Friday Letter: It's not too taxing

The UK Treasury has harpooned the industry with its Budget announcement implementing an immediate tax hike on carried interest. But this change had been coming, and it isn’t a disaster for a maturing industry keen to promote itself as responsible investors.


Only the naïve would have assumed that the politically charged debate in the UK over taxing carried interest would not result in some sort of change to the status quo.

That day arrived on 8 July when the government published its first Budget since it was elected in May. A brief item in George Osborne’s text stated that the Treasury was closing the so-called tax loopholes that allowed fund managers to avoid paying the full amount of capital gains tax (CGT) on carry.

Change might have been coming, but no one expected such an abrupt repositioning of the goalposts. In one step the government has overturned some 30-year-old conventions on how deal profits are taxed. This was even more surprising given capital gains treatment of fund management fees was already addressed in the disguised investment management rules legislated only in April of this year.

Some private equity professionals may have been affronted by the reference to “loopholes” and the immediate implementation of a demand to pay full capital gains tax, which implies some sort of structured tax avoidance has been in play.

Others might have been expecting to be consulted first, given complaints about the level of engagement with the industry over the disguised income rules.

And if you’d been waiting for your carry to be paid out after several years and that occurred on 8 July, your hackles might have been raised. It would certainly throw your tax planning into the air.

But the change might not be as bad as it sounds. In time, it might even result in a win for the industry.

The government has decided to stick with taxing carry on a capital gains basis and not make the bigger and more punitive switch to imposing income tax. Deal profits will be subject to a maximum 28 percent CGT rate, which is still a much lighter burden than paying top rate income tax of 40-45 percent.

And the move, the most significant of a handful mentioned in the Budget that will have an impact on the private equity industry, marks the UK out as one jurisdiction where the debate over CGT versus income tax has been answered. As one GP put it, the sword of Damocles has been lifted. In the US the debate rages on.

The government has given fund manager remuneration a close look in the context of a wider crusade against City tax avoidance. General partners will also note that the Treasury has scrapped the dividend tax credit to eliminate the benefit to directors of drawing a dividend rather than an income-taxed salary. And probably of lesser interest to UK-based firms are new rules that bring tax on carried interest earned by non-domiciles into line.

Of greater significance is the launch of a consultation to determine the criteria on which fund manager rewards are to be taxed as income. Key to this is the distinction between trading and investment.

Rather than viewing the consultation as a continuation of the income versus capital gains tax debate, the government appears to be widening the net to catch funds that have diversified away from long-term investment activity for which capital gains tax is appropriate, to making profits off short-term trading in more liquid assets.

Debt and other more hybrid alternative asset investors may take pause, but your core PE fund plugging away at improving the performance of its portfolio companies appears to have little to worry about.

In today’s political climate, and ever since Nick Ferguson’s notorious 2007 acknowledgement that private equity executives were getting away with paying “less tax than a cleaning lady”, adjusting the rules for the industry was inevitable. For the government to consult it on further changes is wise. A fair tax is no bad thing for an industry primping its ESG credentials.

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