IFM36520 - Carried interest and profit related returns: Meaning of carried interest

Meaning of ‘carried interest’

ITA07/S809EZC(1)-(2)
Definition

The definition of carried interest in ITA07/S809EZC will apply to all carried interest arising to an individual under arrangements ruling out sums which are essentially fixed or largely fixed (i.e. not variable by reference to profits of the investment scheme (IFM36230)).

ITA07/S809EZC provides that a sum arising to a fund manager is regarded as carried interest when it is a profit-related return, subject to the “no-significant risk condition” (ITA07/S809EZC(3)-(4) (IFM36530) and ITA07/S809EZD (sums treated as carried interest).

Any part of the sum arising to an individual which is not a profit-related return will not be excluded from the charge to income tax under the disguised investment management fees (DIMF) rules.

ITA07/S809EZC(2) defines profit related returns.

  1. the sum only arises, or may only arise, if the fund is making profits for a period or on particular investments for the purposes of the investment scheme;
  2. the sum, or potential sum, arising varies substantially by reference to the profits of the fund, and
  3. returns to external investors are also determined by reference to those profits.

Condition 1 is that the sum only arises, or may only arise, if the fund is making profits for a period or on particular investments for the purposes of the investment scheme (ITA07/S809(2)(a)). Where carried interest is calculated on a ‘deal-by-deal’ basis, the individual investments giving rise to the carried interest must be profitable. When the calculation of the carried interest amount is based on the performance of an investment scheme over several years then the period that this condition refers to will be the total period of time that the carried interest is calculated over.

Profits are defined in ITA07/S809EZE(1), and include realised and unrealised profits, and capital and income receipts.

The profits to be considered are the profits based on the period set out in the arrangements. For example, if a fund draws up annual accounts, and a decision on whether to pay carry is based on those accounts, (for example by comparing the net asset value with the net asset value at the start of the accounts period), then the period in question would be the year that this condition is tested against.

Condition 1 may still be met in some circumstances where a fund has made a loss.

Example

A fund is arranged over a 2 year period, it has made a loss in the second year. However, due to substantial profits in the previous year the fund has made a sufficiently high profit over a two-year period.

As the specified period is 2 years, the above situation would meet the first condition despite making a loss in one of the years.

ITA07/S809EZC(2)(b) sets out that the sum that arises, or may arise, must vary substantially by reference to the profits. The intention here is to reflect a standard arrangement in which, provided that a performance “hurdle” rate has been met, carried interest would vary substantially by reference to the fund profits.

ITA07/S809EZC(2)(b) does not require a hurdle arrangement however, it only requires that profits vary substantially by reference to the profits of the fund.

Example

A fund manager is entitled to a fixed fee which will equate to 2% of the value of a fund, payment will be deferred until the fund has positive profits or a capital return.

Just because the fee is conditional (on profits) does not mean that the fee would be carried interest. The amount in this case may be conditional but it does not vary in relation to profits, the value is determined only by the value of the fund - condition 2 is therefore not met.

Condition 3 will not be met where the investments used to determine whether conditions 1 or 2 are met are not the same ones by which returns to the external investors are measured.

Example

Within the fund, a pool of investments is set up with a safe and steady return; the pool was used just for the purposes of determining the payments to the fund managers.

Here these payments to the managers would not be carried interest as the investments upon which the managers’ returns depend is not the same range of investments upon which the external investors’ returns are calculated.

The “no significant risk” test

ITA07/S809EZC(3)-(8)

In addition to the above three conditions, the arrangements must pass an assessment as to the likelihood a sum would be paid. In this guidance we refer to this as the “no significant risk” test (ITA07/S809EZC(3)) for a sum to be regarded as carried interest. This is to ensure fixed or guaranteed performance fees are charged to income tax. More information on the “no significant risk” test can be found at IFM36531.