Following years of targeting the banking industry in order to increase tax revenue, the UK Government has started to focus its attention more keenly on the remuneration of asset managers (particularly carried interest arrangements), with new draft legislation contained in Finance Bill 2016 proposing to tax carried interest as income instead of capital gains in specified circumstances.

Overview

Following the public consultation that took place over the Summer of 2015, draft legislation has been published in Finance Bill 2016 relating to the taxation of performance-linked rewards (i.e. carried interest) received by asset managers. Broadly, the stated intent of the draft legislation is to tax as income (and not capital gains) carried interest received by asset managers where the underlying fund holds investments for an average period of less than three years. For average holding periods between three and four years there will be a sliding scale as to the proportion which will be taxed as income, with average holding periods of four years or more resulting in 100% of the carried interest being subject to capital gains tax. All returns which are not subject to capital gains tax will be chargeable to income tax and class 4 national insurance contributions as trading profits. This will have a dramatic impact on the taxation of such carried interest, with the applicable tax rate increasing from 28% to over 45% in many cases.

The new legislation is expected to be enacted in Summer 2016, retrospectively applying to sums of carried interest arising on or after 6 April 2016, whenever the arrangements giving rise to those sums were entered into.

Selected key points to note

The average holding period is calculated by reference to the time the carried interest arises and the holding periods of the fund investments in relation to which the carried interest is calculated.

Intermediate holding structures are disregarded when determining the period for which an investment has been held.

Partial disposals – the part disposed of and the part not disposed of are treated as separate investments.

There are specific rules to deal with derivative contracts, particularly in relation to the timing of disposals, and most hedges of investments will fall outside the new rules.

There are specific rules to deal with funds that invest in controlling interests in companies. Broadly, where a fund continues to hold a significant interest in a company, these rules result in further investment and certain disposals being ignored when calculating the average holding period.

There are particular rules which will generally prevent carried interest being charged to income tax in the early years of a new fund.

Carried interest received from debt funds is likely to be subject to income tax, subject to certain exceptions.

There is an anti-avoidance rule which aims to look through arrangements which have a main purpose of altering the proportion of carried interest that is subject to income tax.

Next steps

The UK Government has been focussed on the tax treatment of carried interest for a while now and has been seeking, through legislative changes, to tighten the manner in which carried interest has been taxed in the UK. This proposed legislation denies automatic capital gains treatment for carried interest that asset managers receive from underlying funds – instead, the managers would be able to obtain capital gains treatment only if the carried interest clearly related to investment activity of the underlying fund. In other words, if the underlying fund is a true investment fund, there should be capital gains treatment available and if it is not, income taxation will apply. Rather simplistically, four years as an average holding period of investments seems to place a fund in the clear investment category – this arbitrary reference point of four years is likely to have an impact on managers' and the underlying funds' investment (particularly exit) behaviour.

In practice, it is expected that most private equity funds will fall outside the new rules, with average holding periods of investments by private equity funds likely to be in excess of the four year legislative reference point. Nevertheless, it will be key for all funds to monitor the average holding period of their investments.

Where investment managers have made capital contributions to the fund, care should be taken to ensure that any carried interest return is apportioned properly to the capital contribution element although it is unclear how this proposed legislation will apply in practice in such circumstances where investment managers have made capital contributions to the fund.

Current structures and future structures should be assessed to see how this proposed legislation will apply and whether more efficient remuneration options are available.