Recent UK Tax Changes to Fund Returns

Recent tax changes announced by the UK government have largely reversed the favourable tax treatment previously enjoyed by UK fund executives on their returns from funds which are structured as limited partnerships. The changes affect:

• Carried interest (ie executives' performance profit shares).
• Executive co-investment (ie executives' returns on investment interests held in their own funds).
• General partners' profit share (i.e. executives' direct interests in fixed management profit shares).

These changes are effective now and apply to fund returns arising today. This update summarises the effects of the changes, compares the position under the new and historic rules, and suggests actions to be considered.

Previous UK taxation of fund interests

Fund returns were previously taxed in the UK under normal principles as supplemented by specific HMRC guidance. The effect was as follows:

• Carried interest was taxed by reference to the type of underlying return allocated to the executive, but also benefited from the base cost shift tax treatment. As a result, a carried interest holder did not pay tax on those receipts to the extent they were satisfied by allocations of base cost or loan principal (as such allocations did not represent profit). The practical result was to reduce the effective tax rate paid by executives on their overall carried interest returns.
• Executive co-investment returns were taxed by reference to the type of underlying return allocated to the executive. Accordingly, assuming that the highest current UK rates applied, interest returns were taxed at 45 per cent, dividends generally at 30.6 per cent, capital gains at 28 per cent and returns of base cost or loan principal were untaxed.
• General partners' profit share interests were generally taxed on the same basis as executive co-investment returns, described above.

For all of the above, executives resident in, but domiciled outside, the UK generally benefited from the remittance basis (subject to payment of a remittance charge where applicable) under which non-UK investment income and gains received offshore are not subject to UK tax unless brought into the UK. The remittance basis was generally available to non-UK domiciled executives on all of their fund returns.

New UK taxation of fund interests

The new rules introduce two new tax charges for returns paid to UK executives from funds which are structured as limited partnerships:

• A disguised fee income charge at 47 per cent (45 per cent income tax and two per cent NIC). This is aimed at fund returns which represent general partners' profit share interests but also covers any other fund returns which are not carried interest or co-investment as defined by the rules. The charge does not apply to the extent fund returns are taxed in the hands of the executive as trading profit (for example, where an executive receives trading profit as a member of an LLP).
• A new 28 per cent capital gains tax charge on carried interest, regardless of whether the carried interest is satisfied by allocations of interest, dividends, gain or base cost/principal. This carried interest charge operates alongside, and in addition to, the existing principles (including base cost shift) but with credit to avoid a double charge. The practical result is to reduce the benefit of base cost shift, as all carried interest payments are taxed at a minimum of 28 per cent. That rate is a minimum because income returns continue to be taxed at higher rates and, accordingly, the higher the proportion of income returns, the higher the blended tax rate will be.

In addition, there are significant changes to the position of non-UK domiciliaries. The remittance basis does not apply to the disguised fee income charge. Nor does the remittance basis apply to the carried interest charge assuming the executive works in the UK only (although relief is available to the extent that the executive works outside the UK). However, the remittance basis continues to apply to the charges arising under the existing principles. HMRC also regard the new tax charges as applying to situations where the interest is held by a trust in which the non-UK domiciliary is beneficiary.

Effect of the new taxation rules

The practical effect of the disguised fee income charge and carried interest charge is that fund returns fall into three categories for tax purposes:

• Carried interest, as defined in the rules, is subject to the 28 per cent minimum tax charge but not the disguised fee income charge. The definition of carried interest for these purposes includes the typical BVCA model carried interest, i.e. whole of fund carried interest of 20 per cent of profits subject to a hurdle of at least 6 per cent p.a. compounded annually. However, other profit-related returns may also qualify as carried interest for the purposes of the rules if there is a significant risk at the time the carried interest is acquired that the return in question may not arise.
• Co-investment, as defined in the rules, is not subject to the carried interest charge or the disguised fee income charge and so is unaffected by the new rules. Co-investment returns are limited to repayments of the amount co-invested, and arm's length returns which are reasonably comparable to those of third party investors. HMRC accept that returns are reasonably comparable where the co-investment is made on the same terms as third party investors other than being subject to general partners' profit share and carried interest.
• All other fund returns, including general partners' profit share interests, are subject to the disguised fee income charge and so will be taxed at the 47 per cent rate described above.

As the default position is therefore that all fund returns, other than carried interest and co-investment, are subject to the disguised fee income charge, care must be taken to ensure carried interest and co-investment fall within the relevant definitions if that charge is to be avoided.

