In December last year the government published for comment draft legislation restricting the situations in which carried interest, arising on or after 6 April 2016, could be taxed as capital rather than income.  

Broadly, under those draft rules, full capital treatment would only be available if the relevant fund held its assets for an average period of four years or more. Capital treatment would be partially available where the average period was between three and four years tapering from 25% to 100% capital treatment over that period.  Below a 3 year average hold, all returns to managers would be taxed as income.  

There were two announcements in today’s Budget expressly effecting carried interest;

  • it appears that, to get full capital treatment, the average minimum holding period will be reduced from 4 to 3 years and, as no tapering was mentioned, it remains to be seen as to whether these tapering provisions will disappear; and 
  • the carried interest that is treated as capital, will not get the benefit of the new reduced CGT rates but will remain taxable at 28%/18%, as the case may be.

The next draft of the rules (expected 24 March) are likely to be modified to take into account various concerns raised by the fund management industry.

Some more detail

Historically, private equity and other investment funds have commonly been structured so that the performance linked element of the managers’ reward (the “carried interest”) was subject to capital gains tax, rather than income tax, to the extent possible.  The past year has, however, seen a raft of new measures changing this.

Under the disguised investment management fees (“DIMF”) rules announced last year, individuals carrying out investment management services in respect of collective investment schemes are subject to income tax on any sum arising to them, unless the return is “carried interest” (as defined). This new rule also applies to listed investment companies, other than VCTs and REITs.

Under December’s draft rules this exclusion will, from April 2016, now be additionally restricted so as to not apply to “income-based carried interest”. The draft rules have been subject to extensive lobbying by the fund management industry and it is anticipated that they will change significantly before implementation.

The remainder of this article considers the December draft of the rules, along with today’s announcements, and identifies possible areas of change to these rules.

Capital or income?

If and to the extent that the manager’s return is “income based carried interest”, it will be treated as income regardless of the character of the return or type of asset.

It was originally announced that, carried interest would not be treated as “income-based carried interest” only if the investments (by reference to which the carried interest is calculated) were held by the fund for an average period of at least four years. Furthermore, full income treatment would apply if there was an average holding period of less than three years.  The proportion taxed as income would fall by 25% each quarter (i.e. a quarterly basis, not daily), between three and four years. The average holding period would be calculated each time carried interest arose, with the holding period for investments still held being deemed to end at that time.

Following today’s announcement, it is anticipated that the minimum average holding period will be reduced to three years and therefore we wait to see if the tapering relief is removed altogether.

How to calculate the hold periods

The rules contain 3 different ways of calculating the holding period: 

  • the general rules;
  • rules for funds investing in certain trading companies; and
  • rules for certain debt funds. 

An investment is generally described as each use of cash by the fund, rather than simply the acquisition of a particular asset.  For example, investment by the fund of £1m to acquire an asset, will be treated as a separate investment to an additional  investment by the fund of a further £2m to improve the original asset.  This will cause problems for managers in certain sectors such as real estate, which buy properties upfront and subsequently spend considerable amounts developing or improving them over time. It is anticipated that these rules will be altered so as to make the calculation fairer and more appropriate for real estate assets.

This rule is relaxed for funds holding sufficiently large stakes in trading companies or groups.  Here, further investments in investee companies are treated as being made at the same time as the acquisition of the initial stake. It is not clear why the same treatment is not applied beyond private equity to other sectors e.g. real estate. Industry associations of other sectors, such as the BPF for real estate, have been lobbying for changes so that that they are put on the same footing and it is expected that the final version of the rules will incorporate some movement in this regard.

Again, it was originally proposed that, for carried interest arising in the four year period from the day that the fund makes its first investment, a conditional exemption from being “income-based” would be available provided certain conditions were met.  This was included to prevent the DIMF rules applying to carried interest arising in the early years of a fund’s existence, when the calculation methodology would necessarily produce an average holding period of less than four years, in circumstances where the fund actually expected to hold its investments for an average period of at least four years. This period is very narrow and it is anticipated that it will be extended, for example, to ten years, in order to meet the intended policy objective.

Carried interest from direct lending funds will automatically be “income-based”, unless it is expected that, when fully invested, the relevant term of at least 75% of the loans (calculated by reference to the value advanced) will have been at least four years and certain other conditions are met (e.g. the fund is a UK limited partnership or LLP or an equivalent non-UK entity).


The rules do not apply to interests within the “employment-related securities” regime and HMRC are fully aware of this. Counter-intuitively, this may accordingly make employee status more attractive for fund managers.

Other Comment

  • The averaging rule does not take into account early sales of surplus assets even where the fund has treated them as trading assets and taxable, so unexpected distortions and results may arise from different business models. This too may be an area in which modifications are made.
  • The rules are complex and will need to be applied each time carried interest arises, thus increasing the administration burden on fund managers. 
  • Importantly, the rules risk bringing about increased commercial tensions between optimal IRR and ultimate returns to managers through tax distortion. 
  • These changes come on top of other associated changes also made within the last year, such as, the introduction of the DIMF rules and the abolition of the base cost shifts.  While lobbying has gone on, and we expect to see a good deal of movement on the latest proposals, the status quo has now definitely changed completely.  
  • Managers should review their arrangements for new investments.

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