Following the Disguised Investment Management Fee (“DIMF”) rules introduced on 6th April 2015 and the Carried Interest rules effective from 8th July 2015, draft legislation to introduce a further proposed change to the UK taxation of carried interest, to apply from 6th April 2016, has now been published. The proposals are the outcome of a consultation on the taxation of “Performance Linked Rewards”, and could result in income rather than capital treatment for many private equity executives’ carry.
The draft legislation introduces the concept of “income-based carried interest” (“IBCI”). IBCI will be taxable as income, in the same manner as DIMF. This means that, if a UK resident individual is performing investment management services in the UK, then 100% of IBCI arising to him or her will be taxed here as income (at 45% plus 2% national insurance contributions) rather than capital gain (at 28%). Unlike the position under the Carried Interest regime, the impact of the IBCI regime on UK resident but non-UK domiciled individuals isn’t reduced to the extent services are performed outside the UK. Non-UK residents visiting the UK to perform investment management services could also be affected by reference to the amount of time spent working in the UK, subject to relief under a double tax treaty.
It is proposed that IBCI is defined as carried interest arising from a fund which fails to satisfy a minimum weighted average investment-holding period. Full capital gains treatment for carry is only available where the average investment holding period of the fund is four years or longer, with full income treatment for a holding period of below three years. The proportion taxed as income falls by 25% each quarter between a three and four year average. Weighting is applied by reference to cost of acquisition. The investments which are included in the calculation of the average are proposed to be those by reference to which the carried interest received is calculated. On fund-as-a-whole carry, this clearly includes all fund investments.
A fund intending to invest a majority of its cash through direct lending (meaning the origination of loans or acquisition of loans within 120 days of origination) has special treatment. Unless the expectation is that, when fully invested, the term of at least 75% (by value) of the direct loans made by such a fund would be four years or more, and certain other requirements are satisfied, carry will automatically be IBCI.
More positively, it is proposed that carried interest arising in respect of “employment related securities” be excluded from being IBCI. For private equity executives potentially affected by the new IBCI regime, for example members of a fund management LLP, it may be worth giving serious consideration to restructuring their activity as employment. Provided the value of carried interest at acquisition can be shown to be low, so minimizing any employment income tax charge on acquisition, employment may now be the preferred route.The potential national insurance costs, and wider consequences, of such a step, would of course have to be weighed. Such an approach could only be of benefit prospectively, in respect of interests acquired after employment status is acquired (or at least contemplated).
Although the draft legislation is still subject to further consultation, the tone of the proposals does not suggest that there is much scope for change to the material elements (for example the three to four year holding threshold). As such, potentially affected taxpayers should prepare for the IBCI regime becoming effective from 6th April 2016.