US/UK taxation of carried interest awards
Award of carried interest
Upon being awarded an interest in a carry vehicle, first and foremost an investment manager with US and/or UK tax exposure needs to consider making preferential elections. These elections (Section 431 for UK tax and Section 83(b) for US tax), essentially ensure that the carry is taxed at the preferential Capital Gains Tax rate and that it is not an extension of employment income (if an employee) or partnership income (if a partner). These elections have the effect of taxing the award at the unrestricted market value at the date of award. Given the nature of a right to carry, this may be relatively low, but you should work with your employer to ensure the employee and employer treatments are consistent. It is worth noting that both elections have tight deadlines.
The Section 431 election (UK) is a joint election between the employer and employee and must be signed within 14 days of the award of the carry. It does not need to be submitted to HMRC but must be kept on file. Partners may wish to protectively file a Section 431 election, particularly if they become a director of the fund in question further down the line which could subject them to employment rules.
The section 83(b) election (US) does not distinguish between partners and employees; therefore, it affects all investment managers who are US citizens, green card holders or resident aliens. This election has to be filed with the IRS within 30 days of being awarded the carry.
Being awarded carry partway through a fund’s life cycle rather than in its infancy (when it has minimal value) means that upon the filing of the aforementioned elections there may be an income inclusion (at ordinary tax rates i.e., 45% UK rate which can offset the 37% US tax rate) on the difference between the fair market value and the price paid at the date of the award.
How to mitigate double tax on carry?
As mentioned in the previous article, carry is taxed on an ‘accruals’ basis in the US versus a ‘receipts’ basis in the UK. As such, if you are a US taxpayer residing in the UK, the most efficient and prudent way to negate double tax is to make advance tax payments to HM Revenue & Customs (HMRC) on an annual basis, by 31 December. This allows UK tax to be claimed as a foreign tax credit on the corresponding US return. The carry, which is taxed as it accrues and reported annually on a Schedule K-1, will be sourced as foreign so that the income and credits align. Note that this is only in point for the regular US tax, not the 3.8% Net Investment Income Tax (NIIT), which cannot be offset by foreign tax credits. Therefore, there will always be some US tax payable to the IRS each year in respect of carry. This planning is particularly pertinent for US taxpayers who claim foreign tax credits on the ‘paid’ basis (which is the majority), whereby foreign tax credits are included on the US return in the year in which the foreign tax is physically paid as opposed to when it is due.
Given a taxpayer will not necessarily have liquidity from the fund until the carry pays out (and may not have liquidity from other sources) but will have to pay US tax on the carry each year as it accrues, the fund’s Limited Partnership Agreement typically includes a clause which means that annual tax advances can be made to cover the dry tax. This in turn means that when the carry eventually pays out, should the hurdle rate be met, it will be reduced to account for the early distributions covering the dry tax.
From a UK tax perspective, when the carry does finally pay out, the bulk of the UK tax will already be covered by the large credit sitting in the online account with HMRC that has built up over the life of the fund. The credit is the UK tax payments made on an annual basis to frank the regular US tax payable in respect of the carry allocable to the taxpayer each year per the Schedule K-1 from the fund.
How we can help
We are very aware of the potential pitfalls of not considering the tax impact across both sides of the pond when being awarded carry. We can assist investment managers with their US/UK tax compliance and advisory needs throughout the duration of the holding period. This will comprise of ensuring correct elections are made when the carry is awarded, mitigating double-tax and, lastly, ensuring that the global tax position is optimised when the carry eventually pays out. Please get in touch with your usual Blick Rothenberg contact or one of the team using the details on this page to discuss your requirements.
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US/UK Private Client
Personal tax is one of the most complex areas of wealth management and can significantly erode your wealth over time.
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