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Taxation of Performance Linked Rewards Paid to Asset Managers

Business Tax - 18 Jan 2016

In the Summer Budget 2015 the government announced that it would consult on the circumstances in which fund managers’ performance-related returns are to benefit from capital gains tax treatment.  On 9th December 2015 HMRC published the Summary of Responses to that consultation along with draft legislation for inclusion in Finance Bill 2016, which will apply to all carried interests arising after 5th April 2016.  A further period of consultation is taking place between now and when the Finance Bill is published, shortly after the Budget next year (16th March).

It is not HMRC’s intention to change carried interests linked to underlying investment assets from being subject to capital gains tax where there is truly a longer term investment policy occurring.  As such it is considered that carried interests in most Private Equity Funds will be unaffected.  However, HMRC have concerns that due to the somewhat subjective nature of the definitions surrounding such investment activities together with application of the traditional “badges of trade” that some organisations are seeking to manipulate the rules to the extent that rewards which would more correctly be subject to income tax are being characterised as chargeable to capital gains tax instead.

To remove the considerable level of ambiguity the intention is to statutorily define when capital gains treatment will apply.

Two approaches were proposed and HMRC has now settled on what it concludes as the simpler option of being based on the average holding period of the investments to which the carried interest relates.  The proposal is that where the average holding period is 4 years or more the carried interest will be wholly subject to capital gains tax; where the average holding period is less than 3 years the carried interest will be wholly subject to income tax with a graduated rate per below for average holding periods between 3 and 4 years.

Average Holding Period         Proportion Of Any Performance-Linked
Charged To Income Tax
Less than 36 months 100%
At least 36 months but less than 39 months 75%
At least 39 months but less than 45 months  50%
At least 45 months but less than 48 months  25%
48 months or more     0%

The British Venture Capital Association are of the opinion that the 4 year holding period should be reduced to 3 years and will push for such during the consultation period.

The legislation goes into some depth on how the average holding period is calculated for various types of investments, especially where holdings are acquired in tranches and in general seeks to amalgamate debt and equity in investments.

The legislation is seen and drafted as an extension of the Disguised Fees for Investment Managers legislation already in place and is not expected to conflict with the pre-existing Employment-Related taxes legislation.

As with the Disguised Fees legislation any amounts deemed to be subject to income tax will treated as self-employment income and therefore also subject to Class 4 National Insurance in the normal manner.   In line with self-employment income in general, amounts subject to income tax are wholly subject to UK taxation where the individual is UK tax resident irrespective of the location of where duties may be performed.

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Steve Butler

Steve Butler

Business Tax Associate Director

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Office: London