HMRC has published guidance on the proposed legislation contained in the Finance Bill published on 15 July 2015 introducing new rules, effective from 8 July 2015, to ensure that individual fund managers are charged capital gains tax (CGT) on the full economic gain they receive from their carried interest. For the full text of the guidance click here
The guidance sets out the background to the legislation, runs through the main provisions and effects of it and includes some examples of scenarios to illustrate its impact.
Many of the concepts and terms used in the legislation are based on those contained in the Disguised Investment Management Fees (DMF) rules. The intention is that this new legislation together with the DMF rules will provide a comprehensive regime covering the two types of reward an investment manager can receive from a fund (management fee and performance linked reward), while also catering for any co-investment they make. Going forward an individual performing investment management services in respect of arrangements involving at least one partnership will be taxed as follows:
- management fees will be charged to tax as income by virtue of the DMF rules;
- performance linked reward, to the extent it is not charged to income tax as trading income, will be charged to CGT on the full amount of economic gain accruing to the individual fund manager;
genuine co-investment made on terms reasonably comparable to external investors will fall outside the DMF rules and this new legislation and will be taxed in accordance with general principles.
Summary of the legislation
Carried interest for these purposes is defined by reference to the DMF rules as broadly a profit related return where there is some element of significant risk that the return will not arise. It will not apply to amounts treated as investment management fees under the DMF rules or carried interest, as defined by the DMF rules, to the extent it is brought into account in calculating the profit of the manager’s trade, profession or vocation for the purposes of income tax.
The carried interest arising will be the amount of the gain subject only to deductions for cash actually paid by the individual for the right to the carried interest, and for amounts charged to income tax in respect of the acquisition of those rights. Individuals will no longer be able to take a deduction for a proportion of the underlying base cost in investments made by a fund which was provided by third party investors is the so-called ‘base cost shift’. Disposals of a right to a carried interest are also treated as carried interests for these purposes.
The new rules effectively establish a minimum rate of tax on carried interest at the CGT rate of 28%. Where existing rules would tax a carried interest receipt as income for example, the individual would still be liable for that tax although they would be able to claim double tax relief against the CGT also technically due on that income. This means that each component of a carried interest return has to be looked at separately to determine whether it is also taxable under an existing head of charge and to determine what double tax relief is available. This is the only method that will be considered ‘just and reasonable’ under the new legislation.
The rules do not impact genuine co-investment returns where the returns are 'reasonably comparable' to the terms of external investors participating in the fund. An example is given in the guidance where a co-investment is made on the same terms as external investors except it is free from the obligation to pay the priority profit share to the general partner or bear the cost of the carried interest. The example suggests that the return on the co-investment is reasonably comparable to that flowing to the external investors as the provisions are designed to prevent the co-investors paying money to themselves.
The new rules also bring non-UK gains into UK tax for UK resident non-domiciled individuals to the extent the individual performs their investment management services in the UK. This effectively abolishes the remittance basis for wholly UK based non-doms with directly held carried interests. However, the source of the gain will likely be irrelevant for long term UK residents from April 2017 with the proposed changes to the non-dom tax rules.
Business tax team