Most investment funds provide for the payment of performance-based remuneration to the fund manager. The intention is to align the interests of the manager with those of the investors, incentivising management to ensure that the fund performs well. Often, particularly for alternative investment funds where this remuneration is to be shared among the individuals on the management team, this will be structured as carried interest.

Carried interest has increasingly come within HM Revenue & Customs’ focus due to the potential risk of ordinary management fees being disguised as carried interest to avoid income tax. Over 2015 and 2016, new rules relevant to carried interest were introduced that were designed both to reduce the scope for avoidance and to restrict the beneficial tax treatment available (the reforms).

Under a fund’s governing documents, carried interest will be payable as a percentage share of the fund’s profits to the extent that the fund performance exceeds a specified hurdle or preferred return; for example, a percentage return on investor contributions to the fund, a specific annual yield or the outperformance of an index. It could be calculated on the basis of profits from individual fund investments (a deal-by-deal basis) or by looking at all of the profits and losses made on all of the fund’s investments (a whole-fund basis). If carried interest is paid out and performance declines afterwards, the recipient may be required to pay it back under clawback provisions.

The fund manager will need to decide what sort of vehicle will receive the carried interest (the carry vehicle). A typical arrangement involves the fund manager setting up a limited partnership, often Scottish, in which both the fund manager company and the individuals that form the management team become partners. Alternatively, a limited liability partnership might be used.

The carry vehicle acquires an interest in the fund at the start of the fund’s life; typically, in funds structured as limited partnerships, by becoming a limited partner. Each individual, and the fund manager company, will pay an amount for their interest equivalent to the same amount as investors pay per unit of capital in the fund. This is important for individuals who are employees of the fund manager, to ensure that they are treated as paying market value for the carried interest for income tax purposes.

Carried interest is often one of the most hotly negotiated, and complex, terms in the fund documents, since it can generate significant remuneration for the fund manager. Investors will want to ensure that the management team is appropriately incentivised to get the best performance out of the fund, but equally do not want to see excessive or unreasonable carried interest.

For funds in the US, carried interest has historically been earned on a deal-by-deal basis, meaning that when an investment is sold, if the net profits from that investment have achieved the necessary hurdle, the fund manager receives a percentage of the profits in excess of the hurdle. The problem comes if the fund’s next investment performs badly. In this situation, investors are forced to rely on clawback provisions, which require the manager to pay back, usually only at the end of the fund’s life, some of its carried interest so that when the fund’s investments are considered as a whole, it only keeps the agreed percentage of the fund’s total investment profits in excess of the hurdle. This is frequently resisted by investors.

By the time the clawback applies, the management team may have paid tax on the carried interest, which cannot be reclaimed, so the amount actually given back to investors is typically net of tax. The management team may have spent the money and it may be practically difficult to recover the excess. For all these reasons, investors have negotiated various solutions to mitigate against these problems; for example, part of the carried interest could be paid into an escrow account and only released at the end of the fund’s life.

As a result, funds now often work on a whole-fund basis, both in Europe where the whole-fund basis has been the standard for some time, but increasingly also in the US. This means that carried interest is only payable if and to the extent that, looking at all of the fund’s investments (or at least, all of its realised investments), the hurdle has been met. It also reduces the commercial need for clawback provisions, which provides helpful certainty to the recipients of the carried interest.

It is also important to investors that the right people are incentivised. Although the fund documents may provide that carried interest is payable to the carry vehicle, many investors seek reassurance in the fund documents that the partners will not assign their right to receive carried interest to people who are not involved with the management of the fund. Some may go as far as to try to negotiate the proportion of carried interest that is payable to individual managers as opposed to the fund manager company, as this may help to ensure that they remain involved with the fund on a long-term basis.

Before 2015, there was no specific UK regime for the taxation of carried interest. Subject to the employment-related securities (ERS) regime, managers were simply taxed by reference to the nature of the funds used to pay the carried interest, for example, interest, dividends, trading profit or capital gains (see box “Employment-related securities regime”). Managers often benefited from quite low tax burdens compared to those paid by employees on ordinary employment income, although employee managers with carry arising from ERS always had to consider potential income tax charges under the ERS regime.

The Finance Act 2015 introduced the disguised investment management fees rules (DIMF), which apply from 6 April 2015 (Chapter 5E, Part 13, Income Tax Act 2007). The Finance (No 2) Act 2015 introduced a standalone capital gains tax (CGT) regime for carried interest (Chapter 5, Part 3, Taxation of Chargeable Gains Act 1992), which applies from 8 July 2015, and amended the DIMF rules. In addition, the Finance Bill 2016 provides for income-based carried interest rules, which apply from 6 April 2016 (Chapter 5F, Part 13, Income Tax Act 2007).

DIMF. The DIMF rules apply to all sums arising on or after 6 April 2015 to individual managers under arrangements for performing investment management services for investment schemes. These sums are charged to income tax as trading income, to the extent that they are not already subject to income tax as trading or employment income. Given the higher rates of income tax compared with CGT rates, this treatment is unlikely to be desirable for many managers. However, the DIMF rules contain exclusions for co-investment (which covers repayments of investments made by the manager in the investment scheme or arm’s length returns on those) and carried interest. The DIMF carried interest exclusion creates a statutory definition of carried interest for tax purposes (see box “Tax definition of carried interest”). The focus is on profit dependency, tying the concept back to the aim of aligning the interests of managers and investors.

Income-based carried interest rules. Even if managers’ returns fall within the statutory definition of carried interest, they are not necessarily safe from income tax treatment. First, as before the reforms, carried interest will be outside the scope of income tax only if it is paid out of non-income sources (although it could also be within the new CGT regime, but with potential for the CGT charge to be adjusted if the manager makes a claim for avoidance of double taxation). Secondly, all carried interest arising from 6 April 2016 is outside the DIMF rules only if it meets a new condition: either the carry must fall within the ERS regime or meet a holding period test which determines when carry is income-based.

The holding period test is applied at the time the carried interest arises. If the average holding period for the fund’s investments is 40 months or more, none of the carry is income-based. If the average is less than 36 months, all of the carry is income-based and charged to income tax, even if funded out of capital sources. If the average is between 36 and 40 months, a percentage of the carry is income-based. It does not matter whether a particular fund investment was bought, or sold, before the new rules were introduced with effect from 6 April 2016; all that matters is the position when the carried interest arises.

There are detailed rules for calculating the average holding period, dealing with, for example, unwanted short-term investments, follow-on investments and managed sell-downs. Managers will need to carefully track fund intentions and investments over time. Also, managers with ERS carried interest may wish to keep the holding period of their funds under consideration, as the Treasury has power to repeal the ERS exclusion.

CGT treatment. Even for carried interest that is paid out of non-income sources and falls outside the DIMF rules, the position is not quite as beneficial as it was before the reforms. First, the ability to receive carried interest in non-taxable form (for example, loan principal repayments) has been removed. All carried interest will be charged to CGT if it is not charged to income tax.

Secondly, a previous beneficial treatment available to managers, the base cost shift, has been removed. Before the reforms in Finance (No 2) Act 2015, where carried interest was paid out of capital gains managers could deduct some of the acquisition costs of the fund’s investments in calculating the gains on which they paid tax, even though the acquisition costs had been funded by investors. Since 8 July 2015, managers will be charged to CGT on the full amount of carried interest received, with deductions only for actual consideration given by them. In addition, the 20% rate of CGT is not available for carried interest arising from arrangements involving a partnership; instead, the old 28% rate applies.