The British private equity and venture capital community is once again busy analysing the detail of yet more proposed changes to the rules governing the taxation of carried interest in the UK. Draft legislation looking to implement changes arising out of HMRC's consultation entitled "Taxation of performance linked awards paid to asset managers", which was launched on
8 July this year, was published yesterday.
The aim of the new rules is to ensure that investment managers of funds that carry on "trading" activities pay tax on their performance linked rewards as trading income (referred to as income tax below) whereas carried interest from long term "investment" activities would still be subject to tax on the basis that it is an investment return (referred to as capital gains tax below). It was explicitly stated in the original consultation document that the intention was not to change the existing capital
gains tax basis of taxing private equity and venture capital carried interest. In order to try to achieve this, the proposed rules adopt a test based on the average holding period of a fund's investments to determine trading vs investment and income vs capital gains tax treatment.
The rules work by defining "income-based carried interest" and taxing such carried interest as "disguised fees" under the rules in Chapter 5E Part 13 ITA 2007 introduced earlier this year.
The draft rules are discussed in some detail below, but the initial response of the British Private Equity and Venture Capital Association is that the rules need to be rectified in three important respects. The first is that the proposed holding period after which carried interest would be eligible for capital gains tax treatment in full should be 3 years instead of 4 years as this better reflects the impact that the economic cycle has on industry activities. The second is that more explicit provisions are
required so as to protect both the venture and growth capital sectors, where minority stakes are the norm (although they state that the government has acknowledged this and has intimated that they are keen to engage on this point). The third is that the current wording around the concept of controlling stakes requires more work to fit economic practice.
Average holding period test
If the average holding period of a fund (as determined under the rules) is:
- less than 36 months, 100% of the amount received will be "income-based carried interest" and accordingly taxed as income;
- at least 36 months but less than 39 months, 75% of the amount received will be taxed as income (with the rest eligible to be taxed at capital gains tax rates);
- at least 39 months but less than 45 months, 50% of the amount received will be taxed as income;
- at least 45 months but less than 48 months, 25% of the amount received will be taxed as income;
- 48 months or more, then 100% will be eligible to be taxed as capital gains.
Therefore, funds (other than certain lending funds as referred to below) with an average holding period of more than 4 years will continue to have carried interest taxed as an investment return. Even though private equity and venture capital funds usually expect to hold investments for this period or longer, it will not always be the case that the average holding period is more than 4 years at the time carry is paid (see "conditionally exempt carried interest" below). Similarly, the prevailing economic
and commercial circumstances may mean that the average 4 year holding period would not in fact be met. In calculating the average holding period, the cost of the investments as well as the length of time they are held for must be taken into account. The test is broadly to:
- multiply the acquisition cost of each investment by the length of time it has been held for (presumably in months although this is not explicitly stated);
- add together all amounts calculated under the first step; and
- divide that total figure by the total amount invested by the fund.
The test should normally take into account all investments made by the fund, but if carry is calculated on the performance of particular investments, it should only take into account those investments.
The legislation does take into account the fact that a number of investments may be made in the same portfolio company over a period of time. For the purpose of the calculation above, all amounts invested can be treated as being made when the investment was first acquired if the fund holds a "relevant interest" in a trading company or trading group.
"Relevant interest" means either:
(A) a controlling interest (being broadly more than 50% of the ordinary share capital with an entitlement to at least 50% of the voting rights, profits available for distribution and assets available on a winding up); or
(B) a 25% interest (being at least 25% of the ordinary share capital with an entitlement to at least 25% of the voting rights, profits available for distribution and assets available on a winding up) if the fund is a "controlling equity stake fund" (defined as a fund where it is reasonable to suppose that, at the end of the life of the fund, more than 50% of the total value invested by the fund will have been in controlling interests (as defined under (A) in trading companies or trading groups and will
have been held for more than four years).
Similar rules will enable funds with "relevant interests" to treat any disposal event to take place when the fund ceases to have a "relevant interest" in the company. For this test the 50% test is replaced with a 40% test (for reasons that are not clear) for funds that are not controlling equity stake funds. Together, these tests create a "first penny in, last penny out" system for assessing a holding period for investments.
If a fund is not deemed to hold a "relevant interest", then the dates that amounts are actually invested and are actually realised from divestments must be taken into account when calculating the average holding period, meaning there is more chance of falling under the 48 month threshold for a fund that does not hold controlling stakes.
Conditionally exempt carried interest
As mentioned above, it is entirely possible that carried interest is paid at a stage when the average holding period of a fund is less than four years, so that under the new rules a percentage (or all) of the carry would be charged to income tax, even though once all investments are realised the final average holding period for the fund is greater than four years. In view of this, the legislation introduces a concept of "conditionally exempt carried interest", which allows a recipient to make a claim for their
carried interest to be subject to capital gains tax and not income tax when it arises. There are a number of conditions attached to this. The carried interest must arise within the four year period beginning with the first investment of the fund, it would otherwise have been treated as charged to income tax (in whole or in part) and it must be reasonable to suppose that, if the carried interest had arisen at the "relevant time", it would not have been subject to income tax. The "relevant time" is the earliest
- the time when it is reasonable to suppose that the fund will be wound up;
- the end of the period of four years beginning with the time when it is reasonable to suppose that investments will cease to be made by the fund;
- the end of the period of four years beginning with the day on which the carried interest arose; or
- the end of the period of four years beginning with the end of the period by reference to which the amount of the carried interest was determined.
If these conditions are met then the carried interest will initially not be "income-based carried interest", preventing a situation where income tax would be paid and then have to be claimed back years later. There are then provisions that will reverse this treatment should the conditions for capital gains taxation turn out not to be met. In that case, the additional tax plus interest on it would have to be paid.
There are a number of provisions in the draft legislation in relation to other types of investments, such as derivatives, hedging and direct lending funds which are all intended to ensure that funds which effectively carry out trading activities are caught by the rules but that entering into commercial hedging arrangements in respect of currency and interest rate risk does not trigger disposals for the purpose of calculating the average holding period.
Carried interest from direct lending funds will be treated as income unless it falls within a prescribed exemption in the legislation and passes the average holding period test – but even with this exemption, if the nature of the receipt from the underlying loans is income (i.e. interest payments) then it will in any case be subject to income tax under the existing carried interest rules (although not taxed as trading income).
Interaction with the employment-related securities rules
The draft rules exclude any carried interest arising from employment-related securities from being classified as income-based carried interest so that it would all be taxed under the existing carried interest and employment-related securities rules.
As with any draft legislation, there are issues that will need to be ironed out, and a consultation period will run prior to the legislation being finalised for publication in next year's Finance Bill. It will be important that all industry participants review the legislation and consider how it affects them prior to the rules coming into force in April 2016. If you would like further information or to discuss the impact of these changes, please contact Laura Charkin, Stephen Pevsner or your usual King &
Wood Mallesons contact.