Meaning of Carried Interest

Carried interest is essentially a share of the profits from an investment fund that is paid to the fund managers. Unlike a fixed fee, its value depends directly on the fund's performance. This type of payment is considered carried interest if it is a profit-related return and meets a specific "no significant risk" condition.

A payment is considered a profit-related return if three conditions are met: (1) it only arises when the fund makes profits over the relevant period or investments; (2) the amount varies substantially in line with those profits rather than being fixed; and (3) it is based on the same profits used to determine returns for external investors, not a separate manager-only pool.

In addition to these three conditions, the arrangements must also pass a "no significant risk" test. This test assesses the likelihood that the payment will actually be made. Its purpose is to ensure that any fixed or guaranteed performance fees are appropriately charged to income tax, rather than being treated as carried interest.

For fund managers and their advisers, these criteria are central to determining tax treatment. Carried interest will generally be treated as such where it is dependent on fund profits, varies materially with those profits, and is calculated by reference to the same profit pool as external investors, provided the “no significant risk” condition is also met. Where these tests are satisfied, the return is brought within the carried interest tax rules, with corresponding implications for how and when it is taxed.