Overseas workday relief – fund manager carried interest
This is the final piece of a three part series on Overseas Workday Relief (OWR). You can read the first piece discussing OWR on employee earnings here, and the second piece on stock/share options and restricted stock units here.
In this article, we discuss the rather complex matter of carried interest and when OWR can be utilised by those in receipt of carried interest in order to exempt a portion or even all of the non-UK earnings.
Overseas workday relief for carried interest
The concept of overseas workday relief is also applicable in another very different area, in the context of fund manager taxation.
Please refer to our earlier article providing an overview of rules introduced in 2015 to ensure that individual fund managers are taxed on their share of management fees and carried interest, irrespective of the manner in which it is delivered to them.
To soften the blow, the rules allow non-domiciled remittance basis users to treat the carried interest as foreign (and therefore taxed only if remitted), ‘to the extent that the individual performs the [investment management] services… outside the UK’.
The individual needs to satisfy certain criteria to treat part of the carried interest as foreign. Clearly a prerequisite is that they are non-domiciled and claim the remittance basis.
In addition the payment must meet the definition of ‘carried interest’, i.e:
(i) the structure must be of a standard private equity European waterfall model, whereby investors receive a 6% preferred return and return of capital before carry becomes payable; or
(ii) there was a significant risk when the carried interest was granted to the individual that no sums would subsequently arise to the individual.
Quantifying the ‘foreign’ carried interest
A key question is how the ‘foreign’ part of the payment is determined. The legislation is not prescriptive on this, and it is suggested by HMRC that the calculation should be performed on a just and reasonable basis, taking account of the facts and circumstances of each case. As such, a conservative approach (and probably the most common) is to calculate the offshore portion by performing a straight line pro-rating of the payment between UK and non-UK workdays over the relevant service period, which (for waterfall carry) would typically be the date the individual started working for the fund until the date of payment.
Alternatively the foreign part of the carry can be determined by performing an analysis of the services provided by the individual for the fund in each location, giving greater weighting to higher value functions (decision making, capital raising, sourcing investments etc). This approach requires a functional analysis model to enable each individual to track what they were doing, on each day, and in each location. There is clearly a trade off in this approach between the additional administrative burden, and the potential tax savings if individuals perform higher value functions whilst outside the UK.
For individuals who have been working for a fund for many years before moving to the UK and no longer provide services to that particular fund, there may be a reporting position that all carried interest payments qualify as ‘foreign’ for these purposes.
HMRC have suggested that carried interest should not be treated as ‘foreign’ where it relates to work undertaken in a low or no tax jurisdiction. However there is no basis for this suggestion in the legislation.
It goes without saying that whatever approach is taken, it should be adopted on a consistent basis year-on-year, ideally by all executives working for the particular fund manager. Furthermore, HMRC require appropriate records to be maintained to justify the calculation of the ‘foreign’ carried interest, although seem to be accepting of the fact that individuals may have only limited records for periods before the rules were introduced in July 2015.
Bank account segregation
It is critical to ensure that the ‘foreign’ part of the carry is segregated in a separate offshore bank account if the individual wishes to be able to remit the ‘UK’ portion of the carry. If the carry is paid into a single mixed account then any remittances will be deemed to derive first from the foreign carry, triggering a taxable remittance. It will be impossible to access the UK carry (which has already been taxed) until all of the foreign carry has been remitted.
The UK and foreign portions of the carried interest should therefore be paid into separate bank accounts of the individual to avoid commingling, and the individual should only remit from the UK account.
Note that even a remittance of UK carry can result in further tax being payable. This is because the standard tax rate of 28% for remittance basis individuals on (non-IBCI) carried interest is displaced if the amount is remitted and has the character of income (e.g. is a dividend or interest payment).
Further challenges can arise where the carried interest is received by an offshore trust, which are not discussed here.
Comparison with OWR for employment earnings
A fundamental difference to OWR for carried interest compared to employment income, is that the relief is available throughout the period the individual remains eligible for the remittance basis i.e. potentially up to 15 years, rather than the three years permitted for general earnings described above.
Income based carried interest (‘IBCI’)
The general rules discussed above do not apply if the carried interest meets the definition of ‘income based carried interest’ (IBCI). A payment is IBCI, broadly, if the investments giving rise to the payment have a weighted average holding period of less than 40 months, subject to various exceptions (NB – the IBCI rules apply only to sums arising from 6th April 2016).
IBCI is taxable at 47% instead of the standard 28% rate for regular (unremitted) carried interest.
A different, more limited form, of OWR is available to individuals in receipt of IBCI in respect of ‘pre-arrival services’, where they arrive in the UK having been non-resident for the previous five years. Such an individual is allowed to treat carry relating to pre-arrival services as foreign, for the first five years of UK residency.
We have started to see an increasing number of enquiries by HMRC into tax returns of fund managers. It is very important that the UK and overseas days are carefully tracked and documented. If HMRC audits the tax returns, they will need to provide proof that each day claimed is in fact a regular day or workday carried out in the UK or overseas. They should keep careful records of all flight details and boarding passes to provide proof of where they were, as well as accurate calendars to evidence how much time they were working on each day in each location. Even small changes from an audit can result in a lot of additional UK tax owed and potentially heavy penalties. We expect audit activity to continue as the interpretation of the rules evolves, particularly when HMRC’s guidance on carried interest is released in due course.