Taxation of carried interests: transitional rules

The FTT has held that carried interest profits arising and paid after 8 July 2015 were taxable pursuant to TCGA 1992 s.103KA even though those profits were attributable largely to the sale of fund assets made before that time: Ferguson-Davie and Edwards v HMRC [2024] UKFTT 321. The grandfathering provisions introduced only applied where the carried interest arose on disposals prior to 8 July 2015 and it was not sufficient for those profits to be simply attributable to disposals of assets prior to that date.

Background

The case concerns the profits of funds formed as limited partnerships invested in a number of property investments. Pursuant to the limited partnership agreements relevant to the funds, the net income and gains of the funds were required to be allocated to the partners in the following order of priority:

• Firstly, to the limited partners until a 9% per annum return on their loan and capital contributions had been met
• Second, 40% to limited partners and 60% to CIP, until 20% of all allocated profit had been allocated to the CIP
• Thirdly, 80% to limited partners and 20% to the CIP.

CIP was itself a limited partnership whose members were individuals employed by the group of investment management companies which managed the funds.

All of the property investments in the fund were realised prior to 8 July 2015 with the exception of Audley Court. Audley Court was the largest investment of the fund, amounting to some £161m with the next largest only £66m. The Audley Court investment was disposed of in December 2015. This disposal resulted in the allocation of carried interest profits to CIP as the 9% return threshold was met at that point.

Prior to 8 July 2015, private equity partnerships were subject to the ordinary CGT rules applying to partnerships and at the point the profit hurdle was met and the entitlement to carried interest arose, each investor was treated as disposing of part of its share in the partnership and as transferring part of its base cost in the partnership assets to the carried interest holders (base cost shift). Finance (No 2) Act 2015 introduced a new regime for the taxation of carried interest profits from that date (in TCGA 1992 s.103KA) and, in particular, removed the availability of base cost shift. These rules were however subject to transitional rules which grandfathered carried interest arising in connection with the disposal of an asset prior to 8 July 2015.

HMRC contended that the carried interest profits of the appellants were subject to tax pursuant to s.103KA on the basis that the carried interest had arisen and been paid on or after 8 July 2015. However, the appellants argued that the transitional provisions introduced took the carried interest outside the scope of the new rules. These provided that the new rules “have effect in relation to carried interest arising on or after 8 July 2015 under any arrangements unless the carried interest arises in connection with the disposal of an asset or assets of a partnership before that date”.

In particular, the appellants pointed out that the sale of Audley Court was actually made at a loss and that the profits of the fund in fact arose entirely from the disposal of the earlier assets of the fund (even though the necessary return to meet the carried interest conditions was not realised until Audley Court was sold).

FTT decision

The FTT has rejected the appellants’ arguments. The FTT concluded that the carried interest “arose in connection” with the disposal of the Audley Court investment which took place after 8 July 2015 such that the grandfathering provision did not apply.

The words “in connection with” must be interpreted in line with the wording that surrounds them. Considering the purpose of the transitional rule, this was to provide an exception for a substantial change in the way carried interest was taxed which took effect from the date of the announcement. That announcement was designed to prevent forestalling and bring into effect a “fairer” system of taxing carried interest profits immediately. As such, it was clear that the intention of Parliament was that the grandfathering provisions should be narrowly circumscribed. The core concept in the grandfathering rule is the “arising” of the carried interest in connection with one or more disposals. The FTT considered that this rule was not addressing the profits to which the carried interest relates, but the carried interest itself.

The appellants objected that this rendered the grandfathering rule essentially nonsensical. It effectively meant that the new regime applied to carried interest arising on or after 8 July 2015. However, the FTT considered that the grandfathering rule would apply where, for example, the carried interest arose before that date but could only be paid after 8 July 2015 due to partnership rules.

For the purpose of the rules, the important disposal was the one that triggered the entitlement to carried interest rather than the disposals that generated the underlying profits for that return.

HMRC also argued, in the alternative, that the grandfathering provisions did not apply at all. These provisions only applied to s.103KA(2) dealing with carried interests arising in connection with a disposal of assets and not to s.103K(3) dealing with carried interests arising in other circumstances. In particular, HMRC pointed out that the investment in Audley Court was held as a QCB and such gains fall outside the scope of CGT (TCGA 1992 s.115). However, the FTT rejected that argument. Whilst s.115 prevents a chargeable gain arising on a disposal of a QCB, it did not mean that a QCB was not an asset for the purposes of CGT, such that s.103KA(2) applied to its disposal.

Comment

The FTT has adopted a purposive construction of the provisions based on the perceived intentions of Parliament. This allowed the FTT to apply a narrow construction to the wording “in connection with”, which, in other circumstances, would normally attract a wide ambit.