Taking Up the Carried Interest Tax Change Challenge

On Monday 29 July, Chancellor of the Exchequer Rachel Reeves confirmed that the Autumn Budget will be presented on 30 October and paved the way for a number of expected tax increases.¹

What does this news mean for private equity (“PE”) firms and their executives from a tax perspective? Some things we know, some things we don’t and there are some things we might be able to guess.

In the Labour Party’s manifesto the word ‘tax’ appears only 28 times. However, the manifesto confirms Labour’s intention, amongst other things, to increase the tax on carried interest and abolish non-dom status (a UK resident whose permanent home - or domicile - for tax purposes is outside the UK), whilst also stopping the use of offshore trusts for inheritance tax planning purposes. These policies have been re-confirmed, and some additional information provided.² A ‘call for evidence’ in respect of the tax treatment of carried interest has been concluded, and we await the outcome.

So, what are the practical implications for PE firms and for the UK as a whole?

Carried Interest Taxation

Currently, carried interest returns to individuals are taxed, broadly, at 28% (assuming the returns are of a capital nature – e.g., proceeds of the sale of shares in portfolio companies rather than dividend distributions). This rate contrasts with a 20% tax rate that would apply to similar gains (e.g., the proceeds of share sales) outside of a carried interest structure and a 24% tax rate applying to gains on residential property.

Although there are many references to this carried interest rate being a ‘loophole’ (including in Labour’s manifesto) given that it is lower than income tax rates in the UK (which are up to 45%) – it is not. Whilst many will have views over whether or not it is the correct tax rate, legislation both defines carried interest with an underlying capital nature as a capital gain, not income, and specifies this tax rate.

The Labour manifesto estimated that ‘closing [the] carried interest tax loophole’ would net the government £565mn in 2028-29.

The Government could do this by increasing the 28% rate that applies (easy to do, legislation-wise), changing the underlying treatment by re-classifying the income as employment income (more complicated to do, legislation-wise), or it could do something else, such as removing the exemption to apply the ‘income based’ carried interest rules where the right to carried interest was acquired by an employee.

According to a recent article in the Financial Times by Patrick Jenkins, if carried interest tax rates were increased from 28% to 45% and the same amount of carried interest remained taxable in the UK, £1bn of tax would be generated. However, most experts would argue that given the highly mobile nature of PE executives it is likely the eventual figure would be significantly lower, and potentially even reduce the tax take of the Government if this approach was taken.

Doing something less risky and easier to do administratively – like increasing the specific capital gains tax rate from 28% to something like the 33% mentioned by Patrick Jenkins – would result in a favourable outcome for both sides. It would boost tax revenues, allowing Labour to say that it had dealt with the issue, while minimising the number of tax-payers leaving the UK.

A 33% rate would be on the higher end within Europe, but perhaps not too difficult to swallow for those who enjoy living in the UK. An article from Macfarlanes highlights that the effective rate of tax for carried interest ranges from around 23% to 34% across European countries with major financial centres.

Those who do consider leaving the UK to escape the net of capital gains tax are likely to need to remain non-resident for tax purposes for at least five years (to ensure any carry distributions in the interim are not taxed on their return under ‘temporary non residence’ rules). And the potential tax take on their other income will, of course, be lost to the UK.

The Government’s call for evidence³ asks three specific questions:

How can the tax treatment of carried interest most appropriately reflect its economic characteristics?
What are the different structures and market practices with respect to carried interest?
Are there lessons that can be learned from approaches taken in other countries?

The questions appear to hint that the direction the government will follow may involve (1) an alignment of the specific carried interest tax rate with those that apply in other countries (thus hoping to ensure the UK doesn’t become hugely uncompetitive in the PE world); and (2) a change in the conditions that a carry holder would have to meet to be within the tax regime (e.g., perhaps requiring a minimum cash investment into the underlying fund – this could be the fund managers, as a group, being required to have invested their own cash for at least 1% of the fund value).

Knock-on Impacts to Other Structures

One potential (and perhaps likely) consequence of any change to the tax rate applying to carried interest is that HMRC may further focus on the valuations used for share acquisitions as part of management incentive plans (“MIPs”), such as growth shares. MIPs often use a separate class of share to deliver a capital return to management in respect of future growth in a company above a hurdle (the economics not sounding so dissimilar to carried interest). These arrangements typically do not fall within the definition of carried interest and are, therefore, subject to the usual capital gains tax (“CGT”) rates, currently up to 20%. Knock-on impacts on growth share type arrangements are, therefore, also possible.

One of the key benefits of individuals receiving carried interest which is within the tax carry rules is that, subject to the terms of the Memorandum of Understanding (“MoU”) between HMRC and The British Private Equity and Venture Capital Association (“BVCA”), clients may be able to rely on a safe harbour as to the very low valuation on allocation. This is not available for most management incentive plan-type arrangements, with HMRC usually expecting a detailed option-based pricing model to be on file.

Of course, it is also possible that the main rate of CGT is also increased in October. Indeed, if the tax rate on carried interest distributions of a capital nature was increased to the same level as income tax it could set a dangerous precedent for others putting their capital at risk.

The Politics

Under Keir Starmer’s leadership, the Labour Party in opposition carefully avoided taxation policies reminiscent of the traditional socialism associated with former leader Jeremy Corbyn and his Shadow Chancellor, John McDonnell. The effective endorsement of the Edinburgh reforms and Chancellor Reeve’s positive rhetoric towards the financial services industry did much to reassure the City of London that a new Labour Government would understand and appreciate the economic importance of the financial services sector.

Faced with limited options to increase tax revenue, Chancellor Reeves and her team have looked for other areas with apparent tax discrepancy to help boost the Government coffers, and especially areas that would not damage Labour’s credibility on the economy with the general public and that would also appeal to a sense of fairness in approach. As with tax changes for non-doms and VAT on private school fees, the new Government can be reasonably comfortable that public sympathy for the PE sector will be relatively limited and broader opposition to tax changes fairly muted.

Yet, this seemingly innocuous change may have an outsize effect on the Government’s number one priority - economic growth. At a time when great focus is on the competitiveness of the UK (as seen with the introduction of the secondary objectives introduced for financial services regulators) and the desire to attract more inward investment, BVCA has been pushing hard to make the Government and wider stakeholders aware of the risks by highlighting just how internationally mobile PE executives are and how enthusiastically other financial centres are pursuing the business, money and talent that drives the City’s success.

Ultimately, Labour will not back down entirely from changes to carried interest taxation. The Government highlighted a “black hole” in public finances and, irrespective of the accuracy of this figure, the Government will want and need to show consistency and fairness in their approach to tax in order to secure an ongoing stream of investment into the UK economy that will drive the delivery of Labour’s growth agenda. But there is room for manoeuvre. Industry engagement in a way that is evidence-based and informative, that outlines the impacts of the various approaches and offers alternatives to achieving the Government’s objective of economic growth, while boosting tax returns, may go a long way to ensuring a more moderate and consensus-driven outcome that delivers on multiple election promises.

Next Steps

The upcoming changes could be significant. With any changes expected to be announced in the Autumn Budget on 30 October 2024, PE firms and other stakeholders should consider their positions and take steps to assess the risk to them. This might start with a review of the effectiveness of their carried interest and co-investment schemes for executives.

Contact us for support with this, whether it is evaluating the potential impact on your business or looking further forward. We can help with the full range of tax and reward services for Private Equity.

Footnotes:

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