Changes to U.K. Tax Treatment of Carried Interest

On Wednesday 8 July, the U.K. Government somewhat unexpectedly announced changes (effective immediately) to the U.K. tax treatment of carried interest received by individual members of an investment fund management team. 

As of 8 July, all carried interest returns will now be taxed as capital gains (at a rate of up to 28%), regardless of the nature of the underlying profits.  However, the “deductions” available in determining the relevant gains will now be limited to, broadly, amounts paid by the individual for the carry, as opposed to enabling what is known as “base cost shift” to reduce the taxable amount below the actual economic gain.  Whilst this may not initially seem controversial, the changes overturn a practice which has long been accepted by the U.K. Government.

In addition, the U.K. Government is consulting on further changes which, if enacted, could charge to income tax (at up to 45%) certain performance based awards received by individual investment managers, which are currently treated as capital gains.  The consultation appears to be aimed at managers of hedge funds and “short term” debt funds and, therefore, should not affect the taxation of carry received by managers of traditional private equity, infrastructure or core real estate funds.  That said, the devil will be in the detail and it remains possible that the new rules, once enacted, could have a wider scope than anticipated, with the result that traditional private equity arrangements are inadvertently caught.

Investment fund managers appear to be firmly within the U.K. Government’s sights: last Wednesday’s announcements follow the enactment of laws earlier this year (commonly referred to as the “disguised investment management fee” rules), which operated to bring certain amounts that were previously taxed in the U.K. as capital gains into the income tax net.