The latest Finance Bill, published last week, contains new rules governing the taxation of carried interest.  They apply to carried interest arising on or after 6 April this year.  The rules will be of critical importance to fund managers.  They work differently for different fund types so managers will need to monitor which category each of their funds falls into.  In one particular respect it may be advantageous to change fund distribution waterfalls.

Background

The rules were trailered in draft last December (see our client newsflash on the draft).  HMRC have been in discussions with industry in the interim period.  Whilst the basic scheme of the rules is unchanged, there are a number of alternations to the detail, and some new provisions, that will fundamentally affect how the rules apply.  Here are the key changes.   

Average holding period

The average investment holding period required in order for carried interest to be eligible for capital gains tax treatment has been reduced from 4 years to 40 months.  There has been no change in the lower threshold of 3 years, below which all carried interest is charged to income tax.  As a consequence, there is dramatic tapering in the four month gap between 3 years and 40 months.  80% of carried interest arising when the average investment holding period is at least 3 years 3 months will be eligible for capital gains treatment, whereas only 40% of carried interest arising when the average investment holding period is 3 years and 1 month will be eligible. It remains the case that carried interest will only be taxed under the capital gains rules if the funds received are actually capital in nature and the carry satisfies the statutory definition of carried interest introduced last year.

What are the investments?

Intermediate holdings are to be disregarded when working out the average holding period.  This is as trailered, though intermediate investment schemes are now specifically included.  So where one fund invests in another fund it is the investments of the underlying fund that matter.  There are, however, a couple of things to complicate this. The first is that the disregard rule is now to be 'switched off' for funds of funds and secondary funds.  For these funds, it will be their holdings in the underlying funds that are relevant, not the underlying fund's investments.  Details of when a fund will fall into one of these categories are in our briefing note.  The second complication is caused by the explanatory notes. They state that the aim is to identify the assets a fund acquires in economic and commercial substance (and which investors would see as comprising the assets acquired in the course of the fund's strategy).  Investments held by real estate funds will constitute land even if acquired through a corporate holding structure.  Conversely, the relevant investments for a private equity fund investing in trading groups would be the main holding companies, not companies lower down the structure or the actual trading assets.  This appears common sense, but it makes the question of which are the relevant investments somewhat subjective and dependent on the fund type.  This may cause uncertainty in practice.

Packaged assets – unwanted short term investments

In a pragmatic change, the making and disposal of 'unwanted short term investments' will not be taken into account in calculating the average holding period.  This will apply where the fund acquires assets as a package, and the manager has a firm, settled and evidenced intention to retain some assets and dispose of others that are essentially unwanted.  There are conditions as to the value and type of unwanted assets, and the period within which they are actually disposed of.  If it becomes reasonable to suppose that 25% or more of a fund's capital will have been invested in unwanted short term investments by the end of its life then this rule will cease to apply. A potential problem for many existing funds, however, is that any profit resulting from disposal of the unwanted investments must not be taken into account in determining whether the carry hurdle is crossed or how much carry arises.  'Fund as a whole' carry structures which take all profits and gains into the waterfall are unlikely to be able to meet this requirement.  Fund managers may want to look at redrafting waterfalls so that profits and gains from disposals of unwanted short term investments are allocated and distributed to investors without being taken into account at all for carried interest purposes.

Follow-on investments and managed sell-downs

The rules in respect of follow-on investments and managed sell-downs have been expanded.  There is now one basic rule and six sets of separate, more generous, rules for specific categories of funds (venture capital, controlling equity stake, significant equity stake, real estate, funds of funds and secondary funds).  Each category has different conditions and requirements.  For real estate funds, it is worth noting that the rules will apply where a fund owns one piece of land and then acquires an adjacent piece. They will also apply where the fund has a major interest in land and then acquires another, for example where the fund has a long leasehold and then acquires the freehold reversion.  Further details for each type of fund are set out in our briefing note.  Fund managers expecting to rely on these rules will have to ensure their funds have the right investment intentions at the start of their life (determined objectively) and will then have to monitor each investment made.  It will not be possible for funds to mix and match across the categories.

Direct lending funds

Carried interest arising from direct lending funds will be automatically charged entirely to income tax, regardless of the average investment holding period, unless it falls within a limited exception.  Direct lending fund is more widely defined than in the draft.  If a majority of the investments made over a fund's life will be interest bearing loans made directly or acquired within 120 days of funds being advanced, the fund will be caught.

Employment related securities

As in the draft, the new rules do not apply to carried interest arising in respect of employment related securities.  However, there is a new power for the Treasury, allowing them to repeal or restrict this exclusion.  There is no indication of when this may be used, which creates some uncertainty for those whose carried interest arises from their employment.