From 6 April, new rules have been introduced restricting the situations in which carried interest can be taxed as capital and instead taxing it as income. In addition, carried interest will not benefit from the recent reduction in the rates of capital gains tax ("CGT") so, to the extent capital in nature, will continue to be generally taxable at a top rate of 28%.
The steps are the latest in a series of statutory changes aimed at reducing, what the Government considers to be, the preferential tax treatment of fund managers. The new rules are complex and will have a significant impact on how managers of funds structure their profit-related returns.
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 CGT, rather than income tax, to the extent possible. The past year has, however, seen a raft of new measures limiting the availability of capital treatment.
In April 2015, the disguised investment management fees ("DIMF") rules were introduced. Under these, 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 expressly defined under those rules or another exclusion applies. These rules also apply to listed investment companies, other than VCTs and REITs.
Then, in July 2015, the method of calculating the CGT payable on carried interest was changed to remove the "base cost shift", thereby increasing the amount on which the gain was calculated and consequently the effective tax rate.
Under the rules in force from this April, what can be carried interest and get potential capital treatment under the DIMF rules is now itself restricted so as to not apply to "income-based carried interest". Although the rules have been in force from April, the relevant legislation has yet to be enacted. However, we are not expecting the final version of the rules to differ materially from that contained in the current draft legislation.
The remainder of this article looks at what "income-based carried interest" means.
Capital or income?
If, and to the extent that the manager's return is "income-based carried interest" under the new definition, it will be treated as income, regardless of the character of the return or type of asset.
Carried interest will not be "income-based carried interest" if the investments (by reference to which the carried interest is calculated) are held by the fund for an average period of at least forty months. Full income treatment will apply where there is an average holding period of less than three years. The proportion taxed as income will fall by 20% each month (i.e. a monthly basis, not daily), between thirty six months (when 80% is taxed as income) and forty months (when nothing is taxed as income). The average holding period is calculated each time carried interest arises, with the holding period for retained investments being deemed to end at that time (but see below on conditional exemption designed to assist in practice).
How to calculate the hold periods
There are general rules for calculating hold periods, but these are then varied in certain situations. Several of the variations are bespoke for funds investing in a particular asset class, such as real estate, private equity and debt. This article focuses on real estate funds.
Under the general rules:
- an investment is generally each use of cash by the fund, rather than a particular asset, for example, investment by the fund to acquire an asset will be treated as a separate investment to later investment by the fund to improve the same asset;
- intermediate holdings through which investments are held are disregarded; and
- "disposal" generally bears the meaning given to it in the CGT legislation, but also extends to where a fund, in substance closes its position on, or ceases to be exposed to the risks and rewards of, an investment under arrangements it is reasonable to suppose were designed to secure that result.
Real Estate Funds
Following industry lobbying, there are special rules varying the above general rules for "real estate funds". The first thing, therefore, to establish is whether the fund is a "real estate fund" for this purpose.
For these purposes a "real estate fund" is, broadly, a fund:
- in relation to which, when it starts to invest, it is reasonable to suppose that over the investing life of the fund more than half of the total value invested will be:
- invested in land; and
- invested in investments which are held for at least 40 months; and
- which is not a "venture capital fund", "significant equity stake fund" or "controlling equity stake fund". We would not expect a typical real estate private equity fund to fall within any of these categories (which, broadly, are only relevant to funds which primarily invest in trading companies or groups).
Where a "real estate fund" has a major interest in land (broadly, a freehold or a leasehold in excess of 21 years (or, in Scotland, the interest of the owner, or a lessee's interest under a lease for a period of at least 20 years)):
- any further investment in the land is treated as having occurred at the time of original acquisition;
- an acquisition of an adjacent major interest in land is treated as having occurred at the time of the original acquisition, with the adjacent land treated as part of the original land; and
- any disposal of an investment in the land is ignored, until a disposal occurs which has the effect that the fund has disposed of more than 50% of the greatest value invested at any one time in the land for the purposes of the fund.
