UK government publishes carried interest tax draft rules

The UK government has published draft legislation that outlines when carried interest will be taxed as income or capital gains as determined by the length of the underlying investment.

Investments held for an average of four years or more will not be subject to income tax treatment, alleviating previous uncertainty regarding the length of investment that would determine how carried interest is to be taxed.

The proposed new rules will “ensure that a carried interest structure only attracts CGT [capital gains tax] treatment in relation to funds which carry on long-term investment activity,” a policy document said.

The new legislation introduces a proportional measure, where carried interest on an investment held for less than three years will be considered 100 percent income-based, while carried interest on an investment held for at least 39 months but less than 45 will be considered 50 percent income-based and for investments of more than 48 months, none of it will be considered income-based. The average holding period is determined by when the carried interest arises, according to the draft legislation.

“The average holding period of a fund’s investments is calculated by reference to both the value of its investments and the period over which investments are held, meaning that if a fund exits a high cost investment early, its average holding period could be disproportionally skewed,” said Debevoise & Plimpton associate Ceinwen Rees.

The new rules, which will apply to carried interest paid after 6 April 2016, will not impact co-investments made in the fund by a manager, or an “arm’s length return” on the co-investment, the policy document stated.

The new legislation will be introduced in the Finance Bill 2016 to amend disguised investment management fees legislation introduced in the Finance Act 2015.

It follows an industry consultation over the summer and a note in the government’s Autumn Statement that said it was planning to change the way asset manager performance awards are taxed.

“An award will be subject to income tax, unless the underlying fund undertakes long term investment activity,” the note said, but left unclear what it meant by long term, as reported by Private Equity International.