at a later time; and, due to the limited US foreign tax credit carry back rules, it will often not be possible for the individual to get full credit in the US for the UK tax. This will result in double taxation for US private equity executives in the UK. While this point has always existed in theory, the effect of base cost shift and the remittance basis made the issue manageable in practice. HMRC seems to have been unaware of this point and it is hoped that it will address this by allowing an optional basis for individuals to pay UK tax on carried interest on an equivalent basis to the US rules.    
For good measure, in its guidance accompanying the legislation, HMRC has stated that it thinks cherry picking is ineffective ‘being contrary to well-established principles of partnership taxation’. While one can take issue with this justification, it seems clear that any element of cherry picking going forward should have, to borrow a concept from the US rules, ‘substantial economic effect’.
Like the DIMF rules, the carried interest rules are triggered when relevant amounts arise directly or indirectly to an individual. As with the DIMF rules, HMRC regards this as making trusts and other interposed structures ineffective. However, this should only be the case to the extent that such structures are ineffective for DIMF purposes and, as stated above, certain substantive structures can break the chain.
Finally, there are anti-avoidance rules (TCGA 1992 s 103KD). These counteract arrangements which exist to avoid the application of the rules. These provisions, together with the dovetailing of the rules with the DIMF rules, mean that there are now only limited opportunities to avoid the full effect of these rules.
Consultation on further carried interest changes: On Budget day, HMRC also issued a consultation on the types of funds that should be able to issue carried interest which benefits from capital gains tax treatment, with a view to changing the law with effect from 6 April 2016. HMRC is clearly unhappy with hedge funds, concluding that they are investing not trading and converting their annual performance fees to carried interest. However, the consultation would also seem to impact other funds which HMRC does not regard as being sufficient investment in nature.  
The effect of this change, as currently proposed, will be to tax carried interest in relation to funds as income, with only specified funds being entitled to issue carried interest benefiting from capital gains treatment. It is hoped that, as part of the changes, HMRC provides a flat CGT rate for carried interest from qualifying funds, rather than the hybrid ‘minimum tax’ position produced by the new rules.  
Quite how and where HMRC will draw the line between good and bad funds is not clear. HMRC is consulting on whether to distinguish by reference to the nature of the investments held by the fund and/or the length of time they are held for.    
If the first approach were adopted, HMRC’s initial proposed definition of a good fund draws some arbitrary distinctions and would make bad funds of direct lending funds, mezzanine funds, minority funds and some special opportunity funds. For this reason, it is hoped that HMRC’s alternative approach is adopted. Under this, HMRC says it would look to the average hold of investments of the fund, with only funds whose average hold is over two years being entitled to full capital gains tax treatment for carried interest. Under the initial proposal here, there would be some pro rating of income and capital treatments for funds with shorter average holds down to six months below which all carried interest would be income.
Draft legislation will be published in the autumn and it is hoped that the outcome will be a simple, fair yet attractive regime for the tax treatment of performance awards in the asset management industry.