If the conditions for being a "real estate fund" are not met by the fund, then the general rules are not varied, with all the complications in calculation and potentially adverse effects on the tax treatment of the managers that could entail.
Unwanted short-term investments
A further amendment to the general rules which applies to real estate (and certain other asset classes) is that an investment can be ignored when calculating hold periods if:
- it is made as part of a transaction under which at least one other investment is made for the purposes of the fund;
- the value of the investment does not exceed the total of the other investments;
- it is reasonable to suppose that the investment had to be made in order for the other investments to be made;
- at the time the investment is made, the fund managers have a firm, settled and evidenced intention to dispose of the investment within certain time periods (being 12 months in the case of land) and the investment is disposed of within the relevant period; and
- any profit resulting from the disposal has no bearing on whether carried interest arises or on the amount of any carried interest which does arise.
While this is helpful, the penultimate of the above points will need to be considered carefully from a practical, economic and drafting perspective.
The above provisions enabling short term investments to be ignored falls away in relation to future investments if at any time it becomes reasonable to suppose that, when the fund ceases to invest, at least 25% of its capital will have been invested in relevant unwanted short-term investments.
Helpfully, as stated above, the rules contain a "conditional exemption" from carried interest being treated as "income based carried interest". This has been included to prevent the DIMF rules applying to carried interest arising in the early years of a fund's existence, when the calculation methodology will necessarily produce an average holding period of less than forty months, in circumstances where the fund actually expects to hold the relevant investments for a period of at least four years.
The exemption potentially applies where the following 4 conditions are met:
- the carried interest arises in the ten year period beginning with the day on which the fund starts to invest. In certain deemed avoidance cases, this is reduced to a four year period;
- the carried interest would otherwise be "income-based carried interest";
- it is reasonable to suppose that, were the carried interest to arise at the "relevant time" (see below) (but by reference to the same relevant investments), it would not be income-based carried interest to any extent; and
- the relevant individual makes an appropriate claim.
The "relevant time" is, broadly, the earliest of:
- the time when it is reasonable to suppose that the fund will be wound up;
- the end of the period of four years beginning with the time when it is reasonable to suppose the fund will cease to invest;
- the end of the period of ten years (or, in certain deemed avoidance cases, four years) beginning with the day when the carried interest arises; and
- the end of the period of four years beginning with the end of the period by reference to which the carried interest was calculated.
When the period of conditionality ends (which, broadly, will be at the earlier of the "relevant time" and the time at which condition 3 (see above) ceases to be met), the carried interest only becomes "income-based" to the extent it would have been had it arisen at that time. Otherwise, it will be treated potentially as capital in the usual way. Any carried interest which, as a result, is, however, deemed to be "income-based", is treated as being so from the date it originally arose to the relevant individual and all necessary adjustments and assessments are made to individual's tax affairs to give effect to this, retrospectively, if necessary. If the individual has paid any CGT on the carried interest, it is treated as having been paid in respect of the relevant income tax liability, so that there should be full credit and no double tax.
The rules do not apply to interests within the "employment-related securities" regime. Rather, counter-intuitively, therefore, this may make employee status more attractive for some fund managers, though the other tax and non-tax aspects should be considered.
Interestingly, the rules expressly give the Treasury the power to make regulations repealing or restricting this exclusion. This may indicate that the Government is specifically concerned that the "employment-related securities" regime may become the focus of arrangements designed to avoid the new rules.
- The rules for the tax treatment of fund managers are now radically different to what they used to be, representing a major change to the status quo and to the taxation of managers' performance fees.
- There have, however, been significant welcome changes to the rules from those originally circulated in December last year. The Government has listened to several of the concerns of managers (especially in relation to further expenditure on assets, adjacent investments and sell downs of units on a site) and provided bespoke provisions to address them.
- However, ultimately, the circumstances in which tax efficient capital treatment for carried interest can be achieved, have been narrowed and, importantly, the new rules risk bringing about increased commercial tensions between optimal IRR and ultimate returns to managers which will need to be addressed.
- It will be important for managers to review their arrangements in light of the new rules.