US and UK tax on carried interest
16 Apr 2024 •
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There is a mismatch in the US and UK taxation on receipt of carried interest from a partnership. This area is complex, but with strategic planning, there may be opportunities to minimise double taxation for dual US/UK taxpayers.
US and UK tax treatment
The US and UK tax treatment of receipt of carried interest (carry) from a partnership is complicated by the fact that there are different tax points, tax rates and payment deadlines. The following table is a useful overview of the difference in US and UK tax treatment:
| US Federal tax | UK tax |
Tax point | The partnership should provide a schedule K-1 by 15 September following the year end, which will detail the carry allocable to the partner for that tax year. The tax point is when it is accrued rather than distributed to the taxpayer. | The partnership should provide information by 31 January following the end of the tax year detailing the partner’s beneficial entitlement to the carry. The tax point is usually when it is distributed. |
Tax rate |
Dependent on the length of the holding period of the asset held within the fund.
If held for less than 36 months, carry is treated as short-term gains and taxed as ordinary income (up to 37% plus 3.8% NIIT).
If more than 36 months, the carry is subject to preferential long-term Capital Gains Tax (CGT) rate (20% plus 3.8% Net Investment Income Tax (NIIT)).
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Dependent on weighted average holding period of the fund’s investments.
If less than 36 months, 100% of the carry is treated as income-based and it is subjected to Income Tax rates (up to 45% plus National Insurance Contributions).
Between 36 months and 40 months, there is a 20% decrease in the proportion subject to Income Tax rates for each month passed with the remaining % subject to CGT rates (up to 28%) if capital in nature.
If more than 40 months, 100% of the carry may be subject to CGT rates if capital in nature.
|
Payment of tax due | Balancing payment due 15 April following the end of the calendar year. | Balancing payment due 31 January following the end of the tax year (see below regarding a recommendation of a pre-payment of UK tax in the same year carry is reported). |
Minimising double taxation for dual US/ UK taxpayers
For a US taxpayer living in the UK, you are at risk of double taxation. For US tax purposes, a US taxpayer will receive a schedule K-1 from the partnership which reports the carry on an accrued basis. If the partnership delays the distribution of carry to its members, the UK tax point will be shifted as a result.
Due to the difference in timings and missed foreign tax credit opportunities, HMRC recognised the burden to US taxpayers and introduced an election to allow investment managers to align their US and UK tax liabilities to obtain double tax relief.
The elective accruals basis came into place from 6 April 2022. This option enables investment managers to carry out a calculation, which will allow you to mirror the US tax treatment and effectively accelerate the tax point. However, once made, the election is irrevocable. The election must be made in writing to HMRC stating the first tax year the election will take effect and to which fund it applies to. The total tax charged under the election is credited against the final UK tax liability when the carried interest arises. The carry is taxed at the prevailing UK tax rates; you do not benefit if the UK tax rates are lower than when you first enter into the fund. The additional calculation for each elected fund will need to be completed on an annual basis and be completed internally.
If you’re a US taxpayer on the ‘paid’ basis for foreign tax credits, we recommend you make a prepayment of UK tax to HMRC by 31 December of the year carry is reported. The UK tax is claimed as a foreign tax credit against the US tax liability - the credit will not offset US NIIT. Timing of the payment is key here, as the IRS will only allow you to carry back foreign tax credits one year i.e. UK tax paid in 2024 can be utilised in 2024 with excess carried back only one year to 2023. The UK tax would sit on your HMRC self-assessment account to offset the eventual liability.
The above tax treatment is in relation to partnerships, if you have interests in a US Limited Liability Companies (LLC), there is a different tax treatment.
Non-domiciled taxpayers
All UK resident non-domiciled individuals have a choice as to whether they are taxed on the arising basis or remittance basis. Arising basis means that you would be taxed on your worldwide income and gains in the UK. On the remittance basis of taxation, you would not be subject to UK tax in respect of your non-UK sourced carry if it is not remitted to the UK. There may be a separate tax charge of either £30,000 or £60,000, this is dependent on the number of years you have been resident in the UK.
A portion of carry will be deemed to be UK sourced to the extent that investment management services have been performed in the UK. This is usually based on an apportionment of UK and non-UK working days in the relevant period. To maximise relief, you need to ensure that you have the correct offshore bank account structure in place. This will help to reduce the risk of double taxation if later down the line, you decide you would like the funds in the UK.
The Spring Budget 2024 has set out changes to the non-domicile regime which will come into effect from 6 April 2025. Both the Labour party and the Conservative party have indicated changes to the taxation of carried interest and we will update this insight when policies have been confirmed.
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