IFM36540 - Carried interest and profit related returns: Sums treated as carried interest

Sums treated as carried interest

ITA07/S809EZD
Sums treated as carried interest definition

The definition within ITA07/S809EZD follows the description of typical ‘carried interest arrangements’ as set out in the Memorandum of Understanding (MOU) agreed between the British Venture Capital Association (BVCA) and the Inland Revenue in 2003 (and the BVCA’s Statement and Guidelines approved by the then Inland Revenue and Department for Trade and Industry in 1987).

Details of the ‘Memorandum of Understanding’ (MOU)

The MOU (and 1987 statement) is an interpretation of the law, setting out the tax treatment of funds when they are structured in a certain way. It is assumed that funds will very often use the structure as defined in the MOU to ensure that they benefit from the tax treatment which the MOU outlines.

Conditions for sums to be treated as carried interest

Where a sum arises to an individual out of the profits on investments made in a scheme, it is ‘carried interest’ under ITA07/S809EZD providing the following conditions are satisfied:

  • all, or substantially all, of the investments made by participating investors (including loans from external investors) in an investment scheme (IFM36230) have been repaid to those participants.
  • a preferred return (also referred to as the hurdle rate) has been repaid to all external investors on all, or substantially all, of their investments in the scheme.
  • in a situation where profits are repaid on a deal by deal basis (see below) as opposed to a whole fund basis (see below) the same principles as stated above will apply. So carried interest will only be regarded as being paid when, after disposal of particular investments in accordance with the partnership agreements, investments have been returned to partners and the preferred return has been paid to external investors.

This follows a standard structure where individual fund managers do not get profits from carried interest until external investors have had their investments repaid along with a fixed rate of return (preferred return/hurdle rate).

It will be a matter of fact as to what sums are paid to managers. If a sum of 2% of funds under management (for example) is paid annually to managers, as provided in the partnership agreements or elsewhere, then this will most likely not be regarded as carried interest, depending on the facts and circumstances at the time.

The meaning of ‘whole fund’ and ‘deal by deal’

In a ‘whole fund’ structure carried interest will be calculated based on the performance of the fund over the whole life of the fund.

In a ‘deal by deal’ basis carried interest will be calculated based on the profits made on each individual investment that a fund holds.

The meaning of ‘preferred return’ and ‘substantially all’
  • The “preferred return” (or “hurdle rate”) refers to the threshold that investors in an investment scheme must receive as a return before a share of profits is available to be distributed. ITA07/S809EZD(4) defines a “preferred return” (or hurdle rate) as the threshold that must be payable on an investment. This threshold is set at the value of 6% compound interest per annum (with annual rests) for the whole of the period during which the investment was made in the scheme.
  • The reference to “substantially all” of the investments being repaid acknowledges that capital contributions to the investment scheme (rather than loan commitments to the investment scheme, which will comprise the vast majority of the investment made by managers and third party investors) will rarely be repaid until the investment scheme is wound up. Therefore the carried interest may be paid when the capital investment is still outstanding.