The Budget included a measure that will allow UK resident investment managers to choose to accelerate their tax liabilities. This will enable them to align their timing with other jurisdictions. We explain the background to this move, and its benefits.
Carried interest is a key part of the remuneration for private equity managers. It is based on the fund’s long-term performance, above the hurdle rate. Because of its long-term nature, it has been treated as a capital gain rather than income.
Background to the change
The UK treatment of carried interest changed from July 2015 when the Government announced it wanted to make sure “individuals will be charged to Capital Gains Tax on the full amounts they receive in respect of their carried interest”.
These changes ended ‘base cost shift’ and ensured that managers are taxed on the economic return on carried interest. The changes mean that, under the rules as they now stand, it’s only possible to include “permitted deductions” (broadly, sums paid for carried interest) in calculating the taxable gain. Crucially, these changes also included a no-double- tax provision.
In the UK, tax is charged on a receipts basis (when the cash is received). But this is not the case in all jurisdictions. US taxes carry on the accruals basis, as the carry accrues in the fund.
This mismatch between the UK and the US means that US citizens working and resident in the UK will be subject to different rules on the taxation of their carry in each jurisdiction.
US investment managers resident in the UK would historically rely on the no-double-tax provision to prevent a double tax charge. But in February 2022, HMRC removed reference to this from the manuals. This was surprising as the draft guidance when the legislation was first introduced in 2015 referred to tax including UK and non-UK taxes.
The practical impact of the change meant that a UK-resident US citizen investment manager could be subject to double tax on their carried interest. And this made the UK significantly less attractive for international fund managers.
The British Private Equity & Venture Capital Association lobbied HMRC in relation to the change, aiming to find a practical solution. So, as a sensible response to this, the Budget introduced an elective basis for carried interest to be taxed on the accruals basis.
Timing and benefits
This election will allow individuals to make a voluntary and irrevocable choice to be taxed on their carried interest on an accrual basis. As a result, UK resident investment managers will be able to align their timing with that of other jurisdictions, where they may obtain double taxation relief. The measure will apply from 6 April 2022.
The legislation will provide a calculation for how individuals who have made an election should determine the amount of carried interest that has accrued to them in each tax year.
This will match the tax treatment for US individuals who are taxed on the accruals basis in the US and allow them to claim a credit to avoid double taxation.