This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.
Summary and implications
Yesterday HM Treasury confirmed its proposals to radically change the way in which carried interest is taxed. Funds will now need to hold investments for four or more years in order for UK fund managers to get full capital gains tax treatment on payments of carried interest (carry). This is a departure from the current position where a manager's carry is taxed in the same way as the underlying investments.
The draft Finance Bill (the Bill) provides for a tapered system of income tax taxation on carry received in respect of investments that are held by a fund for less than four years:
Average holding period
% of carry taxed as income
< 36 months
≥ 36 months but < 39 months
≥ 39 months but < 45 months
≥ 45 months but < 48 months
> 48 months
The Government believes that the periods above will allow most funds' investment strategies to fall clearly on the side of income or capital. But the rules are quite clear that a holding period of less than 36 months still does not prevent investors from getting capital treatment if appropriate. This produces a potential misalignment of interests between fund managers and investors. Additionally, there is a concern that these changes could signal a more general move away from the case law-based "badges of trade" test.
Holding period test
It is intended that using an average investment holding period (rather than on an individual investment basis) will neutralise the effect of early investment exits made for reasons beyond a fund manager's control where the original intention was to hold the asset for the long term. The period will be calculated on a mean-average basis looking at the value of each investment when it was acquired. Any intermediate holdings or holding structures for investments are ignored for the purposes of identifying relevant investments. The length of time to be used in the calculation is either:
(i) the time an investment was held before being disposed of; or
(ii) where carry is to be paid prior to disposal, the period it has been held up to that point. Disposal for these purposes follows the meaning in TCGA 1992.
Where carry is paid early, on a deal-by-deal basis, but the average hold period is expected to bring the recipient within capital gains tax treatment, an individual may make a claim for that carry to be "conditionally exempt" from income tax. To be expected to be within capital gains treatment it must be reasonable to suppose that were the carry to arise at the earlier of:
(i) the winding up of the fund;
(ii) four years after the expected last investment;
(iii) four years after the carry arose; and
(iv) four years from the end of the period in relation to which the carry was calculated, none of the carry would be charged to income tax.
This treatment is reassessed at the end of the life of the fund.
Where a fund is of the type that expects >50 per cent of its investments to be controlling interests (> 50 per cent interests) in trading companies or trading groups and held for more than four years, the Bill allows such funds to aggregate their investments in that company so as to treat them all as if they had been made when the fund achieved a 25 per cent interest in the company.
The new rules will apply in respect of carry arising on or after 6 April 2016. There will be no grandfathering of existing arrangements.
HM Revenue & Customs is welcoming comments on the draft legislation up to 3 February 2016.
Please contact either of us or your usual Nabarro contact if you would like to discuss the implications of these changes further.