UK: Private equity managers to fork out £1.8bn more in tax as loophole is tightened

In the UK, private equity managers hoping to cut their tax bills under the “carried interest” system will face much tougher tests, in a move that means they will pay almost £1.8bn more in capital gains tax between now and 2021, according to new proposals announced in the Budget, The Telegraph reports.

HMRC said several thousand investment fund managers, chiefly in private equity firms, will be prevented from using tax loopholes to reduce the capital gains tax they pay on their share of their funds’ profits.

Managers are typically paid in two ways: a flat fee for running the fund, plus a share of the profits if it performs well. This profit-share can be structured to pay tax as if the managers were investors in the fund, with a “carried interest”, even when they have personally invested little.

The Budget’s reforms stop short of abolishing the managers’ right to pay capital gains tax, at 28 per cent, rather than their rate of income tax, which can be up to 45 per cent. However, loopholes and deductions will be much more closely regulated, in the hope that managers will no longer offset their tax bills with questionable claims that they are using the money to invest in the fund.

“The government continues to support the asset management industry in the UK, and considers that carried interest should be subject to CGT, as it reflects the underlying long term performance of a fund’s investments,” the Budget documents stated.

The clampdown is forecast to raise an additional £265m in tax in the next financial year, and almost £1.8bn in total by 2021. However, the scale of the reforms is currently unclear. “The practical impact will depend on two things: how an individual private equity house has organised its tax affairs, and the precise details of the legislation and the technical note to be issued by HMRC,” said Tim Haynes, director general of the BVCA industry body.

Peter Boreham at the consultancy Mercer said: “Despite these changes, we anticipate that such plans will still be more tax-favourable than the bonus plans and long-term incentives used in listed companies.”

Closing this loophole was proposed by the Labour party in a tax paper ahead of the General Election. The practice is also the subject of heated debate in the United States, where President Barack Obama has been a vocal critic of the entire carried interest system.

“The changes to the taxation of private equity carried interest bring to an end a basis of taxation agreed with HMRC as long ago as 1987 when the industry was in its infancy,” said Alex Henderson, tax partner at PwC. “This is one of a series of changes that have affected the way the industry has been taxed in recent Budgets and reflects the Chancellor’s progressive tightening of the tax regime and withdrawal of reliefs.”