As the ERS filing deadline approaches, what are the priorities for carried interest holders?
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The employment-related securities (ERS) regime is very broad. It encompasses shares and other securities (including units in a collective investment scheme) acquired by an individual, who is given that right through their employment.
This means that carried interest (and also the right to acquire co-investment) issued to employees or directors of a fund manager, or investment advisers, are generally treated as ERS.
This would also include carry acquired by salaried members and sometimes by members of a partnership who hold directorships with other entities in the group/fund structure (such as the director of a portfolio company). This means the range of people within the ERS regime is often wider than it may at first seem.
Whilst carried interest comes within the scope of ERS, HMRC’s platform and guidance were not well designed for this type of asset. So that can make reporting particularly complex and, as HMRC has a continued focus on this sector, it’s important any reporting is done correctly. We have experience in reporting these types of assets to HMRC and bringing clients’ affairs up to date where needed.
The deadline for filing the ERS return is 6 July. So all fund managers should review their arrangements in advance of the deadline, as there are automatic penalties for late or inaccurate filing. These start at £100 for a late return, with increasing penalties if it is outstanding for more than three months. If the return contains inaccuracies, HMRC can fine up to £5,000 per return.
What needs to be reported?
Before an ERS return can be prepared, the ERS scheme must be registered with HMRC. This should be done with sufficient time for HMRC to provide a reference number in advance of the 6 July deadline. We would recommend registering by 1 June.
- The employer must submit an ERS return in respect of all ERS schemes, including carried interest arrangements
- HMRC provides a template for submitting the ERS return. In relation to the carry, the ERS return will include the acquisition date of the carry, the total interest acquired, and the amount paid for the carry
- The return must be submitted each year, even if no new ERS has been acquired/granted in the period. In years with no activity, a nil return is submitted.
ERS considerations for carried interest
Most people will be awarded the carried interest at the start of the life of the fund. This means they’ll come within the safe harbour set out in the 2003 memorandum of understanding between the BVCA and the Inland Revenue (as HMRC was then known). It states that:
- If a carried interest is acquired before the fund makes its first investment, the initial unrestricted market value (IUMV) of the carried interest shall be taken as the amount actually paid for it.
- If a carried interest is acquired after the fund has started making investments, then IUMV will remain equal to the price paid if it can be shown that the aggregate value of the fund’s investments has not increased above their aggregate acquisition cost at that time. This will need to be considered case by case.
Whilst there is normally no tax due on a carried interest award at this stage, and no valuation required, it’s important to consider making a s.431 election (which has a strict 14-day limit). The s.431 election ensures that the carried interest is taxable as a capital gain in the future, rather than at income tax rates.
Carried interest can be awarded at other times, such as to a new joiner, or there may be an increase following reallocation of a leaver’s carry points.
In these circumstances, it’s crucial to look at the value of the carry. As the carry is an interest in a collective investment scheme, it is likely to be considered a readily convertible asset and taxed under PAYE at the time of award.
Even if the carry appears to have a very low or negligible value (perhaps because there have been no exits or it is still under the hurdle rate), that value should still be determined. HMRC expects to see an analysis in support of any valuation used.
If you have any questions about the treatment of awards of a carried interest or the reporting requirements, please contact Stephen Kenny.