From 8 July 2015 carried interest holders are no longer entitled to reduce their capital gains through “base cost shifting”, unless the carried interest arises in connection with the disposal of assets of a partnership before 8 July 2015. For disposals on or after 8 July, carried interest holders will only be able to take into account their actual investment in the carried interest.
The old regime
Under the old Capital Gains Tax (CGT) regime, at the point when the carried interest of a fund became payable and investors’ profit shares were correspondingly reduced, HMRC treated each investor as disposing of part of its share and accordingly as transferring part of its base cost in the fund’s investments to the carried interest holders based on the percentage of carry (i.e. the so-called “base cost shift”). On disposal of the fund’s chargeable assets, this effectively enabled the carried interest holders to deduct from their carried interest receipts some of the original investment from the fund’s investors in order to reduce their capital gain.
This was a valuable benefit to the carried interest holders which had no negative impact on investors with no CGT liability (e.g. because they were CGT exempt or not resident in the UK). As an example, if an asset was originally acquired for £2 million, carried interest then became payable and the asset was sold for £3 million, the carried interest holders were only taxed on 33% of the cash they received.
The new regime
In the Summer Budget, the Chancellor announced technical changes to the calculation of CGT, with the intent that individual carried interest holders should pay CGT on their “economic gain” from carried interest, i.e. base cost shifting will no longer be permitted. Carried interest holders can now only reduce their chargeable gain by certain limited deductions, such as the nominal capital contributions usually made to the fund in respect of their carried interest or any cash they paid to acquire the right to carried interest.
Genuine co-investments in the fund made by the carried interest holders on comparable terms to the fund’s investors will not be affected by this new legislation and the “base cost shifting” rules will continue to apply.
Although carried interest will continue to be taxed as capital gains rather than income (where the fund is treated as carrying on investment activity for tax purposes), this is a significant change to the actual CGT calculation. HMRC has published guidance in which it states that any attempts to insert separate entities between carried interest holders and their rights to carried interest will be ineffective, and that any such attempts will be investigated and challenged under anti-avoidance rules.
Consultation on CGT treatment of “long term” funds
The Chancellor also announced a consultation on limiting the capital gains treatment of carried interest to funds which have a long term investment strategy. These changes are proposed to come into effect from 6 April 2016. One current option would require an intention to hold investments for a three to five year holding period for long term investment treatment to be available. Under a second option, the percentage of gain for which capital gains treatment would be available would depend on the average period for which assets are held, with full capital gains treatment only being available if an asset is held for more than two years.
The specified target of these proposed rules is the hedge fund industry, despite the fact that taking a carried interest rather than a performance fee is very unusual in this context. However, depending on how the Government in fact frames these changes (e.g. by focusing on certain asset classes to the exclusion of others) the net could be cast significantly wider.