Carried interest - treatment for UK and US tax purposes

12 April 2024

This note is intended to give an overview of the key differences between the UK and the US approaches to the taxation of carried interest and potential issues which arise for UK residents who are also US taxpayers.

This is not intended to be a comprehensive guide to the rules in either case and specific advice should always be sought, but it highlights some points to watch out for. This note does not consider the overlay of the remittance basis nor the changes to the rules applicable to non-domiciled individuals announced at the Spring Budget on 6 March.

The UK carried interest regime

  • Where amounts arise from a fund and are treated as carried interest they are subject to two regimes – the basic rules and the carry rules.
  • Under the basic rules the carried interest cash represents an allocation of the underlying income and gains arising to the fund partnership out of which that cash has been paid. This may represent proceeds from disposal of shares (with a corresponding share of any base cost), dividends and payments of interest on loans and repayments of those loans. The basic rules subject these amounts to capital gains tax or income tax as appropriate and at the appropriate rate – with base cost and repayments of loan principal not being subject to tax at all.
  • To determine the nature of an amount one needs to discern the amount paid out by, or received in respect of, the first opaque entity beneath the fund. This is usually very easily discernible for UK and most international tax purposes as the first company in the ownership chain – with partnerships typically being treated as transparent. (Although beware limited liability partnerships which are often treated as opaque for non-local tax purposes.)
  • Under the carried interest rules, the cash amount itself arising is treated as a chargeable gain arising to the individual and taxed at a special rate of 28% - with credit for any taxes payable under the basic rules on the same item of income or gain (which may be higher).
  • Also, under the carried interest rules, carried interest arising to another person (for example a connected trust or company) will be taxed on the individual concerned, even where there is no basic tax charge for that other person.

The US carried interest regime

  • The US regime works slightly differently in two key ways. Firstly, it is much less easily discernible from which entity the gain or income is seen as arising for US tax purposes due to the ability of legal entities to be treated as pass through or as opaque for US tax purposes on the basis of elections made. This can lead to mis-matches in treatment between the two jurisdictions which can affect the availability of credit. This point should always be considered on the way into investments and is relevant for co-investment as much as it is for carried interest.
  • Secondly, and specific to carried interest, the US does not always tax carried interest by reference to cashflows paid out to partners, but by reference to their true economic share of an amount. The classic example is where a fund is above the hurdle on a NAV basis (because the values of investments are high enough such that if they were disposed of carried interest would be paid), but on a cash basis the hurdle has not been met yet.
  • When an asset is then disposed of, the carried interest holders are allocated their carried interest percentage (so 20% in a typical 2% and 20% private equity model fund) of the gain realised – even though no cash will be distributed.
  • Most fund limited partnerships will contain tax distribution language which provides that in such circumstances the fund will distribute enough cash to the US limited partner to pay this “dry” tax charge.

The interaction between the two regimes

  • US citizens and green card holders are subject to US tax on their worldwide income. Where they are resident in the UK, therefore, they are subject to both the UK and the US tax regimes. As a general matter the UK typically has the first taxing right under the US:UK double tax treaty and as a matter of convention and domestic law – with the US granting credit for UK taxes paid. However, the differences in the regimes can give rise to mismatches which may result in no or reduced credit being available.
  • These include mismatches as to source – for example where an entity is treated as a partnership for US tax purposes but a corporation for UK tax purposes. They can also include classification mismatches – where something is treated as capital in one jurisdiction and income in another for example. These mismatches should be considered when investments are being structured.
  • However, the most common issue which arises is a timing mismatch where the US tax point is earlier than the UK tax point due to the US tax arising before the carry is paid out in cash and the UK tax is payable. In this case, because there is no UK tax to pay (and unless action is taken or cash carry arises for UK purposes in the same year – in which case specific advice should be sought) the US tax charge applies. Later, when the UK tax charge arises on a distribution of cash, the US tax point has passed and it is not possible to claim a retrospective tax credit to get a refund of that US tax.
  • Historically the impact of this mismatch was hidden by the base cost shift and the remittance basis, but it has become much more acute in recent years as the relevance of those principles has waned for many taxpayers (and while we have not covered in this note the proposed changes to the remittance basis announced in the 2024 Spring Budget, it is worth mentioning that the loss of the remittance basis for US taxpayers in receipt of carried interest will have a potentially significant adverse impact). You can find our analysis of the proposed changes on this content hub

Impact and relief/credit

  • The UK carried interest rules do include a double tax relief provision, which provides that if at any time “tax” has been paid by the individual or another person in relation to the carried interest, that tax is creditable against the UK carried interest regime charge (although not the basic charge, so even this would not be a total solution). Initially HMRC accepted that “tax” in this provision meant tax payable anywhere in the world – and therefore the timing mismatch issue would not be an issue in practice as the UK would allow credit for US taxes already paid (even though this is the “wrong” result since the UK should have the primary taxing right).
  • HMRC recently appear to have changed their view on this which has caused a significant issue for a number of taxpayers. The current state of affairs is that in relation to previous years HMRC have generally agreed to allow credit, but not to allow this going forward.
  • Instead, a new election regime has now been introduced which allows a carried interest holder to elect to be subject to tax in the UK on broadly the same basis as they are subject to tax in the US (i.e. removing the timing mismatch). These rules are imperfect and do not help situations where non-UK tax is paid by other persons (for example spouses or children to whom carried interest has been transferred – where the argument over the meaning of “tax” continues), but they should clarify the position for the majority of cases. Unlike the US rules, if the carried interest never arises in cash a UK capital gains tax loss may be available.
  • As a final point, the tax distributions which are received from funds to allow payment of dry tax charges are themselves distributions from funds which are potentially subject to the DIMF rules. As a matter of practice it is generally accepted that these should be taxed as carried interest in the UK as well. This is not specifically recognised in the legislation and this tax is technically payable as well as the fully accelerated charge under the new election regime, but in practice double tax relief should be available to ensure there is no double counting – provided it is claimed in the tax return.

If you would like to discuss any of the points raised in this note, please get in touch.