The taxing question of carried interest

This article previously appeared in Thomson Reuters Regulatory Intelligence

Whilst it is a political decision as to how carried interest is taxed, there is some confusion in the Treasury’s suggestion in the Call for Evidence “that the current tax regime does not appropriately reflect the economic characteristics of carried interest and the level of risk assumed by fund managers in receipt of it.”

In our experience, most carried interest is structured in accordance with paragraph 8 of the Memorandum of Understanding (MOU) between the British Private Equity & Venture Capital Association and HMRC on the income tax treatment of venture capital and private equity limited partnerships and carried interest.

Under that structure, managers will typically purchase an (indirect) equity interest in the underlying investments made by the fund (which they will be involved in managing, directly or indirectly) and receive a capital receipt on an exit to the extent that the investments have been successful and taxed at the higher (28%) rate of capital gains tax applicable to carried interest. If the fund is not successful, managers will not receive anything. It is accepted that, in practice, the subscription price is relatively modest - but that is not very different to the position in respect of the ordinary equity after most management buy-outs (which typically also sits behind any acquisition financing). Any income received from the underlying interest (e.g. dividends or interest, which may be significant in the context of a debt fund, etc) is taxed at income tax rates.

In our view, and as others (such as the CIOT) have commented in their response to the Call for Evidence, this is similar to other situations where ordinary equity is acquired by employees, managers in a management buy-out and owner-managers for their initially low market value. This is of course with the hope of long-term capital appreciation from their patient and careful stewardship of the company - which is how the MOU treats the carried interest. As private equity funds typically have a five-to-seven-year life cycle, the expectation is that managers will hold their carried interest for a material period – tying them into the fund and aligning their interests with those of the investors. Managers may also make a material co-investment alongside their carried interest. This is unlike, for example, a cash-based bonus arrangement, which would typically be measured by annual performance metrics linked to revenue or profit growth and paid out regularly, which managers will likely also receive.

It is also true that any carried interest received by managers is in addition to full market rate salaries and bonuses which will be taxed as income, and any carried interest cannot be related to the work performance of any individual.

The current taxation model of carried interest in the UK has already been subject to significant reform because of recent legislative changes including, but not limited to, abolition of the “base cost shift”, the income-based carried interest rules, the disguised investment management fee rules and the higher (28%) rate of capital gains tax that applies to carried interest.

The proposed changes to the rules for non-domiciled individuals are also disproportionately likely to affect managers at private equity houses. HMRC’s own figures suggest that a material proportion of carried interest tax receipts are paid by non-UK domiciled individuals.

The current model of taxation of carried interest is also in line with (or, in many cases, less attractive than) the models existing in other jurisdictions that have a significant private equity industry. The model of taxation of carried interest which currently exists in the UK is far from unique. Similar (or more attractive) long-standing regimes exist in France, Germany and the US. Further, a number of jurisdictions (including, for example, Italy and Spain) have adopted their own competitive tax regimes to encourage local private equity activity. The exact requirements of these regimes vary, with minimum holding periods ranging from 3 to 5 years, and some jurisdictions require a co-investment by the managers, but all effectively provide for a beneficial rate of tax, varying from around 22.5%% to 34%.

A significant risk of any further reform in this area is the loss of revenue (i.e. the income tax/NICs and capital gains taxes currently paid in the UK) as managers leave the UK and private capital is discouraged from investing here. The numbers of managers at private equity houses are relatively low. As has been widely reported, HM Treasury’s own figures show that, in the 2022 tax year, £5 billion of carried interest gains were reported by just 3,000 individuals, who are well-travelled, multilingual, international and highly sought-after individuals. They are also very cognisant of their tax rates and a very significant flight risk – particularly when a number of mature, attractive and politically stable countries have regimes that are as or more attractive than the UK.

Although only modest numbers of people are employed in the private equity industry in the UK and receive carried interest, the industry supports an array of other (well-paid) jobs in the UK economy, including but not limited to corporate finance houses, investment banks, law firms, accountancy firms and other consulting firms. Typically, these jobs will generate significant tax revenues for the economy. A flight of private capital would materially impact all these areas of the UK economy, particularly at a time when the economy is already smarting from the effects of Brexit, the war in Ukraine and the Covid-19 pandemic.

Rather than reform carried interest, a more fruitful approach for the Government would be to bolster the attractiveness of the UK as a place to start, grow and list companies.