IFM37266 | Charging Provisions: Definition of "arising": Deferred carried interest

Deferred carried Interest

TCGA92/S103KG(2)

Under ITA07/S809EZDA and S809EZDB deferred sums will generally be treated as arising to a fund manager and taxed on them at that point in time, i.e. without regard to the deferral period. This is the correct result in the context of fees charged to income where the deferral of a tax charge is inappropriate and contrary to the established approach of the UK tax code and recent legislative developments. However, with carried interest chargeable to capital gains tax, it would represent an unduly harsh outcome which would undermine genuine commercial arrangements designed to provide investors with a level of protection in funds which have long-term investment objectives.

TCGA92/S103KG therefore contains a specific provision (TCGA92/S103KG(2)) for deferred carried interest. These rules (explained in more detail below) only apply to carried interest chargeable under TCGA92/S103KA, not to rewards charged to income (such as Income Based Carried Interest (IFM38000 onwards, this reference is currently not active - manual awaiting completion)) or any other tax charge. Where certain conditions are met, carried interest will not be treated as arising to a fund manager while it remains held in escrow. The carried interest will come into charge when it is released from the arrangements.

TCGA92/S103KG(2) provides that if carried interest meets the “deferred carried interest” conditions and arises to a company connected with an individual (A) or a person who is not connected with A, ITA07/S809EZDB does not apply.

TCGA92/S103KG(3) states that carried interest will be “deferred” where its provision to A (or a person connected with A) is deferred under genuine commercial arrangements which involve both A and external investors in the relevant investment scheme.

However, if one of the main purposes of the genuine commercial arrangement is to avoid a tax liability, the carried interest will not qualify as being deferred. If this “main purpose” test is failed, the entire amount of carried interest is treated as arising (TCGA92/S103KG(13)). This provision is not qualified by any concept of “to the extent”, such that if, for example, a fund manager enters into an escrow agreement which is genuinely commercial but he or she agrees an extended escrow period to try and defer a tax charge, the whole arrangement will be treated as arising immediately.

The arrangements referred to in TCGA92/S103KG(13) can involve an individual acting alone or jointly with others who provide investment management services. Provided the escrow arrangements are entered into with external investors and represent a genuine commercial agreement which is not designed to avoid tax, the type of arrangement or the number of individuals who are a party to it is irrelevant.

A deferral cannot be applied if the sum of carried interest is applied directly or indirectly as an investment in a collective investment scheme (TCGA92/S103KG(12)). Even where all the other conditions in TCGA92/S103KG are met, if carried interest is invested in a collective investment scheme while held in escrow, it will be chargeable on a fund manager as soon as it arises.