What is carried interest?

Asides from annual salary or profit share from the management entity, investment managers in the private equity, venture capital and hedge fund arenas can be remunerated in the form of carried interest (carry).

Carry is typically received as cash distributions but may also be in the form of shares (distributions-in-specie).

If the fund performs well enough to breach the hurdle rate (the preferred rate of return, which is typically 8-10%), then a portion of the excess profits are allocated to the investment managers as carry. Typically, this is split 20% to the investment managers and 80% to the limited partners, i.e., outside investors.

How is carried interest taxed across both sides of the pond?

Carry is taxed very differently in the US compared to the UK. As a result, ensuring the alignment of income and credits across the two jurisdictions requires specific expertise.

From a US tax standpoint, carry is taxed as it accrues, i.e., as it is allocable to the taxpayer rather than when it is actually distributed/paid to the taxpayer. Typically, individuals with US tax exposure will receive a Schedule K-1 on an annual basis from the fund, which tends to be a partnership. This will detail the income and gains allocable to the partner. Those income and gains are reported on the taxpayer’s Federal US Income Tax return. More often than not, there may also be State source income per the K-1 and therefore State Income Tax returns may be required. 

To the extent the carry is with respect to assets which have been held for at least 36 months, those gains will suffer US Federal tax at the preferential long-term capital gains rate of 20% together with 3.8% Net Investment Income Tax (NIIT). To the extent they have been held for less than 12 months they are treated as short-term gains and taxed as ordinary income at a rate of up to 37% plus 3.8% NIIT. Lastly, there is the concept of mid-term gains, specifically for carry, i.e., those gains for which the holding period falls within the 12- to 36-month timeframe per section 1061 of the Internal Revenue Code. These gains are also taxed as high as 37% plus 3.8% NIIT.

On the other hand, from a UK tax perspective, carry is taxed as and when the taxpayer receives beneficial entitlement, i.e., when it is distributed. This can be many years after the inception of the fund. This can create a complete mismatch in the taxing point of the carry across the US and UK for those individuals with exposure to tax in both jurisdictions.

For a UK resident taxpayer who is UK domiciled, deemed UK domicile or filing on the arising basis (subject to UK tax on their worldwide income and gains) as a non-domicile of the UK, the taxation of carry distributions is relatively straightforward. Carry comprising of capital gains is taxed at 28%, dividends at up to 39.35% and interest and trading profits at up to 45%. 

For UK resident taxpayers who are non-domiciled in the UK and elect to file their taxes on the remittance basis (subject to UK tax on UK source income and any remittances of overseas income/gains to the UK), there are special rules. ‘Non-Domiciled Remittance Basis’ taxpayers are only subject to UK tax on the portion of their carry which is considered UK source, provided the non-UK source portion remains overseas. The most common method of calculating the UK sourced portion is by allocating the distribution amount over the worldwide workdays performed by the taxpayer since they joined the fund in question through to the date of the carry distribution. If, for example, 80% of their workdays were performed in the UK, then only 80% of the distribution suffers UK Capital Gains Tax at 28%. If that UK source element of the carry is remitted to the UK and it pertains wholly to capital gains, then no further UK tax is due upon remittance. If, however, a portion of the remittance pertains to interest, dividends or trading profits, that portion will suffer an additional 17% tax (45% less 28%) assuming the individual is an additional rate taxpayer.

To ensure the segregation of the non-UK source element from the UK source element of a carry distribution, the structuring of a taxpayer’s overseas accounts in conjunction with an understanding of HMRC’s remittance ordering rules is imperative to optimise their effective global tax rate.