The Complexities of Carried Interest: Aligning UK and US Tax Obligations
For investment managers and private equity professionals operating in both the UK and the US, the taxation of carried interest can be a daunting and complex issue. The misalignment between the two countries’ tax regimes and reporting requirements often leads to inaccuracies and potential double taxation. In this article, we will delve into the key differences and recent developments that affect how carried interest is taxed in both jurisdictions.
Taxation of Carried Interest: UK vs US
In the UK, carried interest is generally treated as income and is subject to income tax rates. However, the UK has introduced specific rules to manage this type of income. Since April 2022, an elective accruals basis has been available, allowing investment managers to align their UK tax liabilities with their US tax treatment. This election enables managers to accelerate the tax point on carried interest, mirroring the US accrual basis and potentially avoiding timing mismatches.
In contrast, the US treats carried interest differently. For US tax purposes, carried interest is often reported on a Schedule K-1 on an accrued basis, even if the distribution is delayed. This can result in US taxpayers being taxed on the carry before it is actually received, which can create discrepancies when reporting to HMRC.
Double Taxation and Credit Issues
One of the significant challenges is the risk of double taxation. US citizens and green card holders resident in the UK are subject to both UK and US tax regimes. The UK typically has the first taxing right under the US-UK double tax treaty, with the US granting credit for UK taxes paid. However, differences in how entities are classified and how income is sourced can lead to mismatches that reduce or eliminate the availability of these credits.
For instance, if an entity is treated as a partnership for US tax purposes but as a corporation for UK tax purposes, this classification mismatch can complicate the application of double tax relief. Similarly, if carried interest is treated as capital gains in the US, taxed at a lower rate of up to 20 percent, but as income in the UK, taxed at higher income tax rates, it can lead to significant tax liabilities and reduced credit opportunities.
Recent Developments and HMRC’s Stance
HMRC has recently changed its stance on allowing credits for taxes paid in other jurisdictions. Historically, HMRC accepted that tax paid anywhere in the world could be credited against the UK carried interest regime charge. However, this view has been revised, and HMRC now generally only allows credits for previous years but not for future years. This change has created significant issues for taxpayers who had relied on this previous interpretation.
The Elective Accruals Basis: A Solution
To mitigate some of these issues, the UK introduced the elective accruals basis from 6 April 2022. This option allows investment managers to align their UK tax treatment with the US accrual basis, effectively accelerating the tax point on carried interest. Once made, this election is irrevocable and must be applied consistently to the specified fund. The total tax charged under this election is credited against the final UK tax liability when the carried interest arises.
This election requires an annual calculation for each elected fund and must be completed internally. While it helps in aligning the tax treatment, it does not provide a benefit if UK tax rates are lower at the time of the initial election compared to when the carry is actually received.
Practical Considerations
Given the complexities and recent changes, it is crucial for investment managers to carefully structure their investments and reporting. Here are some practical steps to consider.
Consult tax advisers. Ensure that you are working with tax advisers who are well-versed in both UK and US tax laws to avoid mismatches and optimise your tax position.
Elective accruals basis. Consider making the elective accruals basis election to align your UK and US tax liabilities, but be aware of the irrevocable nature of this choice.
Annual calculations. If you opt for the elective accruals basis, ensure that the necessary annual calculations are completed accurately and on time.
Double tax treaty. Understand the implications of the US-UK double tax treaty and how it applies to your specific situation to maximise available credits.
Conclusion
The taxation of carried interest is a multifaceted issue that requires careful attention to detail and a deep understanding of both UK and US tax regimes. The misalignment between these regimes can lead to significant tax liabilities and administrative burdens. By understanding the recent developments, such as the elective accruals basis, and taking proactive steps to align your tax treatment, you can better manage your tax obligations and avoid the pitfalls of double taxation.
At Cutts and Co Accountancy, we specialise in helping our clients navigate the complexities of international taxation. If you are an investment manager or private equity professional facing challenges with carried interest taxation, we are here to provide expert guidance and support to ensure you comply with all tax requirements while optimising your tax position.
