The UK tax reform juggernaut continues its rampage through long-established UK private equity funds tax practice. For those struggling to keep up with the ever-changing UK tax landscape, this article provides a short blow-by-blow account of the changes leading to the brave new world in which private equity professionals working in the UK now operate.
April 2015—Disguised Investment Management Fee Rules
The first change, which laid the foundation for the new UK tax regime, was introduced with effect from 6 April 2015. The stated purpose behind these rules was to catch a common UK structuring technique whereby, under certain conditions, investment professionals were able to receive a proportion of what otherwise would have been management fees as capital gains and pay tax only on a deferred basis, essentially allowing them to co-invest on a tax free basis.
Despite this fairly narrow aim, the Disguised Investment Management Fee rules (“DIMF”) have fundamentally changed the approach that the UK tax authorities take to distributions made by funds to their investment teams.
The DIMF rules establish a taxonomy for all amounts arising to investment professionals from a fund with, broadly, every amount needing to be classified as either:
- management fee taxed to income tax;
- disguised investment management fee;
- carried interest; or
The default classification is disguised investment management fee. Therefore, an amount that is not management fee taxed to income tax, carried interest or co-invest, is deemed to be disguised investment management fee, irrespective of the real-world commercial position. The scope of the rules therefore extends beyond the management fee planning technique mentioned above and catches all sorts of payments that don’t fall naturally into the statutory definition of carried interest or co-invest.
Disguised investment management fees are subject to 45% income tax plus 2% national insurance charges, a material increase from the 28% rate levied on capital gains. Further, disguised investment management fees are deemed to have a UK source, meaning that UK resident non-domiciled individuals are subject to UK tax on such amounts, irrespective of whether the amounts are remitted to the UK or not.
July 2015—Carried Interest Rules
The change in UK government in May of last year gave the government a second bite of the tax apple in this area. Ostensibly this second set of changes was brought in to counteract a quirk of the UK tax rules on partnerships which (by long-standing practice of the UK’s tax authorities) means that in a fund scenario, the investment team is taxed on an amount that is less than the distribution that they actually receive.
The simple way to think about this long-standing practice is that some of the third-party investors’ base cost in the fund is transferred to the investment team. Technically, what actually happens is that there is a profit shift from the investors to the investment team when a fund moves into carry. This profit shift is commonly referred to as a “base cost shift.” By way of example, on an investment of $100 ($99.99 invested by LPs and $0.01 invested by the carry recipients), if a $150 gain is made and distributed on an 80:20 split:
- for UK tax purposes, the investment team is treated as receiving a distribution of $30 which is reduced by $20 representing “their” base cost (rather than the $0.01 of actual base cost); and
- assuming that the fund operates a typical buyout strategy, the investment team will be liable to UK capital gains tax at 28% on $10 rather than on $29.99. This brings the effective rate of tax down, in this example, to just over 9%. Given that the highest rate of UK income tax is currently 45%, this treatment makes an already attractive capital gains tax rate even more desirable.
When the legislation relating to carried interest was published there was a further, unexpected, twist; carried interest arising from and after 8 July 2015 is deemed to have a UK source to the extent that investment management services are performed in the UK. This impacts UK resident non-domiciled individuals as it means that such people will be taxable in the UK irrespective of whether they remit their carried interest returns to the UK in relation to non-UK investments.
HMRC rather enigmatically states that the split between UK services and non-UK services will be made “on a just and reasonable basis … [which] will depend on the facts or circumstances of each particular instance.” HMRC accepts that carry paid in a particular year doesn’t always relate to services provided in that same year and that it may be necessary to look back over a longer period.
We recommend that UK resident, non-domiciled individuals receiving carried interest consider having their distributions split at least as between UK source and non-UK source carry and having these distributions paid into separate bank accounts. Depending on the fund’s strategy and structure it may be desirable to split out distributions even further into UK source income and UK source gains and then the same for non-UK source income and gains.
October 2015—Deemed Arising Rules
In October additional rules were published affecting both the carried interest rules and the DIMF rules. Under these supplementary rules, amounts may be deemed to be taxable to an investment professional where they are paid to persons connected to the investment professional or to unconnected persons or companies where certain, easily satisfied, enjoyment conditions are met. This expands the scope of both sets of rules and brings many trust arrangements into question. The result could be that individuals face a UK tax charge even though they do not receive the distribution that gives rise to the tax liability.
December 2015—Income Based Carried Interest Rules
2015 was closed out with one final set of changes: draft legislation that seeks to disrupt the taxation of carried interest even further. From 6 April 2016 all carried interest amounts will be classified as good or bad carried interest. Good carried interest will be taxable in the same way that carried interest has always been taxed. So, if it derives from a capital transaction, like the sale of a company, it will be eligible to be taxed as capital gains. Bad carry on the other hand, irrespective of the source of a distribution, will be taxable as if it were a disguised investment management fee and subject to UK income tax and national insurance.
Whether an amount is good or bad carried interest depends on the average holding period of the fund’s investments. Currently the magic switch from bad to good carry happens when the fund’s average holding period is four years, with a partial switch happening from three years. The calculation of a fund’s average holding period is weighted by reference to the amount invested by the fund into each investment, so for example, a high-value, short-term investment will skew the fund’s overall average holding period.
Each time carried interest arises the average holding period has to be established, and investments held at the point of such calculation are deemed to have been disposed of on the date of calculation. Therefore, while the fund still holds investments it is likely to be difficult to satisfy the four year test. Further difficulties arise with this legislation when you take into account follow on investments, partial disposals or restructurings.
Some of these issues are dealt with, to a certain extent, in the draft legislation but largely these fixes are deficient. Further, any fund that does not operate a standard buy-out strategy faces additional, particularly knotty problems under the draft legislation. We expect that some of these wrinkles will be ironed out in the next draft of the legislation, which should be published in late March. It is also possible that the four-year period will be reduced. That said, any fund operating with UK carried interest recipients should expect to have to engage with this legislation. Given the short lead time between final draft legislation’s being published and implementation, we suggest engaging sooner rather than later.