Carried interest election to pay tax as scheme profits arise

21 April 2023

At the Spring Budget 2023, the Government announced its intention to introduce an election for UK resident carried interest holders to accelerate their UK tax liability on carried interest. The purpose of this is to allow them to better align the timing of their UK tax with their US tax, and so be more easily able to claim double tax relief in the US. The details of the election have now been published in the Spring 2023 Finance Bill.

The problem

UK:US double tax can arise in relation to carried interest due to the US recognising income and gains earlier than the UK and it not being possible to carry back excess foreign tax credits in the US by more than one year. Under UK tax rules, an individual is taxed on carried interest in practice on a cash basis, thus respecting the fund’s commercial waterfall. In the US, carried interest is taxed on a hypothetical whole fund liquidation basis. The mismatch in timing can be problematic for UK residents who are US citizens who will end up suffering double tax if they cannot credit the later UK tax in the US.  

Although the US example is the most common scenario, a risk of double taxation can arise in other jurisdictions. For example, if an individual holding carried interest migrates to the UK and is subject to an exit tax on the unrealised appreciation in the market value of the carried interest in their country of departure, they may also be subject to tax in the UK when the carried interest is realised.

Double taxation may also arise if an individual holds their carried interest in a non-resident company (this may be the case where an individual migrates to the UK with a holding structure established in their country of departure). When the carried interest arises, that company will be liable to tax in its country of residence. Although the carried interest is owned by a non-UK resident company, the rules in UK legislation impute the gains to the UK-resident individual. Two countries therefore consider that they can tax the gains based on residence.

Until very recently, these issues were not previously a problem as it was generally established practice to rely on HMRC guidance that allowed a credit in the UK for foreign tax suffered under s103KE. HMRC initially interpreted this as including non-UK taxes, but since January 2022 its view has changed, and it now considers that the correct interpretation is that s103KE is limited to UK tax.  

The solution

The new legislation provides carried interest holders with a mechanism to accelerate the UK tax charged on carried interest income and gains with a deemed charge. The rules operate as an irrevocable election on a fund-by-fund basis with a calculation to determine the amount of carried interest that has accrued to them in each tax year. Broadly, this is achieved by aggregating the gains realised on disposal in the tax year (and earlier tax years if relevant), the proceeds that would arise on a disposal at cost for assets not disposed of, and any other income received by the fund relevant to the carried interest holder. The amount of carried interest the individual would receive if that sum were distributed based on the fund waterfall is then determined, less any amounts charged under these provisions in early years. This should, in theory, mirror the way the US tax is calculated under their hypothetical liquidation rules however as the wording does not replicate the US rules on a word-by-word basis, in practice the method may lead to slightly different results.

As the legislation currently stands, the deemed charge recognises distributions that relate to earlier disposals as if they had happened in the relevant tax year. On this assumption and under this hypothetical calculation the carried interest hurdle will be met later than it actually is, resulting in carry holders being treated as entitled to a lower amount of carried interest than they are entitled to.

The new UK rules recognise that not all schemes will return carried interest over the course of the fund’s life. The ability to offset losses is envisaged where an individual has accrued a chargeable gain under the new rules but is in an overall loss position once all or substantially all of the investments have been disposed of.

In practice

The rules have primarily been designed so that the UK tax is creditable against US tax on the basis that the tax has arisen in the same year. This should therefore resolve the timing issue for a large population affected by the change in practice, but it is by no means a universal solution.

In the other scenarios, for example exit taxes, the outcome will heavily depend on the local domestic rules in place and whether the accelerated UK tax can be recognised at the time, for example when an exit tax arises. The proposed solution is not designed to anticipate the nuances of every jurisdiction’s carried interest rules therefore this is unlikely to be a universally applied solution in practice, however where it works, it offers another route to alleviate double taxation.

The new election does have its limits. It will not be possible to use the accrual basis to hedge against a future increase in the UK tax rate. The accelerated tax charged under the accrual basis is credited against the UK tax liability when the carried interest arises, meaning distributions after an increase in rates will ultimately be taxed in the UK at the prevailing rate.

Timing and transition

The election is voluntary, but once made it is irrevocable for that scheme, therefore individuals will want to think carefully about whether and when they elect into the regime. The election must be made in writing to HMRC stating the first tax year the election will take effect. The election will apply on a fund-by-fund basis (including associated funds) but unrelated funds will not be caught so the individual has some discretion on which scheme to make this election for.

The new rules come into effect for the 2022-23 tax year, with the rules backdated to 6 April 2022. As noted earlier, HMRC’s change in practice occurred in January 2022 therefore there is a short gap in coverage for overseas liabilities arising between that date and 5 April 2022.