The impact of non-domicile reform on US fund executives

In our prior article we discussed the impact of the proposed abolishment of the non-domiciled regime on US persons living in the UK. Our analysis of this topic can be found here. The general summary in that article was that, on what we know so far, US persons would not be as impacted as other nationalities and that the UK would remain an attractive location to be based.

Within the article we noted that certain taxpayers, specifically fund executives would, however, be affected more than others. The potential ramifications for fund executives have of course been heightened further by the recent election of a new Labour government. Whilst Labour has indicated its broad agreement with the abolition of the non-domicile regime as announced by the previous government, Labour also included a commitment in its manifesto to ‘close the carried interest loophole’. What this means in practice is not clear, but it seems likely that the rate of tax on carried interest will increase (even if the amount by which it increases is unknown at present). Such an increase is only likely to exacerbate some of the issues facing US fund executives in the UK and which are discussed below.

The focus of this article will be on the tax treatment of carried interest (carry) and specifically carried interest which qualifies for capital gain tax rates in both the US and UK. We will not be discussing income-based carried interest in this article.

For carry which qualifies for capital gains tax treatment, the remittance basis as it currently stands may provide significant benefits to recipients.

The main issue that US fund executives receiving carry face is the disparity in the timing of when carry is taxed in the US and UK. Typically speaking, the US will look to tax carry at an earlier point that the UK. Carry is treated as taxable to US individuals once valuations indicate that any hurdle has been reached whereas in the UK, the carry will be taxable when the individual receives a benefit (normally only once investors have received back their capital and any preferred return).

A typical carry structure may not see a significant distribution of funds to carry holders until a number of years after the carry is allocated to an individual under US rules. This timing difference between allocation and distribution makes it incredibly difficult for US taxpayers in the UK to manage their foreign tax credits and avoid double taxation.

When claiming a credit for foreign taxes on their US tax return, most US taxpayers will be reporting the foreign taxes paid during the calendar year. However, if the carry is not taxable in the UK until a later US tax year there would not be a credit to report on the US tax return in the year that the carry is taxable for US purposes. This, therefore, provides for the very real possibility of double taxation.

A taxpayer can look to prepay their UK taxes such that the income and corresponding credit is aligned in the US. This, however, is not a risk-free strategy as the IRS may look to disallow the credit.

This is on the basis that in order for a foreign tax to be qualifying as a credit in the US, the taxes paid must represent the legal and actual foreign tax liability paid in the year (other conditions must also be met but not relevant for this discussion).

Given that the UK liability will not be determined until some point in the future, i.e., it is not final at the time of the payment, payment could be said to represent a voluntary payment to HMRC. If a payment were to be classified as voluntary, it would not be creditable and rejected by the IRS. A taxpayer would then be exposed to double taxation.

It is also important to ensure that the carry gain is subject to an effective rate of overseas tax in excess of 10%. Absent this, the gain would be deemed to be US sourced and thus the tax due could not be offset by foreign tax credits. Since January 2022, the UK will not allow a credit for the US taxes paid on the UK portion of the gain and thus the taxpayer is subject to double tax.

One way to mitigate against the 10% requirement is to make sufficient distributions from the fund to crystalise an effective 10% tax rate in the UK. It is common practice for funds with US carried interest holders to make tax distributions, thereby ensuring that the fund executive has sufficient liquidity to settle any taxes due on carry allocated to them. This also has the advantage of possibly advancing the UK tax point on a portion of the carried interest and thereby reducing the timing mismatch discussed above and as a result, also reducing the exposure to double taxation. As tax distributions generally do not exceed 40% of the carry allocated under US rules, this at best will only provide a partial alignment.

Prepaying significant funds to HMRC far in advance of the actual due date of the liability is still often implemented but this represents a major cash flow disadvantage, albeit this is still preferable to facing a double tax charge. Prepaying is far from ideal, not just given the opportunity cost forgone in potential investment returns but also due to the uncertainty whether the IRS would accept that a pre-payment of US tax was creditable in any case.????????

It should be noted the issue of the US and UK taxing carried interest at different points, and how one manages relevant foreign tax credits is not a new one, but it will certainly be exacerbated as a result of the proposed abolishment of the non-domiciled regime.

Current rules

Under current rules fund executives eligible for the remittance basis can look to reduce their exposure to double taxation by excluding the foreign portion of their carry from UK taxation (subject to meeting certain conditions). This ability potentially lasting for up to 15 years. However, under the new proposals this will no longer be an option once the four-year window for excluding foreign income and gains from UK tax closes. As such, US individuals in receipt of carried interest will after four years of UK residency have significantly greater exposure to, and risk of, double taxation on carried interest.

It is also worth noting that even ignoring the timing difference referenced above US executives often faced having a significantly higher rate of tax on carried interest that citizens of other countries. This arose from the imposition by the US of the 3.8% Net Investment Income Tax (NIIT) which is imposed on top of any regular income tax/capital gains tax. Where carried interest was fully taxable in the UK, a non-US person might face an overall tax charge of 28%, but a US person would often face a charge of 31.8%. The remittance basis both helped to reduce the effective tax rate closer to that prevailing in the US (generally 23.8% with NIIT) whilst also helping alleviate the double tax risk arising from the US and UK, taxing carry at different points.?

Effective for tax returns for years ending 5 April 2023 and onwards there is the possibility to make an election in the UK (s103KFA TCGA) that would potentially enable a partial alignment of US and UK taxing points to mitigate the timing issue identified. Whilst this may appear to be beneficial as a means to avoid double taxation, the election has, in our experience, been little utilised to date as the rules around this are very prescriptive and can introduce their own complexities.

For example, the calculations need to be made based on a UK tax year basis, using US K1 reporting is not permitted whilst the calculations required are too complex to be undertaken by the taxpayer (or even their advisors) and can only be undertaken by the fund. Even if the information was available to enable such an election the taxpayer would still need to track and tax their actual carry distributions and then claim a credit in the UK for the tax which has been prepaid. The prescriptive nature of the calculation methodology and the need to track and claim future tax relief has made this option unattractive.?

Prospective new rules

The abolition of the non-domicile regime is likely to increase the double tax risk and the more general exposure by US persons to higher rate

s of tax on carry. Of course, any further increase in the rate of tax imposed on carried interest (as suggested in Labour’s manifesto) will just increase the cost of these issues further - potentially to such an extent that the UK may no longer is seen as a practical location to be based.?

The abolition of the non-domicile regime will, as discussed in our prior article, be expected to have less impact on US persons than others as a) US persons are subject to tax on worldwide income in any case and b) US persons often did not claim the remittance basis beyond seven years. US fund executives are very different from the general population as i) the tax rate differential on carried interest was often significant i.e. up to 8% (and could increase further under Labour proposals), ii) there was a double tax risk and iii) generally US fund executives claimed the remittance basis for the full 15 years. For these reasons US fund executives are likely to be more sensitive to changes.

The abolition of the non-domicile regime, especially alongside potential future tax increases on carried interest, could significantly raise the effective tax rate and increase the risk of double taxation for US carried interest holders. Whilst it is likely the election under s103KFA will become more attractive, the effective rate of tax incurred on carry will undoubtedly increase as a result of these changes as will the complexity in both managing US/UK interaction and applying any elections. It remains to be seen whether the significant increase in taxes on carried interest and the additional increase in complexity will cause US fund executives to leave the UK.

Author:

Thomas Gaughan, Senior Manager, EY Private Client Services

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