With the publication on 24th March of the UK’s Finance (No.2) Bill 2016, we now know the final details of the new “Income Based Carried Interest” (“IBCI”) regime, to be effective for carried interest arising from 6th April 2016. Following consultation, several changes have been made to the proposed rules.
We summarized the initial proposals in our earlier memo here. The basic proposition is that carried interest arising from funds with a “weighted average asset holding period” considered to be “short-term” will always be taxed as income rather than capital.
The key change, which many have been anticipating, is a shortening of the weighted average asset holding period that a fund must achieve in order to fall outside the rules. Full capital treatment is now possible for an average holding period of three years and four months or longer, with full income treatment arising for an average of under three years. A sliding scale operates between those points. (The previous proposal had provided for capital treatment for averages of four years and over, so the key threshold has been reduced, through lobbying, by eight months.)
Another concession relates to direct lending funds. These are deemed to produce carry that is income regardless of hold period, subject to an exception for limited partnership funds only, which as originally proposed required the fund to have a minimum 6% preferred return to be excepted. The hurdle here has been dropped to a minimum 4% preferred return, taking more lending funds out of the regime.
The rules on the computation of a fund’s average holding period have been made fairer, but at the cost of greater complexity. New provisions help to avoid separate incremental investments and dispositions in the same asset being treated separately for the purposes of the average, where controlling interests in trading companies are held and/or a fund is a real estate fund, a venture capital fund or a fund that acquires large equity interests in trading companies. There are also improvements in the rules to assist funds of funds, treating each-fund interest held as an investment rather than requiring those interests to be looked through. The short term divestment of assets acquired as part of a package together with other assets that are intended to be held for the longer term can also now be disregarded in appropriate circumstances.
The important exception for carried interest arising in respect of “employment related securities” is retained in the final form of the rules. This exception is now attracting significant interest from affected individuals who do not currently have employment status.
The original drafting of the rules was defective in that carry arising after the fourth year of a fund’s life could be taxed as income even if in the long run the fund’s average holding period proved adequately long to qualify carry as capital. This has now largely been resolved, at least for private equity style funds, with contingent capital treatment available for the first 10 years of a fund’s life based on the expected eventual average holding period.
There is also an improvement for non-UK domiciled UK residents, but only for the first four years after their arrival in the UK. During that period, such individuals may be able to claim the remittance basis on IBCI to the extent it is attributable to services they performed outside of the UK before coming to the UK. As expected however, more established non-UK domiciled individuals will in practical terms be unable to benefit from the remittance basis in relation to IBCI.