IFM36534 - Carried interest and profit related returns: The "no significant risk" test: Timing of significant risk tests

Timing of significant risk tests

ITA07/S809EZC(5)

The risk should be assessed at the latest of the following situations:

  • an individual becoming party to the arrangements,
  • the point in time an individual begins to perform investment management services directly or indirectly in respect of the scheme under the arrangements, and
  • the time a material change is made to the arrangements so far as relating to the sums which are to, or may, arise to the individual.

The assessment of risk to be untaken is both in relation to:

  • each actual sum (and the investments to which it relates) individually, also taking into account any other sums that might have arisen to the individual under the arrangements, and
  • the actual sum or sums and any other sums that might have arisen to the individual under the arrangements by way of profit-related return in the tax year (and the investments to which all those sums relate) taken as a whole.

In practice, where there is more than one sum paid in a year each sum should be considered individually then consider all the sums together.

It is expected that where sums are taken together, there would only be a different outcome in circumstances where a fund had invested in a series of investments which when taken together, deliver a certain return to the managers.

Generally, this means that for a fund with a defined lifespan (closed ended fund) the test is likely to be applied at an early stage in the life of the fund. Later in the life of a fund that has been successful, it may be certain that sums will arise to the managers under the arrangements. This does not mean that a sum does not qualify as carried interest, so long as there was significant risk that the sum would arise when the arrangements were entered into.

Where an individual leaves a management team and that individual’s entitlement to a sum is wholly or partly reallocated between the remaining managers, this will generally not be considered a material change, provided that:

  • the individuals receiving the allocation were previously entitled to a portion of the carried interest in respect of the scheme; and
  • the reallocation does not materially distort the proportions in which those individuals will share the carried interest between themselves.

If an individual receives a re-allocated award of carried interest that is greater than the pro-rata amount, then a material change will generally not be considered to have occurred in relation to the original carried interest amount as long as the new carried interest addition has no bearing on the calculation, right to receive or previous arrangement. If the new carried interest addition does have any bearing on the previous arrangement then a material change will have deemed to have occurred for all of the individual’s carried interest balance.

There is no legislative definition for material change. Whether a “material change” has occurred or not will depend on the facts.