The new carried interest regime: what it means for real estate-based strategies

Broadly speaking, the new charge applies where carried interest arises to a fund manager from an investment fund. The concepts of "carried interest" and "fund manager" are both broad, and will  typically catch (respectively) anything that is commercially considered to be carried interest (or "promote") and anybody providing any form of fund management or advisory services. Importantly, the concept of investment fund has been expanded (from the current position), to include corporate funds, thereby bringing more real estate fund managers within the scope of the carried interest tax regime.   

If the conditions for a charge are met, the carried interest (less any money paid for the right to the carried interest) is taxed as trading profit at rates of up to 47% (45% income tax plus 2% national insurance contributions), regardless of the underlying nature of the return.  However, provided the carried interest is "qualifying" only 72.5% of it comes within the charge, giving an effective tax rate of around 34.1% (47% x 72.5%).  The rules for determining whether carried interest is qualifying are contained in a rebranded and improved version of the IBCI regime (see "AHP and real estate-based strategies") which will be extended to apply to executives (currently employees are out of scope).

For some executives in real estate-based funds that are within the existing carried interest tax regime a 34.1% flat rate may represent a rate reduction. This is because, although under the current rules, a 32% capital gains tax (CGT) rate is available, it is a minimum charge which, in effect, is displaced by higher income tax charges that arise under normal tax principles. For example, if the carried interest from a real estate fund consists of rental payments, executives will be subject to tax on it at normal income tax rates of up to 45% (with relief available for the 32% CGT charge). Similarly, if the carried interest from a real estate credit fund consists of interest payments, executives will be subject to tax on it a normal income tax rates of up to 45% (with relief available for the 32% CGT charge). In practice, it is common for carried interest from real estate-based funds to consist of a number of underlying returns taxed at different rates (e.g. repayment of capital taxed at the minimum 32% CGT rate plus interest taxed at 45%), giving rise to a blended rate over 32%.

As carried interest will be taxed as trading profit, it will fall within the UK's "payment on account" rules, under which self-employed individuals are required to make advanced payments on account of their expected future tax liability based on their liability for the previous tax year. This is likely to give rise to significant cash flow issues for executives as carried interest tends to be lumpy and unpredictable.

There are specific relaxation of the rules for non-residents, for more information on these and the other aspects of the new regime, please see our detailed briefing.

Carried interest will be "qualifying" provided it derives from a fund that has a weighted-average holding period (AHP) for its assets of at least 40 months. Where a fund has an AHP of more than 36 months but less than 40 months a proportion of the carried interest will be qualifying. When calculating holding periods, the general rule is that you ignore intermediate holding entities and look to the underlying investment.

The starting position is that every injection of cash into an investment is treated separately - with its own holding period that feeds into the overall AHP. That means, without special rules, later bolt-on acquisitions would reduce a fund's AHP, as would early part disposals.  The legislation addresses this by having a series of bespoke rules (often referred to as "T1/T2" rules) for different investment strategies which seek to ensure that holding periods are measured in a commercially realistic way.

Real estate funds (non-credit)

There are T1/T2 rules for real estate funds. These are funds that, when they start to invest, it is reasonable to suppose that over their investing life (i) more than half of the total value invested will be in land, and (ii) more than half of the total value invested will be investments held for at least 40 months.  A fund that would otherwise be a "real estate fund" is prevented from being one in the unlikely event it is also a venture capital fund or a fund that acquires significant or controlling equity stakes in trading companies.

Where a real estate fund acquires a "major interest" in land:

1. any later (i) investment in that land, or (ii) acquisition of an adjacent major interest, is treated as occurring at the same time as the original major interest was acquired; and
2. any disposal of an investment in the land after the time of the acquisition is treated as not being made until a "relevant disposal" has occurred. A "relevant disposal" is, broadly, one that has the effect that the fund has disposed of more than 50% of the greatest amount invested in the land at one time (including amounts deemed to have been invested on acquisition as a result of point 1 above).

Under the current IBCI rules, a "major interest" is essentially a UK freehold interest or a leasehold interest of more than 21 years (or, in Scotland, of at least 20 years). In a helpful reform, under the new regime, the definition will be expanded to encompass equivalent non-UK interests (although the current proposed drafting will need some tidying up to reflect this).

Real estate credit funds

Currently, it is difficult for credit funds to give rise to anything other than IBCI (non-qualifying profits under this new regime) – in fact, they do not even have their own T1/T2 rules, but this position is set to change.

The new regime is much more helpful for credit funds.  "Credit funds" are funds that, when they start to invest, it is reasonable to suppose that over their investing life (i) more than half of the total value invested will be debt investments, and (ii) more than half of the total value invested will be investments held for at least 40 months.  A fund that would otherwise be a "credit fund" is prevented from being one if it is also a venture capital fund, a fund that acquires significant or controlling equity stakes in trading companies or a real estate fund.

Where a credit fund has a "significant debt investment" (broadly, a debt investment of at least £1m or at least 5% of the total amount raised from external investors):

1. any later investment "associated" with that original investment (essentially, a debt or equity in the same debtor or a member of their group) is treated as occurring when the original investment was made; and
2. any disposal of the significant debt investment or any associated investment is not treated as occurring until a sufficiently large disposal has been made. (This is when either (i) the fund has disposed of at least half of the greatest amount it has invested in the significant debt investment and associated investments, or (ii) its investment in them is worth less than £5m or 5% of the total value invested in them before the disposal). 

Helpfully, for these purposes, a debt investment is treated as made once a facility is unconditionally committed (even if no advance has yet been made).

Other welcome features of the credit fund rules include:

• the unexpected prepayment of a loan before the 40-month holding period has elapsed, can (provided certain condition are met) effectively be treated as generating a 40-month holding period; and
• provisions designed to prevent holding periods being treated as shortened by common transactions which are not, from a commercial perspective, considered to be disposals of investments. These include transactions undertaken for commercial purposes before and after which the fund is exposed to substantially the same risks and rewards in respect of the debtor group. The full intended scope of this provision is not entirely clear. We expect HMRC intends it to be read broadly, so encompassing a wide variety of debt restructurings such as "debt for equity swaps" and the acquisition of secured assets from defaulting borrowers, but prompt HMRC confirmation of this would be very welcome.