Carried interest is the share of the profit earned by the fund due to the investment managers on the funds’ investments.
The carried interest is structured as a relatively small investment into the fund and once the external investors have received the initial capital back, together with a fixed return (the hurdle rate, often set between 6%-8%) the carried interest holders will receive a return, typically 20% of the fund’s returns above the hurdle rate.
The definition and treatment of carried interest were historically set out in a Memorandum of understanding between the British Private Equity & Venture Capital Association (BVCA) and HMRC in 2003. The memorandum set out that provided the carried interest met the definition agreed in the memorandum, the carried interest returns were incredibly tax efficient. The carried interest arising on disposals of investments would be taxed at normal capital gains rates and the availability of base cost shift would allow managers to pay tax on a gain far below the actual economic return.
However, over the years carried interest has been subject to several targeted rules which have increased the tax burden on carried interest and removed many of these benefits.
How is carried interest taxed
Whilst carried interest is still taxed as a capital gain on equity disposals, they are taxed at a special rate of 28% (as opposed to 20% on normal capital gains). In addition, the manager is now subject to tax on the full “economic return”.
When calculating the taxable gain on carried interest a manager is only able to deduct the actual amounts paid for the carried interest and any amounts that have been subject to income tax. As the manager will have typically invested at the start of the fund’s life, any base cost will be minimal.
Who is taxable
In most circumstances, carried interest is taxable on the individual who has performed the investment services which has given rise to the carried interest distribution, even if the carried interest is legally owned by someone else.
It used to be common for carried interest to either be put into a trust or held by family members (spouse/minor children) to take advantage of their lower tax rate.
Now where carried interest is owned by someone else (or a trust) the carry will be taxable on the legal owner and the investment manager. This can give rise to a double tax charge.
Tax relief is given by a tax credit to the manager for the tax paid by the legal owner.
However, there can be specific problems for carried interest held in a trust structure, which used to be particularly common for non-domiciled taxpayers. This is considered further here. [link to non-domiciled section]
In certain circumstances carried interest will be treated as income, rather than a capital gain.
When the average holding period of all the fund’s investments, weighted to the value of the investments is less than 36 months, the carried interest will be treated as income in the hands of the manager, even if the disposal arises on equity disposals.
When the average holding period is over 40 months the carried interest is subject to capital gains tax.
If the holding period is between 36 months and 40 months there is an apportionment between income tax and capital gains tax.
The income-based carry rules are very complex and there are special rules for determining the average holding period, which is calculated on an overall fund basis.
There are also special rules for venture capital funds, funds of funds, and secondary funds.
In certain circumstances, carry might arise early in the fund’s life, but when looked at in the overall context of the fund’s expected life it would not be considered income-based carry. It is possible to treat carry in those circumstances as conditionally exempt.
There are also specific considerations for non-domiciled investment managers considered here. [link to non-dom section]
The taxation of carried interest is highly complex and specialist advice must be taken to ensure the amounts arising are treated correctly.