The table below summarises the effect of the changes.

* Assuming the non-UK domiciliary works in the UK only.

Example

Suppose that a UK resident and domiciled executive is entitled to carried interest which is satisfied as follows: £10,000 of interest, £10,000 of capital gain and, after application of the base cost shift, £10,000 of base cost and £10,000 of debt principal.

Under the existing rules, the debt principal and base cost would be untaxed, the interest taxed at 45 per cent and the gain at 28 per cent. The tax arising would therefore be £7,300, made up of £4,500 in respect of the interest and £2,800 in respect of the gain, and representing an effective tax rate of 18.25 per cent.

Under the new regime, the full £40,000 would also be subject to the carried interest charge at 28 percent (i.e. £11,200). Credit would, however, be given for tax paid under the existing rules against tax paid under the new regime (and vice versa). Overall, therefore, the tax arising after the introduction of the new rules would be:

• £7,300 arising under the existing rules (i.e. 28 per cent on the gain and 45 per cent on the interest);
• £11,200 arising under the new carried interest charge (i.e. 28 per cent on the full £40,000); with
• a credit of £5,600 (representing the fact that the gain of £10,000 and interest of £10,000 would both be subject to tax at a rate of at least 28 per cent under each regime).

The net charge of £12,900 represents an effective tax rate of 32.25 per cent.

Action steps

The practical implications of the new rules will vary according to the circumstances of particular funds. However, the following action steps should be considered:

• Confirm that existing carried interest and co-investment interests are treated as such under the definitions in the new rules (and therefore are outside the scope of the disguised fee income charge). In particular, leveraged co-investment arrangements may not fall within the definition of co-investment but may instead fall within the definition carried interest (in which the new carried interest charge would apply).
• Consider minimising the blended tax rate on carried interest by ensuring that carried interest allocations are satisfied by gain or base cost / principal as appropriate so that the effective tax rate is as near to the 28 per cent minimum as possible. This is particularly relevant to debt and income funds where satisfying carried interest with interest allocations would increase the blended rate. Possibilities include optimising investment holding structures to keep returns in gain form.
• Non-UK domiciliaries should review their position generally and in particular: (i) consider claiming the remittance basis so that no tax arises on carried interest distributions under existing principles and charges are limited to the 28 per cent gains tax rate; (ii) those holding interests through trusts should confirm that the tax credit mechanism avoids double taxation in their particular circumstances; (iii) those who are US nationals may wish to check that the carried interest charge is creditable against their US carry tax; and (iv) consider reviewing their offshore bank account arrangements with a view to minimising additional taxes on remittance, although current rules relating to the remittance of foreign income and gains may mean that it is not possible to match perfectly the amounts which have been subject to the 28 per cent charge and the amounts which are deemed to be remitted.
• Consider carefully any potential transfers of carried interest because of the deemed market value rule. While initial guidance has been issued by HMRC on the new rules, the legislation was introduced without consultation with industry and some of the potential anomalies in the legislation may therefore yet be ameliorated.

Consultation document on the taxation of performance-linked rewards paid to asset managers

The Government is also consulting on the introduction of a specific tax regime for performance-linked rewards paid to investment management executives. While the primary focus of the consultation appears to be trading (i.e. hedge) funds, it is expected that all performance-linked rewards will be taxed as income (i.e. potentially taxed at a rate of at least 45 per cent assuming current highest UK income tax rates), except to the extent that the fund carries on certain limited categories of activity which HMRC regard as "investment activities" for these purposes and/or the investments of the fund are held for a minimum period of time.

Private equity funds typically hold their assets as investments and do not carry on a trade, and the consultation states that the Government expects that carried interest in these circumstances will generally fall outside the new specific tax regime. However, it looks as though that will ultimately depend on whether the activities of a particular fund fall within certain limited exceptions and the position for fund managers in respect of other asset classes (including debt) does not yet appear to have been properly considered, particularly given that the investment objectives of many of these funds, bar asset class, will be very similar. Fund managers may therefore wish to follow the consultation closely, in particular the development of the proposed exception at section 2 of the consultation document. Ashurst has already contributed to that process.

Ashurst investment funds group

Ashurst's global investment funds group advises on all aspects of investment funds, including private equity funds, private debt and credit funds, and real asset funds. The group includes specialist investment funds lawyers and expert funds tax and regulatory lawyers in London, Singapore, Hong Kong, Australia and the United States.