An excessive response to 'excessive' remuneration?

The UK and the Netherlands have both reacted to public criticism of the private equity industry by passing new tax legislation

Darren Docker is a tax director in the mergers and acquisitions and private equity group of PricewaterhouseCoopers in the UK and can be contacted at darren. Gijs Fibbe is a manager in the mergers and acquisitions and private equity group of PricewaterhouseCoopers in the Netherlands and lecturer in international tax law at the Erasmus University in Rotterdam. He can be reached at

In recent years, private equity has received significant political attention in Europe. This seems to be driven in the first instance by anxiety regarding private equity ownership of companies that are household names, and the leverage used to acquire them. Whether this attention will abate or intensify in the wake of the global financial crisis remains to be seen. In reacting to this political attention, policymakers have – among other measures – focused on the tax treatment of private equity managers. In this article, we examine two different jurisdictions, the UK and the Netherlands. On first sight, some of the proposed tax changes raised eyebrows in Europe's private equity community. On further reflection however, in the changes one may detect a more measured response to political concerns than may have been feared.

The European playing field
The approach of some European Member States towards remuneration in the private equity industry should be viewed in the broader context of corporate governance around the remuneration of multinational executives in Europe. In the early part of this decade, public disapproval and media scrutiny of the senior management of multinationals receiving bonuses which were perceived to be excessive prompted the European Commission to issue recommendations to the Member States in 2004. These encouraged the implementation of an appropriate regulatory regime governing the remuneration of multinational executives to ensure that shareholders received a clear and comprehensive overview of the company's remuneration policy by way of an explicit item on the agenda of the annual shareholders meeting subject to a vote.

Recent developments in some European countries concerning private equity remuneration should be seen as an extension of this earlier scrutiny. However there are additional factors at work in the context of private equity. Highly leveraged acquisitions of prominent European companies have become commonplace (at least before recent restrictions in credit availability), as capital allocated to the asset class by large institutional investors has grown. The leverage used, in addition to creating the perception that portfolio companies will suffer under debt servicing burdens, means that the corporate tax paid in relation to other national corporates is relatively low. While corporate tax payments are a simplistic measure of an organisation's total tax contribution, this has been a source of criticism.

The criticism has taken a number of forms, from unprecedented media scrutiny of individual executives – and mainstream media analysis of the perceived effects on companies which have been the subject of a leveraged buyout – to parliamentary enquiries or the passing of private equity-specific tax law.

It seems that national policymakers have sought to an appropriate reaction to this intensified public concern. Perhaps from an electoral perspective, higher taxation of private equity remuneration is an appealing policy to pursue, and it is in line with the broader discussion in Europe regarding the tighter corporate governance around remuneration of senior management. From a political standpoint it seems that the balance to be struck was appealing to the public appetite for change in the fiscal treatment of a small number of individuals, and adversely affecting perceptions in the business community of governmental attitudes to commerce and entrepreneurial activity.

The reaction of the UK and Netherlands to these investment schemes
In most European tax systems, carried interest has been taxed as investment income. Traditionally, investment income is taxed at lower tax rates than income from employment and does not attract social security liabilities.

However, critics of the private equity industry have disputed the status of these returns as investment income. They argue that the restrictions which are attached to carried interest and co-investment schemes, such as ongoing participation in the schemes being conditional on continuing employment with the private equity house, and the fact that participation in the schemes is generally not available to non-employee investors, mean that the returns should be taxed as employment income. Similarly the lack of investment when viewing carried interest on a standalone basis (i.e. ignoring any opportunity or obligation to co-invest) also leads critics to conclude that carried interest is a form of employment income, i.e. a bonus.

Actual tax reform however has spared private equity from carried interest and co-investment being fully taxed as employment income with associated social security costs.

