The basics of the charge
Broadly speaking, the new charge applies where "carried interest" arises to a fund manager from an investment fund. If the conditions are satisfied, the carried interest (less any consideration given for the right to the carried interest) is taxed as trading profit, regardless of the underlying nature of the return. A slight caveat to this is that employment tax charges take priority, but, in practice, these rarely arise, especially where section 431 tax elections have been made.
Although trading profit is usually taxed at rates of up to 47% (45% income tax plus 2% national insurance contributions), provided the carried interest is "qualifying" (see "qualifying carried interest" below) only 72.5% of it comes within the charge, giving an effective tax rate of around 34.1% (47% x 72.5%).
What's changed?
There have not been any significant policy changes but, helpfully, the government has ironed out a number of technical issues that arose from the first draft of the legislation, including by:
- clarifying the concept of "tax distribution", so that it properly captures US-style tax distribution models;
- inserting an ability for an executive to claim UK unilateral relief (so not under a double tax treaty) for carried interest that is subject to foreign tax on capital gains; and
- clarifying the provisions designed to prevent double UK taxation, so that those provisions work as intended.
Qualifying carried interest
The rules for determining whether carried interest is qualifying are contained in a rebranded and improved version of the income-based carried interest (IBCI) regime. Accordingly, carried interest will be "qualifying" provided it derives from a fund that has an 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. Importantly, the exclusion from the IBCI rules for carried interest held by employees will not be pulled through to the new regime.
When calculating AHPs, 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) which seek to ensure that holding periods are measured in a commercially realistic way.
What's changed?
There have been a number of (mostly) helpful changes to the mechanics of the AHP calculation. Many of these changes are technical but the key points to note are:
- Debt investments and credit funds: The first draft of the legislation contained provisions designed to significantly improve the position of credit funds from that under the current IBCI rules (where it is difficult for them to give rise to anything other than IBCI). In particular, it introduced a helpful suite of T1/T2 rules for "credit funds". The Finance Bill takes this further in two ways:
- extending the applicability of some of the new T1/T2 rules relating to debt investments, so that they apply to any fund (and not just "credit funds") e.g. the rule designed to mitigate the impact of early borrower prepayment on the fund's AHP; and
- clarifying the scope of the proposed T1/T2 rules for debt investments or credit funds e.g. expressly providing that debt for equity swaps will not shorten AHPs.
- Secondary funds and funds of funds: The new regime merges and improves the current separate T1/T2 rules for funds of funds and for secondary funds. However, a problem with the original draft legislation was that it introduced an additional gateway condition, requiring the fund to be a "qualifying fund", which was likely to be difficult to apply in practice. The Finance Bill drops that additional condition and, helpfully, now specifically facilitates the relevant fund co-investing alongside independent funds in which it has invested.
- Conditionally qualifying carried interest: To prevent carried interest arising early in a fund's life necessarily being treated as non-qualifying (as the fund will not have a 40-month AHP yet), it is possible for an executive to make an election to have such carry provisionally treated as qualifying. The Finance Bill has extended the time period in which such election can be made for funds where carry is payable before investors have received back their investments, something which should help evergreen funds.
Non-residents
Under the new regime, non-residents are subject to tax based on the proportion of their "applicable workdays" (broadly, days in which they carry out work for a fund) in the "relevant period" (see "What's changed") that are "UK workdays" (broadly, days in which they carry out more than three hours work in the UK for a fund). However, a non-resident's UK workdays are ignored if:
- they are prior to 30 October 2024. This effectively operates as a form of grandfathering;
- they are in a tax year in which the non-resident has fewer than 60 UK workdays. This is designed to ensure that short-term business visitors are protected from UK taxation; or
- they occur in a period since which at least three tax years have passed when the non-resident has had fewer than 60 UK workdays. This effectively means there is a three-year limit to any "tail" liability for an executive who becomes non-UK resident (provided thereafter they have fewer than 60 UK workdays per tax year).
What's changed?
There are two welcome changes relating to the position of non-residents.
First, under the first draft of the legislation, the three limitations for non-residents only applied in relation to qualifying carried interest – not non-qualifying carry. This was potentially problematic because at the time an executive is considering whether to provide UK services they may well not know whether the fund will have a 40-month AHP. To address fear that this would discourage non-resident executives from coming to the UK even for short periods, the Finance Bill, effectively, extends the second limitation (fewer than 60 UK workdays in the tax year) to non-qualifying carried interest to the extent it was reasonable to assume, when the first UK workday took place, that the carried interest would have been qualifying.
Second, the definition of "relevant period" has been amended. Under the revised legislation, broadly, it begins on the later of (i) the day on which the first external investor is admitted to any fund that is part of the carry-paying "arrangements" and (ii) the first day the executive starts working in relation to a fund under those "arrangements", and ends on the earlier of (i) the last day in the tax year (for which the carry tax charge arises) on which carried interest arose to the individual under the "arrangements" and (ii) the last day on which the individual works in relation to a fund under the "arrangements".
This change should remove some anomalies that arose under the first draft of the legislation, where the carrying out of any UK fund management work could increase a non-resident's tax liability, so, for example, UK work carried out after changing firms could impact carry received later on from a fund the executive had worked on in their previous role.
Application of POA rules
As carried interest will be taxed as trading profit, it will fall within the UK's POA rules, under which self-employed individuals are required to make advanced payments on account of their expected future tax liability. This is likely to give rise to significant cash flow issues for executives as, although the POA rules work well for regular income streams, carried interest tends to be lumpy and unpredictable.
What's changed?
Nothing - despite significant lobbying from industry on the point. Indeed, matters could get worse. Buried in the recent Budget papers, the government said that there will be a consultation on "timelier tax payment" for those with self-assessment income. If that proposes accelerating the deadlines for POA, this will exacerbate difficulties for executives.
