Carried interest – a simple overview

Carried interest is a share of the profits realised by investors in a private equity fund. It is used as an incentive for fund managers to maximise the profitability of the fund.

Carried interest enables key management to benefit from equity type returns. As it only has value to the extent that investors in the fund make a return in excess of the pre-determined “hurdle rate”, the significant income tax charges associated with the acquisition of employment-related securities should generally be avoided.

The Hurdle rate is the minimum rate of return on a project or investment required by investors.  If the management do well in achieving the turnaround or growth targets, they can participate in a share of the extra return above the hurdle they’ve generated for investors. 

Government changes that are beginning to bite

While carried interest isn’t new, tax law changes that were introduced in 2017 are only now being felt because of the pandemic’s disruption in recent years.

Prior to 2017, a concept known in the industry as “base cost shift” applied to carried interest when it was triggered.  Once the normal investors had achieved a target return (the hurdle rate), the management were entitled to a share. While the first, say, 8% IRR (Internal Rate of Return) generated by the fund went to the investors, anything above the 8% threshold was split (typically 80:20) between the investors and the managers.

When this target rate was hit in the fund there was a deemed disposal between the investors and the managers in the fund, which would typically be structured as a partnership so HMRC Statement of Practice D12 would apply.

This enabled the management to benefit from a share of the acquisition cost for CGT purposes, even though those costs had been paid by the investors. As a result, the managers tended to pay very little capital gains tax on carried interest.

The changes in 2017 blocked the application of base cost shift to carried interest. Additionally, the capital gains tax rate for carried interest was increased to 28% instead of the normal 10% and 20%. 

Finally, for non-UK domiciled managers, all carried interest is treated as UK source and is therefore taxed in the year of receipt. This is regardless of whether the carried interest is in a foreign fund and whether or not the proceeds are remitted to the UK.

DIMF rules

Alongside these changes in 2017 the Disguised Investment Management Fees (DIMF) Rules came into being.  These were introduced to identify amounts received by managers which were in reality management fees but had been structured to seek advantageous CGT treatment.

The rules therefore include specific exclusions for carried interest and co-investment returns but are very broadly drafted and need careful consideration when establishing new private equity funds

Key takeaways

It’s important that funds and their managers factor in the changed tax position when working out potential financial returns for management. 

The arrangements in relation to management fees and carried interest will need to be considered carefully when establishing any new funds, both as a result of the issues outlined above but also, as always, fee arrangements will need to be structured to avoid irrecoverable VAT arising.

If you would like to chat through the potential tax issues surrounding a deal, please contact Steve Hanlon on tel 020 7312 0000

Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. If you would like advice or further information, please speak to your usual Shipleys contact.

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