In the Netherlands, pending legislation is expected to enter into effect per 1 January 2009 – although at the time of writing this article the legislation is still subject to a vote. Under the new legislation, returns (i.e. income and capital gains) from qualifying “lucrative investments” may be treated as a type of income which is taxed at similar rates as employment income.

Although the legislation has been adopted to discourage “excessive” remunerations, to fall within its scope an investment must qualify as a “lucrative investment”. An investment is deemed to be a “lucrative investment” if the returns, based on the facts and circumstances under which the employee shareholder receives these returns, were intended to be a reward for the activities undertaken by the employee shareholder. Although some indication has been given, exactly what is covered by this obscure term is not fully clear. In addition, the application of the new legislation under the tax treaties concluded by the Netherlands has not been given sufficient thought.

Finally it should be noted that the new legislation provides for explicit safe harbour rules that allow taxpayers to significantly reduce the tax liability. Where it concerns a direct or indirect investment in equity, the legislation provides for safe harbour rules. Provided certain other conditions are met, the proposed set of measures should generally not apply:

  • Where the equity held by the individual belongs to a subordinated class of shares that forms at least 10 percent of the total outstanding share capital (e.g. including preference shares); or
  • Where the equity concerns preference shares with a return lower than 15 percent per annum.

    In the UK, reform was precipitated by trade unions, media and political pressure and in particular the discussions between representatives of the UK industry body, the BVCA, and the UK Treasury Select Committee (a committee established by the House of Commons). It seemed possible that the UK government might introduce new law, or interpretations of current law, which would tax carried interest at the income tax rate of 40 percent and oblige UK private equity houses to pay social security costs on carried interest. Executive co-investment was not the subject of debate in the way that carried interest was, although there was a residual risk that this too could be recharacterised as employment income.

    Instead the measures introduced, effective from April 2008, were not specifically targeted at the private equity industry. Rather, the reform concentrated on the rate at which capital gains are taxed. Capital gains tax is critical to the tax position of UK resident carried interest holders because a large element of carried interest payments are characterised as capital gains for UK tax purposes. However, many other (non-private equity) investors are also impacted by changes in the capital gains tax rate: owners of small businesses, investors in commercial property etc.

    From 6 April 2008, the effective rate of tax on gains was fixed at 18 percent whereas prior to that there was a complex system which, depending on the type of asset sold, would lead to a range of rates between 10 percent and 40 percent (although it was considered that most carried interest payments and co-investment profits would be taxed at 10 percent, this was not certain given the complexity of the system).

    Many private equity investment professionals were publically critical of the change in tax rate to a flat 18 percent, arguing that taxation of profits arising from entrepreneurial activity, which had previously been likely to benefit from the 10 percent tax rate, were now taxed at the same rate as, for example, investors in public equities. However it seems likely that privately the UK private equity industry considered the reforms a measured and reasonable response to public criticism, given that it represented a significantly better outcome than the worst case scenario of carried interest being taxed as employment income.

    “On further reflection however, in the changes one may detect a more measured response to political concerns than may have been feared.”

    In addition it should be noted that guidance on the valuation of carried interest for employment taxes purposes, introduced in July 2003, has survived. As in many other jurisdictions, the UK taxes acquisition of an asset by an employee as employment income when the employee pays less than the asset's market value. But carried interest, which is treated as an asset which has the potential to give rise to employment income when acquired, is difficult to value, and following lobbying by the BVCA in July 2003 the UK tax authorities introduced a concession on valuation, a “memorandum of understanding”. The memorandum of understanding effectively eliminates the incidence of deemed employment income when an employee acquires carried interest at the outset a private equity fund. It had been assumed by many observers that this memorandum of understanding would be repealed in 2007 or 2008, leaving private equity executives with uncertain tax exposures on the acquisition of carried interest, but this repeal has not taken place.

    In reacting to public debate, European policy makers have introduced changes on the tax treatment of private equity executives. Specifically looking at the UK and the Netherlands, these changes may not have the impact after all as one may have thought on first sight.