The UK Government, as anticipated, issued draft legislation on 9 December designed to establish clear rules as to when carried interest can qualify for favourable capital gains tax treatment.  The draft legislation follows a consultation exercise announced in the Summer Budget (please refer to our earlier updates in this regard).

The Summer consultation paper issued by HMRC initially proposed two alternative methods for determining when carried interest could qualify for capital gains tax treatment. The first method looked to the fund’s investment strategy or proposed activities (so called “Option 1”), while the second method looked to the average holding period of underlying assets (so called “Option 2”). The draft legislation confirms that Option 2 is the favoured option.

On a positive note, in pursuing Option 2, HMRC has followed the preference of most industry respondents, who generally favoured Option 2 because of the greater certainty it should offer. However, the four year average holding period proposed by the draft legislation has set a high bar and, in our view, is unnecessarily restrictive.

In summary, the draft legislation purports to tax a carried interest return entirely as income unless it is derived from a fund which holds its underlying assets for an average holding period of at least three years. Where the holding period is between three and four years, a proportion of such returns will be taxed as income. Only where the average holding period exceeds four years will capital gains treatment be obtained in full. The calculation will be made at the time the carried interest arises.

The calculation of the average holding period for these purposes will be based on a “weighted average” so that the original cost of an investment will be important. For example, a particularly large investment which is sold after a short period of time could have a major distortive impact on the calculation. This could present a conflict of interest between investment managers and their investors as to the time of disposal of such an asset.

Specific rules have been introduced for loan origination funds. Originally, there was concern that such funds would be incapable of qualifying for capital gains treatment for carried interest returns. However, the draft legislation envisages that this will be possible, broadly speaking, where loans are extended generally for a term of four years or more, although such funds will need to meet additional conditions in order to qualify for such treatment.

As the impact of failing the new test is to convert what would otherwise have been a capital gain into income along similar lines to the existing “disguised investment management fee” rules, non-domiciled individuals should note that this will also convert what might otherwise have been taxed as capital gains on a remittance basis into UK source income taxed on an arising basis.

If implemented in accordance with the draft legislation, the new rules will prevent capital gains tax treatment for carried interest arrangements for the large majority of hedge or alternative funds with short to medium term holding periods, irrespective of whether such funds could be considered to be carrying on an investment rather than a trading activity. While most private equity funds ought to be capable of satisfying the average holding period requirements, the four year period is still longer than would be wished for (especially as some of the detail contained in the calculation aspects of the rules may present further scope for failing in specific circumstances). The new rules will also introduce an additional compliance exercise, in order to monitor and undertake the necessary average holding period calculations.

The new rules are designed to come into effect from 6 April 2016 and arrangements entered into before that date will not benefit from grandfathering. As a result, if implemented, the new rules will impact on existing structures. Existing structures should therefore be reviewed in the light of the proposals. However, there is still a further opportunity for consultation prior to delivery of the final legislation which is expected on or around the budget next year.

As noted in our earlier article, the Summer Budget also introduced significant other changes to the taxation of carried interest. In overview, the changes are designed to ensure that carried interest is subject to tax at a minimum rate of 28% (essentially preventing the application of “base cost shift” and “profit cherry-picking” to reduce the effective rate of tax further). In addition, changes were made to the sourcing of the capital gain for non-UK domiciled individuals so that gains arising on non-UK investments derived from a non-UK carried interest fund structure could still be taxed in the UK if the executive works in the UK. In conjunction with the draft legislation discussed above, these changes constitute a major shift in the UK tax treatment of carried interest which will impact upon current structures and materially change the structures put in place in the future.