Carried interest – raising the effective rate of capital gains tax

Graham Chase, Tax Partner, CMS

Gains arising on or after today via carried interest are subject to new computational rules. Essentially, an affected individual will be taxed by reference to the full amount received less any sums actually invested by that individual. Whilst a capital gains treatment is preserved, it is intended that gains will be calculated in line with the economic benefit.

This changes long-standing practices relating to base cost allocation contained within Statement of Practice D12, which until today could result in significant reductions in the effective rate of tax for carried interest. At the heart of this reduction is the base cost shift which occurs upon changes in profit sharing; partners with an increasing profit share (ie the investment manager whose carried interest entitlement arises) obtain a proportion of available base cost in the underlying asset from the corresponding partners whose profit share is reduced. Base cost shift is a pragmatic solution to the complexities of partnership tax transparency which otherwise arise from such changes, but where the shift is from a non-tax paying partner (ie an offshore investor or exempt institution, as is usually the case in an investment fund context) then the practical effect is a tax advantage for participating individuals who benefit from a lower effective rate.

The surprise is that this treatment, accepted by HMRC and successive British Governments for over 35 years, is suddenly curtailed without any prior consultation and with immediate effect. Defending such arrangements is difficult – but given that existing arrangements are not grandfathered affected individuals might  feel as if the rules have been changed mid-game.

Until now base cost shift has resulted in effective rates significantly below 28%. In some cases gains might be virtually eliminated by “enhanced base cost shift” where asset revaluations prior to carried interest entitlement give rise to uplifted acquisition costs for participants.  It was also possible for fund-as-a-whole carried interest to escape tax altogether, if paid out of partnership disposal proceeds which did not give rise to a gain such as investments realised at a loss after carry conditions are satisfied.

The new rules do not do away with the Statement. Instead, the rules will borrow from elements of the disguised investment management fee rules introduced earlier this year by FA 2015. It remains to be seen how wide the net will be cast in relation to carried interest – FA 2015 includes an exclusion from income tax in relation to carried interest , but presumably that exclusion will not be a direct read-across.

Also, if participating individuals do not benefit from an enhancement in base cost then presumably corresponding partners do not suffer a reduction (albeit this is only relevant where such partners are within the scope of charge to UK tax, which will not typically be the case).

A final thought. It looks to be right that tax on gains should follow the economic benefit obtained. But in practice the position could be complex, with carry entitlements arising in multiple years, perhaps including both capital and income elements as well as contractual adjustments which might not operate perfectly in the context of the new rules.

Also published today was a consultation document, “Taxation of performance linked rewards paid to asset managers” which proposes an income tax treatment for performance incentives where the fund itself carries on trading rather than investment activity; hedge funds appear to be the main target. I hope to comment on this in a later blog post.

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