Collision of offshore trusts holding carried interest is 'full of misunderstandings'
The taxation of non-domiciled individuals and offshore trusts is a deeply complex area that is traditionally the preserve of private client advisers, says Chris Moorcroft, partner at law firm Harbottle & Lewis.
Of equal complexity is the topic of private equity tax, which incorporates the Disguised Investment Management Fund (DIMF) rules and is the preserve of an equally specialist (but usually separate) set of private equity tax experts.
Where the two areas interact, such as in the case of offshore trusts which hold carried interest rights, misunderstandings pervade.
This article attempts to examine this interaction and debunk a popular myth: that offshore trusts are now almost always inappropriate for holding carried interest - usually resting on the logic that a trust is effectively ‘transparent' when payments of carried interest are made to trustees. This oversimplifies a complex debate.
Background
Prior to the introduction of the DIMF rules, on 8 July 2015, it was common to see UK resident, non-domiciled private equity executives use offshore trusts to hold carried interest. Payments of carry tended to arise from non-UK limited partnerships and give rise to non-UK capital gains, making the interests appropriate for remittance basis taxpayers (more commonly known as res non-doms) to settle into offshore trusts.
However, the DIMF legislation dealt a serious blow to the tax efficiency of such structures by deeming that carried interest ‘arises' to - and is taxable on - a UK resident fund manager regardless of who owns the carried interest right. This means that £100 paid to an offshore trustee holding the right to carried interest will typically produce a personal tax bill for the fund manager, at a special Capital Gains Tax (CGT) rate of 28%, and so probably of £28 (but subject to some ability to use the remittance basis, which topic is an article to itself). This is generally known as a ‘dry' tax charge because the fund manager is liable to tax despite not having received funds personally with which to pay the tax. The same £28 tax bill would typically have arisen if the carried interest had been held by the fund manager personally.
As a consequence an assumption has taken hold in some quarters: that there is no longer any benefit to holding carried interest in offshore trusts, and further, that doing so will make the tax position worse.
In some cases, on an objective analysis of the client's circumstances, that assumption may be correct - it may indeed be the case that the carried interest should be held other than in an offshore trust, with straightforward personal ownership often being the best alternative. However, the decision is rarely straightforward and there can be several good reasons for continuing to use trusts for carry, some of which are set out below.
The ‘asset like any other' myth
One of the biggest misconceptions is that carried interest is an asset like any other - a house or a car - that can be passed on like any other. This is dangerous. Carried interest is almost always an interest in a partnership, which may be based in the Channel Islands, Delaware, Cayman or many others.
The consequences of a death of a partner on that person's partnership interest will depend entirely on what the fund documents say about what happens on the death of a partner, which will vary from fund to fund. Common practice will vary even more between jurisdictions.
It can be extremely dangerous to assume that the carried interest right is akin to any other ‘asset', and that the value of the interest will be ring-fenced and protected in full upon death. Holding the interest in trust sidesteps this problem.
UK inheritance tax and post-death payments of carry
Whilst the imposition of a trust might on one level seem tax neutral from a UK tax perspective (because of the ‘arises' rule described above), the reality is that this perceived tax neutrality is in fact based on one relatively narrow scenario: when sums of carry are paid out and either (i) taxed on the fund manager (if held personally), or (ii) deemed to ‘arise' to the fund manager and taxed on them in any event (if held by the trust).
For many other tax purposes the trust is far from neutral. Take for example the very frequent case of resident non-domiciled individuals who have become deemed domiciled by virtue of being UK resident for 15 years or more. Upon their death (assuming they were still UK resident and deemed domiciled at death) their worldwide estate (including the remaining value of the carried interest plus any carry proceeds that have been paid to them) will be subject to UK inheritance tax at 40%.
In contrast, carried interest rights and sums representing carry proceeds will, if held in an appropriately structured offshore trust, fall outside their estate for inheritance tax purposes notwithstanding the fund manager's personal UK tax position.