The UK private equity community went through a sea change in terms of taxation during the last 12 months. As tax return deadlines loom closer, firms and individuals will be turning their attention to the impact of this new legislation. Here we explore the main features and practical considerations resulting from the tax changes for those in the private equity industry.
Removal of Base Cost Shift
For many years, private equity managers have been able to structure investment funds to benefit from base cost shift, with the effect that taxable gains on carried interest were further supressed by having a greater cost base to set against the proceeds. The UK Summer Budget of July 8, 2015 changed the methodology applied to determine the chargeable gain, and the base cost shift methodology will only be followed if the carried interest arose in connection with the disposal of assets before July 8, 2015. Otherwise carried interest holders will now pay CGT on their “economic gain”, thereby reducing their chargeable gain only by their capital contribution or amounts paid to acquire the right to carried interest.
Action required: If you have triggered carry in the 2015/16 tax year, it will be necessary to determine whether the carry was triggered pre July 8, 2015 when the base cost shift methodology was still applicable.
Disguised Investment Management Fee Rules
Disguised Investment Management Fee (DIMF) rules were introduced in April 2015 and have been through several iterations and expansions in scope. DIMF comes into consideration where an individual provides investment management services (including activities such as marketing, capital raising, research and analysis) and pure investment management to an investment scheme. Where amounts are generated from the performance of such activities which are not taxed as either trading or employment income, HMRC will look to tax the individual on any untaxed amounts. These rules were specifically targeted at private equity managers who instead of receiving a management fee sometimes receive a first slice of future fund profits which may be taxed at CGT rates. Loans in advance of these profits are sometimes made annually to enable the managers to meet their costs. DIMF taxes all untaxed amounts, including loans, at income tax rates plus national insurance.
Initially DIMF applied to management fees but from April 2016 it is extended to income based carried interest (as discussed below) which would include performance fees. Essentially any amount paid by an investment scheme will fall within the scope of the DIMF provisions unless it is not long term carried interest or a return on co-investment.
In both DIMF and the carried interest rules, a charge is triggered when an amount arises to an individual from investment management services where the individual or connected person has a power to enjoy amounts arising. Trust and partnership arrangements may not avoid a DIMF or carried interest charge.
General anti-avoidance provisions have been written into both the DIMF and carried interest rules. HMRC will investigate XXX where it considers artificial arrangements have been created for the purpose of circumnavigating the rules.
Action required: Careful and detailed analysis will be required to assess whether a tax charge arises on the individual under the DIMF rules. Transfer pricing protects the business but not the individual and income flows from an investment scheme should be separately analysed under the DIMF rules.
Income Based Carried Interest
Carried interest rules were introduced in the UK Finance Bill 2016. These rules provide strict parameters as to when HMRC will allow an amount paid to a manager to be subject to CGT. The Bill is not yet enacted however these rules will apply to amounts arising to a manager from April 6, 2016. Whether or not carried interest is income based carried interest and therefore subject to income tax depends on the length of the average holding period of the investments. A sliding scale will be applied to determine what proportion of the amount is subject to CGT with the remainder being taxed at income tax rates. If the average holding period is longer than 40 months then all of the amount arising to the manager will be subject to CGT and not considered to be income-based carried interest. If the average holding period is less than 36 months then 100% of the amount arising to the manager will be income based carried interest and will all be taxed to income tax. A sliding scale exists if the average holding period is between 36 and 40 months.
If the carried interest is granted as an employment related security then it is exempt from being classified as income based carried interest. The complexities of the employment related securities rules need to be carefully considered if the exemption is applicable.
As noted above, these rules apply to amounts arising after April 2016 and there are no grandfathering provisions. As such it will be necessary to look back over the life of the fund and determine the average holding period when a carried interest amount arises to the manager. Some funds also provide for crystallisation of carried interest upon certain trigger events and not just at the end of the life of the fund, and these rules must be applied to determine the taxation of those amounts.
Action required: It may be necessary to perform calculations to determine whether intermediate payments of carried interest are income-based carried interest or can benefit from the CGT regime. Managers’ expectations of their tax expenses should be managed if the average holding period of a fund looks to be less than 40 months.
Carried Interest Generated by UK Activities is Taxed in the UK
From July 8, 2015 HMRC also changed the rules in relation to carried interest that was a foreign chargeable gain and therefore outside the scope of UK tax for non-domiciled tax payers filing under the remittance basis. Previously, if carried interest relating to non UK situs assets arose to non-domiciled, UK resident individuals that carried interest was not subject to UK tax provided the remittance basis regime was adopted by the individual. Now the carried interest will only be considered to be a foreign chargeable gain if the recipient of the carried interest performed their services relating to the generation of carried interest outside the UK.
Apportionment then becomes critical and in this respect the industry is awaiting further HMRC guidance. We know that HMRC will review individual facts and circumstances when assessing a taxpayer’s claim to apportionment and they accept apportionment should be done on the basis of the value of contribution towards generating the carried interest rather than on a pure day count basis. Factors to be considered when apportioning the gain are whether the carry was generated evenly throughout the life of the fund or are greater value attributable to particular points in the lifecycle of the fund; what was a person’s role in adding value and where were they reside at the time this value was added. Of course, normal best practice standards for non-domiciled taxpayers of having separate offshore bank accounts continue to apply here.
Notably, if the foreign carried interest is income based carried interest it cannot be apportioned for foreign chargeable gains purposes.
Action required: Record keeping evidencing the position taken on apportionment is vital to demonstrate the activity generating the carried interest arose or partially arose due to offshore activities. This of course may all be academic for non-domiciled taxpayers who have been in the UK for 15 of the last 20 years from April 2017. It may become much easier to declare all the carried interest generated as a UK chargeable gain and not have the associated tax risk that comes with defending a filing position taken.
CGT Rates Dropped to 20% but not For Carried Interest
Lastly with effect from April 6, 2016, CGT rates fell from 28% to 20% but gains accruing on carried interest were excluded from this rate drop along with residential property disposals. It is important to separately identify carried interest from any other gains made by the portfolio manager and make sure the lower rate of CGT is not inadvertently applied. Whilst this is an issue for next year’s (2016/17) tax return, it is important not to under reserve for your tax liability. It is also an indicator that HMRC views carry as a separately identifiable asset and is prepared to tax it separately.
These pieces of legislation are very detailed with specific definitions and tests provided within them. HMRC guidance hasn’t always kept pace with the expansion of the legislation and HMRC have advised that in such circumstances it does not consider the guidance to be relevant to the rules as they are currently drafted. It is therefore important that careful consideration is given to the application of these rules and advice is sought where the tax position is unclear.