HMRC has today (9 December 2015) published draft provisions that will have the effect of determining whether carried interest is taxed in the UK as capital gain or as income by reference to the actual average holding period of assets in the relevant fund.
These rules will apply irrespective of the underlying assets held by the fund. The proposed rules represent a considerable and (for many) unwelcome restriction on the capital gains tax treatment of carried interest, not only as compared with the current rules but also as compared with the original proposals issued in July 2015.
The broad thrust of the provisions is that if the average holding period of assets in a fund is under three years then all of the carried interest is taxed as income; there is a sliding scale for between three and four years and over four years all is taxed as capital gain. The averaging will be weighted by the amount invested. This represents a doubling of the required holding period to achieve capital gains treatment set out in the original consultation document (which had suggested a total holding period of two years with tapering of the amount treated as income occurring after a six month holding period). There are detailed rules as to the calculation – such as when disposals of assets are treated as made, how hedging is dealt with, and the circumstances in which carry can be conditionally treated as receiving capital treatment pending further calculation.
The new rules, if implemented, will apply to carried interest “arising” after 1 April 2016. There is no grandfathering – in fact the legislation specifies that the rules apply “whenever the arrangements under which the sums arise were made”.
It will be important for funds and fund managers to review their arrangements before the new rules come into effect so that they are not caught out by the changes. The proposed changes, if implemented, will be seen by many as unwelcome and may cause a significant tension between the desire to realise assets at the time which is best commercially and the time which achieves capital gains tax treatment for the carried interest holders.