Carried interest tax reform
Carried interest tax reform
The newly elected UK Labour government has committed itself to “take action against the carried interest loophole” and published a call for evidence on the taxation of carried interest. We responded based on our significant experience advising and supporting private equity structures from executives and investors to private equity backed companies, and taking into account input from a range of our private equity clients.
Although it is clear that change in some form is coming, carried interest is a vital way to incentivise investment managers to deliver the returns that investors seek and helps to drive growth in the UK’s private equity industry. The UK’s market is highly valued as a place to do business and currently offers a tax and regulatory environment which provides stability, certainty and ease of doing business and this status must be retained for this market to grow. An outline of our responses in shown below but the overriding points we made to the Government were:
Read our full Budget predictions here.
How can the tax treatment of carried interest most appropriately reflect its economic characteristics?
We made clear that we believe the current tax treatment of carried interest already accurately reflects its economic characteristics, highlighting that there is already significant legislation, HMRC practice and case law to ensure that the 28% carried interest rate is only relevant to the extent the profit represents capital gains from underlying disposals in a fund.
If carried interest comprises interest income, it is already subject to income tax at up to 45% and dividends are subject to income tax up to 39.35%. However, there are several rules that can apply to classify carried interest as trading income taxed at up to 47%, for example, the Disguised Investment Management Fees (DIMF) anti-avoidance rules and the Income-based carried interest (IBCI) rules that class short-term returns as trading income rather than capital.
Similarly, the Employment-Related Securities (ERS) rules apply to carried interest awards acquired by UK employees and directors and can apply employment taxes if, for example, unrestricted market value is not paid on acquisition of awards and / or certain tax elections are not made.
What are the different structures and market practices with respect to carried interest?
There are a wide range of structures adopted across the PE sector, but these are driven ultimately by what investors need, and the profile and jurisdiction of investments. Specific points we raised here include:
We pointed out that such a rule could pose significant issues of affordability for smaller and start-up funds, and more junior investment managers.
Are there lessons that can be learned from approaches taken in other countries?
There are lessons that can be learned from other countries’ approaches. For example, in the US, there is a three-year holding period requirement for carried interest to be subject to tax at a lower rate as long-term capital gains.
In other competitor regimes i.e. in Italy, Guernsey, Switzerland, Ireland, UAE, Greece and Monaco, it is possible, subject to meeting certain conditions, for carried interest returns to be taxed at lower rates or be subject to certain exemptions.
We pointed out the difficulties posed by certain jurisdictions i.e. France and Spain which require funds to be located in particular geographies, and that any reforms should seek to be avoid similar complexities – for example, the payroll compliance issues that can arise in Spain.
We also note the potential impact of the proposed four-year foreign income and gains (FIG) regime, which replaces the non-domiciled regime applicable to certain executives. Although the FIG appears to be encouraging for executives contemplating moving to the UK for a short-term, for others looking to move longer term and where they have carried interest from historical funds where no UK work will be undertaken, the regime appears to pose difficulty.
If you would like a copy of our full response, please contact us.
Although it is clear that change in some form is coming, carried interest is a vital way to incentivise investment managers to deliver the returns that investors seek and helps to drive growth in the UK’s private equity industry. The UK’s market is highly valued as a place to do business and currently offers a tax and regulatory environment which provides stability, certainty and ease of doing business and this status must be retained for this market to grow. An outline of our responses in shown below but the overriding points we made to the Government were:
- The carried interest rules must be practical, certain and simple to attract people to the UK
- The rules are fair to retain the existing population of fund executives
- Reclassifying all carried interest as income would reduce the attractiveness of the UK as a base location for investment management activities
- If changes are introduced, grandfathering or suitable transitional provisions should be included to avoid retroactive tax liabilities.
How we can help
We can help you plan for any upcoming changes by assessing the impact of different scenarios on you and your investment structures. If you would like to discuss this or your structures more generally, please feel free to get in touch with Jennifer Wall or your usual point of contact at BDO.Read our full Budget predictions here.
Taxation of Private Equity Carried Interest – outline of our response
The consultation focused on the following three questions:How can the tax treatment of carried interest most appropriately reflect its economic characteristics?
We made clear that we believe the current tax treatment of carried interest already accurately reflects its economic characteristics, highlighting that there is already significant legislation, HMRC practice and case law to ensure that the 28% carried interest rate is only relevant to the extent the profit represents capital gains from underlying disposals in a fund.
If carried interest comprises interest income, it is already subject to income tax at up to 45% and dividends are subject to income tax up to 39.35%. However, there are several rules that can apply to classify carried interest as trading income taxed at up to 47%, for example, the Disguised Investment Management Fees (DIMF) anti-avoidance rules and the Income-based carried interest (IBCI) rules that class short-term returns as trading income rather than capital.
Similarly, the Employment-Related Securities (ERS) rules apply to carried interest awards acquired by UK employees and directors and can apply employment taxes if, for example, unrestricted market value is not paid on acquisition of awards and / or certain tax elections are not made.
What are the different structures and market practices with respect to carried interest?
There are a wide range of structures adopted across the PE sector, but these are driven ultimately by what investors need, and the profile and jurisdiction of investments. Specific points we raised here include:
- Although the standard share of carried interest is 20% of fund profits post hurdle, 15% or even 10% is increasingly chosen as part of a commercial negotiation with investors
- Carried interest holders may be invested in funds that are wholly corporate structures, such as some Luxembourg / Nordic based funds, so there may be little or no capital return
- Funds may utilise the UK Qualifying Asset Holding Company (QAHC) regime, although we are yet to see this become a common master holding structure for PE
- We often see clawback or escrow mechanisms to ensure that the overall fund profits are relevant when calculating carried interest returns.
We pointed out that such a rule could pose significant issues of affordability for smaller and start-up funds, and more junior investment managers.
Are there lessons that can be learned from approaches taken in other countries?
There are lessons that can be learned from other countries’ approaches. For example, in the US, there is a three-year holding period requirement for carried interest to be subject to tax at a lower rate as long-term capital gains.
In other competitor regimes i.e. in Italy, Guernsey, Switzerland, Ireland, UAE, Greece and Monaco, it is possible, subject to meeting certain conditions, for carried interest returns to be taxed at lower rates or be subject to certain exemptions.
We pointed out the difficulties posed by certain jurisdictions i.e. France and Spain which require funds to be located in particular geographies, and that any reforms should seek to be avoid similar complexities – for example, the payroll compliance issues that can arise in Spain.
We also note the potential impact of the proposed four-year foreign income and gains (FIG) regime, which replaces the non-domiciled regime applicable to certain executives. Although the FIG appears to be encouraging for executives contemplating moving to the UK for a short-term, for others looking to move longer term and where they have carried interest from historical funds where no UK work will be undertaken, the regime appears to pose difficulty.
If you would like a copy of our full response, please contact us.