Financial Services Quarterly Report - Fourth Quarter 2015: Further Change to the UK Taxation of Carried Interest

by Dechert LLP

The UK Government, as anticipated, issued draft legislation on 9 December designed to establish clear rules as to when carried interest can qualify for favourable capital gains tax treatment. The draft legislation follows a consultation exercise announced in the Summer Budget1.

The Summer consultation paper issued by H.M. Revenue & Customs (HMRC) initially proposed two alternative methods for determining when carried interest could qualify for capital gains tax treatment. The first method looked to the fund’s investment strategy or proposed activities (so-called Option 1), while the second method looked to the average holding period of underlying assets (so-called Option 2). The draft legislation confirms that Option 2 is the favoured option.

On a positive note, in pursuing Option 2, HMRC has followed the preference of most industry respondents, who generally favoured Option 2 because of the greater certainty it should offer. However, the four-year average holding period proposed by the draft legislation has set a high bar and, in our view, is unnecessarily restrictive.

In summary, the draft legislation purports to tax a carried interest return entirely as income unless it is derived from a fund which holds its underlying assets for an average holding period of at least three years. Where the holding period is between three and four years, a proportion of such returns will be taxed as income. Only where the average holding period exceeds four years will capital gains treatment be obtained in full. The calculation will be made at the time the carried interest arises.

The calculation of the average holding period for these purposes will be based on a “weighted average” so that the original cost of an investment will be important. For example, a particularly large investment which is sold after a short period of time could have a major distortive impact on the calculation. This could present a conflict of interest between investment managers and their investors as to the time of disposal of such an asset.

Specific rules have been introduced for loan origination funds. Originally, there was concern that such funds would be incapable of qualifying for capital gains treatment for carried interest returns. However, the draft legislation envisages that this will be possible, broadly speaking, where loans are extended generally for a term of four years or more, although such funds will need to meet additional conditions in order to qualify for such treatment.

As the impact of failing the new test is to convert what would otherwise have been a capital gain into income along similar lines to the existing “disguised investment management fee” rules, non-domiciled individuals should note that this will also convert what might otherwise have been taxed as capital gains on a remittance basis into UK source income taxed on an arising basis.

If implemented in accordance with the draft legislation, the new rules will prevent capital gains tax treatment for carried interest arrangements for the large majority of hedge or alternative funds with short-term to medium-term holding periods, irrespective of whether such funds could be considered to be carrying on an investment rather than a trading activity. While most private equity funds ought to be capable of satisfying the average holding period requirements, the four-year period is still longer than would be wished for (especially as some of the detail contained in the calculation aspects of the rules may present further scope for failing in specific circumstances). The new rules will introduce an additional compliance exercise, in order to monitor and undertake the necessary average holding period calculations.

The new rules are designed to come into effect from 6 April 2016, and arrangements entered into before that date will not benefit from grandfathering. As a result, if implemented, the new rules will impact existing structures, which should therefore be reviewed in the light of the proposals. However, there is still a further opportunity for consultation prior to delivery of the final legislation, expected on or around the budget next year.

The Summer Budget also introduced significant other changes to the taxation of carried interest. In overview, the changes are designed to ensure that carried interest is subject to tax at a minimum rate of 28% (essentially preventing the application of “base cost shift” and “profit cherry-picking” to reduce the effective rate of tax further). In addition, changes were made to the sourcing of the capital gain for non-UK domiciled individuals, so that gains arising on non-UK investments derived from a non-UK carried interest fund structure could still be taxed in the UK if the executive works in the UK. In conjunction with the draft legislation discussed above, these changes constitute a major shift in the UK tax treatment of carried interest, which will impact current structures and materially change the structures put in place in the future.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Dechert LLP | Attorney Advertising

Written by:

Dechert LLP

Dechert LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.