UK: The BVCA Agrees With the Inland Revenue That Carried Interests are to Remain Exempt From Income Tax

There has recently been considerable concern within the venture capital and private equity industries that new provisions relating to "employment related restricted securities" introduced by Finance Act 2003 with effect from 16 April this year will result in fund managers participating in a limited partnership suffering a 40% income tax charge when they acquire a carried interest in the limited partnership assets. However, the BVCA has now scored a considerable achievement by reaching a "Memorandum of Understanding" with the Inland Revenue which effectively provides that in most cases carried interests will continue to be free of income tax.

Prior to the introduction of the new regime in Finance Act 2003, under guidelines issued by the BVCA in 1987 and approved by the Inland Revenue, a fund manager was not regarded as acquiring his carried interest by reason of his employment provided simply that he received a full arm’s length remuneration for the services he provided. This was sufficient to ensure that he avoided any income tax charge in respect of his carried interest.

Matters are not quite that straightforward any more. Under the new regime, an income tax charge is imposed whenever "employment related restricted securities" are disposed of or the restrictions attaching to them are varied (or, if an appropriate election is made, on a one-off basis when the securities are acquired).

A carried interest in a limited partnership held by a fund manager constitutes a unit in a collective investment scheme which falls within the definition of a "security" for these purposes. These securities will automatically be "employment related securities", since this term is extremely wide-ranging, covering any securities if the right to acquire them is made available by the holder’s employer or a person connected with that employer. Furthermore, the "securities" will invariably have restrictions attached to them in this context and will therefore be "employment related restricted securities". Carried interests therefore fall within the ambit of the new regime.

The way in which the BVCA’s "Memorandum of Understanding" operates to ensure that fund managers nevertheless do not incur an income tax charge is as follows. As stated earlier, assuming an appropriate election is made, there will be a one-off income tax charge on the acquisition of the carried interest. This charge is calculated as equal to the "initial unrestricted market value" (the "IUMV") of the carried interest less the price actually paid for it. It follows that if the price paid equals the IUMV, no income tax charge will in practice arise. What the Memorandum in essence does is to provide that the price paid will be taken as equal to the IUMV provided that certain conditions are satisfied as follows.

• the fund must be structured as described in the Memorandum – there is a large amount of detail in the Memorandum which is not reproduced here. The key point to note, however, is that while the detailed requirements will need to be examined in every case, most funds should qualify;

• the carried interest holder must pay the same per unit of capital for his partnership interest as the investors (eg, if the investors pay £10,000 in return for 80% of the aggregate partnership capital, the carried interest holders must pay £2,500 to acquire the remaining 20%);

• the only restrictions applying to the carried interest can be leaver, vesting and general transfer restrictions; and

• negotiations between investors and fund managers (including the carried interest holders) must be at arm’s length (or the terms agreed must be those which would have been agreed between unconnected third parties).

The discussion above assumes that the carried interest was acquired on "Day 1" before the fund makes any investments. In the relatively unusual case that an incoming manager acquires a carried interest after the fund has closed, then IUMV will only be taken as equal to the price paid if it can be demonstrated that the total value of the fund’s investments at that time is not greater than their total acquisition cost. If this is not the case, then an income tax charge will arise for the new carried interest holder.

Similarly, if an existing carried interest is transferred by its holder to the other carried interest holders, a tax charge may also arise since the IUMV of this carried interest will not inevitably be the amount paid for it, but will instead need to be determined at the time.

The Memorandum provides that when the fund partnership acquires securities, the carried interest holders will not themselves be regarded as acquiring an interest in those securities as far as the "employment related securities" provisions are concerned. There is therefore no prospect of an income tax charge arising on the carried interest holders in relation to any underlying securities acquired by the partnership.

The new regime only applies from 16 April 2003. The Memorandum specifically provides that, if a manager has acquired a carried interest before that date, it will not be regarded as an "employment related security", and therefore the provisions discussed above will not apply to them (although he will be able to rely on the assurance in the Memorandum that underlying securities subsequently acquired by the fund partnership will not be treated as an acquisition of a new security by him).

In order to obtain the beneficial treatment described in the Memorandum, it will be necessary for a joint election to be made by the employer and the fund manager (or someone appointed to do so on his behalf pursuant to a power of attorney). The time limit for making an election is 14 days after the acquisition of the carried interest or, for carried interests acquired before the "appointed day" (which is scheduled to be not earlier than 18 August 2003), 14 days thereafter (ie, 2 September 2003 at the earliest).

The BVCA has also agreed a second ‘Memorandum of Understanding’ with the Inland Revenue. This operates in a similar manner to the one dealing with carried interests in order to ensure that shares acquired by managers in the company in which a venture capital or private equity provider invests will not attract an income tax charge provided certain detailed conditions are satisfied. One of the key conditions is that managers pay the same for their shares as the venture capital investor. Often this is not the case, and therefore the safe harbour negotiated may be of less practical value in this area.

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