Changes to the tax treatment of carried interest (to the detriment of fund managers) are becoming a regular feature of Finance Acts. Yesterday’s draft Finance Bill clauses will continue the trend by implementing last July’s proposals to tax some carried interest and other performance incentives as trading income where the fund does not hold its assets for at least four years on average. Instead of paying capital gains tax at 28% on their share of asset sale proceeds, they will pay income tax at their marginal rate (likely to be 40-45%) plus national insurance contributions. These changes will apply to carried interest arising on or after 6 April 2016, even if the managers’ partnership interests were acquired before that date. The proposals were originally thought to be targeted at hedge fund managers but it is now clear that they potentially apply to other sectors too including private equity, debt and property funds.
One of the major factors in determining whether a fund is trading or investing has been its intention at the time of acquisition of assets; an early sale was not necessarily fatal to investment treatment if the intention was to hold the asset in the long term and circumstances changed. Intention will no longer be relevant as far as taxation of carried interest is concerned. It should be noted that these changes will not affect the tax treatment of external investors in the fund, nor that of management co-investment. They will still be treated as realising capital gains on sale of investments if the fund is not trading on general principles.
Instead of implementing Option 1, which would have applied different holding period requirements for different asset classes, the Government has chosen Option 2 (which looks to the average holding period of the fund’s entire portfolio) and has increased the qualifying period for full investment treatment from two to four years. Carried interest will be taxed entirely as trading income if the average holding period is less than three years and part will be taxed as trading income if the holding period is between three and four years.
The draft legislation is highly technical and HMRC have indicated that it is to some extent a work in progress which will need to be refined following discussions with the BVCA and others. The current draft includes the following features:
- The average holding period will be weighted by reference to value of assets as well as their holding periods.
- Intermediate holding structures are disregarded.
- Where a fund increases its holding in a company, it can treat the additional shares as having been held since the initial investment was made, provided that the initial investment was a controlling holding, or (in the case of investment by a fund which mainly invests in long-term controlling holdings) is at least a 25% interest.
- Capital gains tax rules will be applied to determine when disposals are treated as taking place; this means that reorganisations which are not treated as disposals for CGT purposes should not shorten holding periods.
- Carried interest received in the early years of a fund will be conditionally exempt from trading income treatment if it is expected that the average holding period of fund investments during the life of the fund will exceed four years.
- Carried interest in debt funds which lend direct to unconnected companies on commercial terms with fixed maturity dates will generally be taxed entirely as trading income unless at least 75% by value of loans made are for terms of at least four years and the carried interest is dependent on profits and genuinely contingent.
- There are complex rules dealing with hedging and derivatives (presumably reflecting the fact that hedge funds were the original target of this legislation).
- It is not intended to charge to tax as trading income carried interest already within the employment related securities regime.
- Artificial arrangements to reduce the amount of carried interest within the charge to income tax will be disregarded.
At the beginning of this year carried interest was still taxed at very low effective rates of CGT. It enjoyed the benefit of base cost shift and some escaped tax altogether if paid out of the proceeds of investments not realised at a gain. We now have disguised management fees legislation for GP divert arrangements (round 1), taxation of actual economic gains on carried interest (round 2) and now trading income treatment if average holding periods fall below four years (round 3). What a difference a year makes!