CGT treatment of carried interest preserved (mostly)

Earlier this week the UK Government published draft legislation detailing new rules governing the taxation of carried interest.  These rules will take effect in respect of carried interest arising from 6 April 2016.
 
In summary (where a whole fund carry is calculated), carried interest will be taxed as capital gains provided the average investment holding period (at the time the carry arises) is at least four years.  If the average is less than three years, then the carried interest will be taxed wholly as trading income.  If the average falls between three and four years tapering provisions will apply as follows:

Click here to view the table.

The average investment holding period is to be calculated as a weighted average by reference to the cost of investments and the period over which they are held.  These are hard and fast rules, deliberately drafted with no reference to the nature of the underlying assets – so the same rules will apply to an investment in a brand new start up as would apply to investment in an established operating business and the same rules will apply to, for example, investment in real estate or in infrastructure projects. At the end of this note you will find a worked example of how the calculation will work.

Specific rules designed not to discourage follow-on investments or managed sell downs will apply to Funds taking controlling stakes in trading groups (or which will, at the time of exit, have had more than 50% of their value invested in such controlling stakes for over 4 years). These specific rules are narrow in their application and the BVCA has expressed concern that they are too narrow given that the norm for many Funds is to take only minority stakes. Provision is also made for circumstances where some carried interest is paid out early in a Fund's life but the average holding period is expected to exceed 4 years at specified later dates.  CGT treatment will be provisionally available for the 'early' carry.

The new rules do not affect the tax treatment of profits and gains arising on Manager co-invest.  

History

Ever since a sharp-eyed journalist commented that the tea ladies of our esteemed PE houses were paying tax at higher rates than the senior managers, carried interest schemes have come under increasing scrutiny from the Treasury.   Earlier this year a new statutory definition of carried interest was introduced and both the benefits of the so called "base-cost shift" (whereby carried interest participants attributed acquisition costs to their share of carry even though they did not fund the same) and the ability to receive carry in non-taxable form were removed.  Likewise the ability of "non-doms" to pay tax on carry on a remittance basis was limited. 

The draft rules just published are designed to ensure that only managers of funds that are genuinely investing (as opposed to more "hedge" style trading funds) will benefit from favourable CGT rather than income tax treatment of their carry. To get CGT treatment from next April, carry will need to both fall within the statutory definition introduced earlier this year and arise from Funds meeting the new average holding period requirement.  Failure to do this will result in income tax treatment (though such treatment will be in respect of trading income, and so will not change the established position that carried interest is not taxed as employment income and is not subject to PAYE) and a charge to Class 4 NICs.

Misalignment of Interests

The carried interest model has proved remarkably robust in the light of market forces and greater regulatory scrutiny of performance related fees.  At least in part this robustness can be attributed to its success in aligning the interests of the managers with the interests of investors.  It is a matter of some regret that the new rules will disturb the alignment.  Specifically managers may have an interest in adjusting the timing of disposals, in order to benefit their own tax position.  One can envisage circumstances whereby it is actually in a manager's interest to defer making a taxable disposal thereby increasing his after tax share of carry, whilst decreasing the IRR of the Fund. Whilst, no doubt, reputable managers will continue to put the interests of investors first, investor perceptions could be altered by this potential conflict.   Existing fund documentation  will often not have disclosed or otherwise addressed this specific conflict to date and both existing and new funds (and their managers and investors) will need to consider how best to manage this potential conflict going forward.

And from here?

The proposals are only in draft form (comments to be submitted by 3 February 2016) and the BVCA state their belief that the door remains open for further detailed discussion.  Specifically they will be lobbying hard to reduce the four year period down to three and to extend the additional protections that apply to Funds taking majority stakes to those Funds where the norm is to take minority positions. Whilst changes may therefore be made before April, the current draft provides a good indication of the Treasury's current thinking and it is difficult to imagine that a delay in implementation beyond April would be politically acceptable.

Worked example

A Fund acquires three investments in year 1 for £500,000, £750,000 and £1,000,000 each.  It holds them for 2 years, 3 years and 5 years respectively.  Carry arises when the third asset is sold.  (This example assumes the carry meets the statutory definition of carried interest introduced earlier this year.)

The calculation is as follows:

  • Multiply cost of each investment by period held and add totals for all investments: (£500,000 * 2) + (£750,000 * 3) + (£1,000,000 * 5) = £8,250,000
  • Divide the result by the total cost of the investments: £8,250,000 divided by £2,250,000 = 3.666
  • Multiply the result by 12 to give the average holding period: 44 months

Applying the tapering provisions here, 50% of the carry will be charged to CGT and 50% to income tax.