On March 15, Chancellor Jeremy Hunt introduced the UK's Spring Finance Bill 2023 (hereinafter the "Budget").
One of the proposed Budget measures offers welcome tax relief to US citizen private equity fund principals residing in the UK. This measure should help reduce the risk that a dual US/UK fund principal is "double taxed" on his or her carried interest.
By way of background, a UK tax resident who also holds US citizenship is generally treated as a tax resident of both jurisdictions and is hence subject to tax in each country on his or her worldwide income and gains. For such an individual, the only real avenue for alleviating double taxation is to rely on the "foreign tax credit" systems of each respective jurisdiction, as coordinated through Article 24 of the US-UK Double Tax Treaty.
At a very high level, the foreign tax credit rules function more effectively when the tax accounting systems of each country agree on the timing of the relevant tax event. Conversely, foreign tax credits are more likely to go badly awry when the two jurisdictions disagree about exactly when the relevant taxable event has occurred to an affected individual.
This issue has caused concern in recent years for many dual US/UK PE principals holding direct or indirect carried interests in the underlying fund. A carried interest in a fund partnership typically entitles its holder to a share of fund profits per a waterfall allocation that is set forth in the fund's limited partnership agreement. The carried interest entitlement generally does not kick in until the fund's realised book earnings have surpassed a defined threshold. For US federal tax accounting purposes, a PE fund principal is very generally (and with certain exceptions and caveats beyond the scope of this alert) subject to US federal income tax during the year in which the carried interest hurdle has been surpassed from a book perspective—typically when a portfolio company exit has closed (an "accrual basis" approach"). In the UK, by contrast, an individual is, broadly speaking, not subject to tax unless and until he receives an actual distribution of cash (a "cash basis" approach). These tensions have the potential to create irresolvable double tax problems, particularly when the fund partnership recycles some or all of the cash it receives from a portfolio company exit. In the worst case, these incongruities could result in a more than 50% all-in effective tax rate on portfolio exit profits for dual US/UK carried interest holders.
While HMRC has provided some ad hoc relief to affected individuals, on the whole the situation has been unsatisfactory and fraught with risk.
The Budget measure would address this problem by permitting UK taxpayers to elect accrual basis taxation in the UK on carried interest entitlements. Once made, the election would be irrevocable. The election would have the effect of potentially accelerating the affected individual's UK tax liability on carried interest profits going forward to an earlier tax year than would have been the case absent the election. While most UK-resident fund principals would have no reason to make such an election, from a technical foreign tax credit perspective a dual US/UK taxpayer will be highly incentivized to trigger an "early" UK tax charge on his or her carried interest profits and ensure that the US and UK tax events occur within the same taxable year, ie the year the exit gain accrues at the fund partnership level.
The measure will be effective when the Spring Finance Bill 2023 is given Royal Assent. Once enacted into law, it will apply on a retrospective basis back to the 2022 UK tax year.
The measure makes significant strides toward solving the double tax problem for dual US/UK carried interest holders. It also represents a welcome concession on the part of the UK government that the current problem is attributable to a defect in the technical rules and does not have any basis in sound tax policy.
Withers LLP has a unique expertise in navigating the tax challenges and optimization problems faced by dual US/UK individuals.
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