The draft Finance Bill 2016 contains legislation concerning performance-linked returns for managers of collective investment schemes, the effect of which is that a manager’s performance fee, or carried interest, will be subject to income tax unless the underlying fund undertakes long-term investment activity.
In the July 2015 Budget, the government launched a consultation on legislation to determine when performance fees arising to fund managers from their fund management activities would be treated as capital in nature and benefit from CGT. According to the consultation, it was considered that fund managers should not automatically have CGT treatment on the performance-linked reward they receive from the fund, but that this should be dependent on their fund's activities clearly being of an investing nature. The consultation proposed two options:
- a "white list" of activities that were, in the government’s view, clearly investment activities, so that a performance-linked interest in a fund performing those activities would be charged to tax as chargeable gains provided certain conditions were met; or
- a "holding period" approach focusing on the average length of time for which the fund held investments. The government considered that this provided a simple and more objective test to determine whether a performance-linked interest in the fund gave the fund manager a stake in underlying long-term investments so that capital treatment was appropriate.
The 2015 Autumn Statement confirmed that the Finance Bill 2016 would implement the "holding period" approach.
Draft Finance Bill 2016
The draft Finance Bill 2016 legislation provides that, if an individual performs investment management services for a collective investment scheme, performance fees or carried interest arising from that fund will subject to:
- CGT treatment alone, if the fund holds investments, on average, for at least four years;
- part CGT treatment and part income tax and Class 4 NICs treatment, if the average holding period is between three and four years; and
- income tax and Class 4 NICs treatment alone, if the average hold period is below three years (although carried interest from lending funds receives this treatment by default unless certain conditions are satisfied, in which case it benefits from the "average holding period" rule as set out in the legislation).
The measure is designed to ensure that carried interest only attracts CGT treatment for funds that carry on long-term investment activity. Otherwise, it is "income-based carried interest" and charged to tax and NICs as trading income under the existing disguised investment management fees rules. Carried interest taxed as employment income is not caught by this measure, however.
To prevent carried interest being charged to income tax in the early years of a fund's life, carried interest is provisionally charged to CGT provided certain conditions are met.
The draft legislation also makes provision about derivatives and foreign exchange and interest rate hedging instruments:
- Derivatives – derivatives are themselves to be treated as investments if they are entered into for the purpose of an investment scheme. Derivatives are not an investment if entering into such a derivative contract constitutes a deemed (part) disposal of an investment i.e. ending exposure to risks and rewards;
- Foreign exchange hedging - provided certain conditions are met (as set out in new section 809FZG of the Income Tax Act 2007), foreign exchange hedging instruments will not be treated as investments; and
- Interest rate hedging – similarly, provided certain conditions are met (as set out in new section 809FZH of the Income Tax Act 2007), interest rate hedging instruments will not be treated as investments.
The legislation will come into effect for carried interest arising on or after 6 April 2016, regardless of when the arrangements under which the sums arise were made.