Carried interest transitional rules
The carried interest rules impose a minimum 28 per cent tax on carried interest distributions to UK resident fund managers, subject to potential reduction for those who are non-domiciliaries. Those rules apply to carried interest arising on or after 8 July 2015 but also contained transitional rules.
Those transitional rules provided that:
[The new carry rules have] effect in relation to carried interest arising on or after 8 July 2015 under any arrangements, unless the carried interest arises in connection with the disposal of an asset or assets of a partnership or partnerships before that date.
The stated intention of these transitional rules was to ensure that the new carry rules did not apply to a distribution of carried interest after 8 July 2015, where the distribution related to a disposal that took place before that date. That might have been the case where the carried interest was being held in escrow or was otherwise in the fund awaiting distribution to carry holders.
It was announced as part of the Budget that these transitional rules are being repealed from 22 November 2017.
The reason for this change is that, last year, HMRC discovered that certain advisers were interpreting the transitional rule more widely than HMRC had intended and were taking a position that (at the extreme) could mean that the new carry rules did not apply to a carry distribution, where any disposal prior to 8 July 2015 was relevant in the calculation of that distribution. In a whole fund carry this could mean that a carry distribution in 2020 would not be caught by the new carry rules where the fund in question had made a disposal before 8 July 2015 which went through the whole fund waterfall. The interpretation would be that the 2020 carry distribution would be made “in connection with” the pre-8 July 2015 disposal.
In December 2016, HMRC issued a statement that they did not agree with this view and would challenge any taxpayer taking the position. While thinking the transitional rule was badly drafted, we agreed with HMRC on this point and took the view that the transitional provision (and the related charging provision which uses the same language) was referencing the disposal of the asset which produced the proceeds which is the source of the carry distribution in question.
However, HMRC are clearly worried by the open-ended nature of their exposure on this point and are legislating now to cap that exposure. Despite not saying anything in the accompanying explanatory note, we understand that HMRC see this change as “for the avoidance of doubt” and that their view on the scope of the transitional rule up until 22 November has not changed.
We understand HMRC’s intention behind the change is to stop taxpayers being tempted into adopting the wider interpretation. However, taxpayers might interpret the change as an admission by HMRC that they were wrong all along and now look to file (or refile) on the basis of the wider interpretation for carry distributions between 8 July 2015 and 22 November 2017. Given we understand HMRC’s position has not changed, and for the reasons set out above, we would not recommend this.
The real concern is that HMRC have thrown the baby out with the bathwater with this change. The transitional rule was still providing legitimate protection to fund managers in two situations:
- where a disposal triggering carry took place before 8 July 2015 but that carry continues to be held back in an escrow (perhaps due to a legal dispute or under the normal retention arrangements agreed with investors); and
- where carry generated from a disposal before 8 July 2015 was compulsorily reinvested in the fund.
We understand that HMRC are aware of this potential impact but did not think there would be many managers with amounts still held back 28 months on.
For affected taxpayers, apart from making clear to HMRC the extent of the damage caused, a possible route may be to argue that the carry amounts in question “arose” to them before 8 July 2015 notwithstanding the fact that the cash was not distributed to them. If this was the case, they do not need to rely on the transitional rules. That, of course, would be a reversal of the view previously held in the industry and supported by the draft HMRC guidance that those amounts do not arise until they are accessible by managers.