Last year was not the best year for private equity fund managers who hoped that the UK taxation status quo would hold steady. In the past year, we have seen: the Disguised Investment Management Fee rules take effect; the abolition of base cost shift on carried interest; the deemed UK sourcing of carried interest; and, as examined below, a new classification regime for carried interest in which “bad” carry may be subject to a combined tax rate of 47%.

From April 6, 2016, all carried interest amounts attributable to carry recipients residing in the UK will be classified as “good” or “bad” carried interest. “Good” carried interest will be taxable as it was before April 6. So, if it derives from a capital transaction, like the sale of a company, the carry will be eligible for taxation as capital gains at 28% (carried interest is specifically excluded from the new 20% capital gains tax rate), but without the benefit of base cost shift. “Bad” carry on the other hand, irrespective of the distribution’s source, will be taxable as if it were a disguised investment management fee and will be subject to UK income tax and national insurance at a combined rate of 47%.

Whether an amount is “good” or “bad” carried interest depends on the weighted average holding period of the fund’s investments. Each time carried interest is paid, the average holding period must be calculated and all current investments treated as sold on the date of the calculation. At the time of writing, “good” carry arises when a fund’s weighted (by value) average holding period hits 40 months, with a taper starting at 36 months. For example:

Year 1

Year 2

Year 3

Year 4

Year 5

Investment A

Acquire 100

-

-

-

Dispose

Investment B

-

Acquire 100

-

-

-

Investment C

-

Acquire 300

Dispose

-

-

If, in the above example, carry is payable in each of years three and five and each investment is made at the start of, and sold at the end of, the relevant year, then, even though it ostensibly looks like the average holding period is well within the 40 month requirement, the high-value, short-term Investment C skews the calculation. Consequently, the average holding period calculations will be as follows:

Year 3

Year 5

A: 100 x 3 = 300

B: 100 x 2 = 200

C: 300 x 2 = 600

Average holding period = (300 + 200 + 600)/(500) = 2.2 years

A: 100 x 5 = 500

B: 100 x 4 =400

C: 300 x 2 = 600

Average holding period = (500 + 400 + 600)/500 = 3 years

This example shows how a high-value, short-term investment can skew the average holding period and demonstrates the importance of a provision in the regime that allows carried interest to be treated as conditionally exempt from the income-based carried interest rules for up to ten years after the day on which the fund starts to invest. Without this concession, during the initial years of a fund’s life when there are unrealized investments, it would be difficult to satisfy the 40 month average holding period requirement.

That’s the good and the bad. Now on to the ugly. The rules are dense and not for the fainthearted. They also contain some technical errors, which make their application somewhat uncertain. In recognition of the fact that sponsors employ different strategies, there are a number of sub-regimes within the rules, which adjust (for the most part favorably) the calculation of the average holding period. These regimes deal with:

  • Substantial equity stake, controlling equity stake and venture capital funds. For these funds, the regime permits certain follow-on investments and partial disposals to be made without negatively affecting the average holding period calculation.
  • Real estate funds. For these funds, the regime similarly allows for certain follow-on investments and partial disposals without negatively affecting the average holding period, while also recognizing that investments are not always in securities or even into the same asset. For example, a follow-on investment may be in adjacent property.
  • Fund of funds and secondaries funds. For these funds, the regime resolves the tricky question of what constitutes the “investment” for the average holding period calculation, with an investor fund and its investments falling within this sub-regime being permitted to look at the investee fund rather than the underlying portfolio investments. In addition, the regime provides for favorable follow on and partial disposal treatment.
  • Direct lending funds. For these funds, the regime presumes carried interest to be income-based carried interest, although the presumption can be rebutted if the fund satisfies various conditions.
  • Special opportunities funds. For these funds or, more specifically, debt funds that invest in distressed debt with a view to securing (1) direct or indirect ownership of the debtor’s assets or (2) assets that are subject to a security interest in respect of the debt, the debt and relevant assets are treated as one investment for the purposes of calculating the average holding period. These are referred to as “loan to own” investments. We assume that this should catch situations where a fund obtains control of the debtor itself, but this is not entirely clear in the definition.

The conditions and exceptions to the above sub-regimes are fairly involved and no fund should assume that it will necessarily fall within the regime relevant to its investment strategy. For example, to qualify, a venture fund must satisfy conditions regarding the type of investments it makes, and then, further conditions with regard to each specific investment, including conditions relating to portfolio company activities, the fund’s involvement at board level and the use to which invested capital with be put.

Provision has been made in the draft rules for “unwanted short-term” investments. Inevitably, there are a series of conditions which need to be satisfied for an unwanted short-term investment to be outside the income-based carry rules. Notably, the time limit for such disposal is variable depending on the asset class; for investments in land, the period is 12 months, for securities in unlisted companies, 6 months and for “direct loans”, either 120 days or 6 months depending on the fund’s other investments. These timings seem broadly in line with the market, but must be kept in mind by management teams when planning such activities.

The overall makeup of a fund’s investments will also need to be considered: the new regime ceases to apply once it is reasonable to assume that at least 25% of the fund’s investments will be in unwanted short-term investments. There are some technical issues with the drafting of this concession, which means that it is not as valuable as it perhaps initially seems and, as with the sub-regimes discussed above, no assumptions should be made.

The much vaunted exclusion for carried interest holders operating in an employee environment has been retained, which is helpful for any manager that is a corporation. Wide anti-avoidance rules, however, mean that managers currently operating as partnerships should not view incorporation as an easy fix.

Investment managers receiving carried interest in the UK in respect of services performed for the fund prior to their arrival in the UK will be able to receive a proportion of their carried interest outside of this regime.

Overall, the new income-based carried interest rules are certainly better than those originally drafted in December 2015. The trade off, however, is the level of complexity that has been added to the regime. Fund managers need to take stock of their current arrangements and consider how they plan to deal with these rules for carried interest arising on or after April 6, 2016.