Changes to tax regimes, notably in the UK and US, are focusing attention on tax efficient remuneration structures and incentivisation structures for closed-ended fund managers and their teams, says Simon Burgess, head of Real Estate Fund Services – EMEA at State Street…
Carried interest, as the profit share paid to fund managers, aligns the interests of the fund promoter and investors. Typically, managers cannot take their profit share until the end of the fund’s lifecycle, and the amount of carried interest is significant only if the fund clears a high performance hurdle. The taxation of carried interest has been a key issue in the UK and the US in the past few years, with some debate as to whether it should be taxed as income or as a capital gain.
In the UK, carried interest is currently taxed as a capital gain because the government regards it as value creation. (The differential is significant — for higher earners, capital gains tax (CGT) currently stands at 28 percent, while income tax can be up to 50 percent.) Carried interest vehicles are often structured as limited partnerships in places such as Jersey and other offshore locations. For example, they can have a Jersey general partner (GP), or use special purpose vehicles (SPVs) to hold the carried interest.
In the US, a split taxation model exists whereby executives pay income tax on a portion of their carried interest in the area where they live and CGT (at a lower rate than income tax) on the carried interest where they work.
A new landscape
With increased leverage in the marketplace, investors are in a stronger position to insist that carried interest is paid at the end of the lifecycle of the fund rather than during it. However, carried interest vehicles, where fund managers can take out some of the profit periodically throughout the life of the fund, still exist. As capital values, particularly in real estate, vary dramatically, the timing of withdrawals is critical. One year the fund could do very well, resulting in high carried interest, but it could perform badly the following year — with the net effect of low returns for investors at the end of the lifecycle, and therefore lower CGT.
With the move toward more closely aligning manager and investor objectives, there has also been a shift in the structure of the fee payments to fund managers. It is now more common for the fee to be based on a percentage of the fund’s growth than on a percentage of the initial investment — as the fee that the manager receives during the life of the fund should be a fair reflection of the cost of providing services to the fund as fund manager.
The economy is a key driver of taxation changes, and while the post-crisis emphasis on transparency and accountability is driving taxation policy, the weak economic conditions have also significantly reduced the amount of carried interest payable through carried interest vehicles. Fund managers on both sides of the Atlantic have been concerned about the effect of new tax categorisation on their remuneration. While the changes so far have perhaps not been as harsh as fund managers were expecting, this area is likely to receive continued scrutiny from both legislators and investors.
