Is this the end of the carried-interest loophole?by
The Good Law Project is claiming to have banished the carried-interest loophole that hands tax savings to private equity executives, but HMRC lacks the resources to respond to the challenge.
The Good Law Project (GLP) instigated a legal challenge earlier this year, imploring HMRC to close the “carried-interest loophole” that hands hefty tax savings to private equity (PE) executives. This has now concluded with the GLP claiming victory while HMRC insists it has shot the GLP’s fox as the proposed challenge “lacks any legal merit”.
What is carried interest?
PE executives, the fund managers, usually buy into the funds that they manage in the form of “carry points”. If the fund performs above a set level (“the hurdle”), “carried interest” is (typically) 20% of investment returns above that hurdle. It is allocated to the fund managers according to the number of carry points that each holds.
When considering how carried interest should be taxed, the principle of substance over form comes to mind – surely it is performance-related and should be taxed as income. The GLP and Ecotricity founder Dale Vince argues that it should. In Vince’s words, “private equity funds can be subject to the same tax rules as nurses and teachers”.
The "sweetheart deal"
Thanks to what the GLP refers to as a "sweetheart deal" between the then Inland Revenue and the British Venture Capital Association (BVCA) in 1987 (although the BVCA assert that this was a mere statement of the existing law), carried interest is treated as capital, attracting the 28% capital gains tax (CGT) rate – much lower than the 47% full marginal rate (including national insurance) that an equivalent banker would pay on similar performance-related income. This, says the GLP, has cost the government “hundreds of millions of pounds a year – enough to pay the salaries of more than 10,000 nurses”. Put in those emotive terms, it’s easy to see why the Labour Party has pricked up its ears and vowed to “close the carried-interest loophole”.
PE never part of the deal
The 1987 statement was designed to deter venture capital (VC) funds from taking their activities offshore to enjoy more favourable tax treatment. VC funds typically buy a minority interest in start-up businesses, so tax breaks in this sphere play a part in encouraging UK entrepreneurship. PE tends to swoop in at the other end of an investee company’s life, with PE buyout funds purchasing mature businesses, flipping them and selling them for a profit.
The spirit of the "deal" has somewhat lost its way due to HMRC’s seeming to apply a “blanket policy” to carried interest across VC and PE, although the 1987 deal does not explicitly mention PE. Paragraph 1.4 reads: “Where a venture capital fund is run through the medium of a limited partnership and it purchases shares and securities with the intention of holding them as investments, any profits or losses on disposal of those shares and securities will not… be treated as income of a trade.”
HMRC highlighted this in its response to the GLP. Paragraph 7 states: “(a) Paragraph 1.4 of the 1987 BVCA Statement concerns venture capital funds, not private equity buyout funds.
“(b) HMRC’s Investment Funds Manual does not proceed on the unexamined assumption that capital gains and not income tax treatment applies to carried interest. No such assumption is made in relation to private equity buyout funds.”
This, claims HMRC, renders the legal challenge redundant and the carried-interest loophole a figment of the imagination. The real issue at stake is whether private equity buyout funds are being adequately assessed to determine whether they are “trading”. If so, all parties agree that the carried interest should be taxed as income.
Repeatedly denying the existence of any blanket policy, HMRC’s letter continues: “While HMRC does not consider at present that this is a ‘high risk’ area that merits a greater allocation of its limited resources, HMRC would naturally give appropriate consideration to evidence concerning a particular fund or fund type with activities that might weigh more in favour of trading.”
HMRC says “whatevs”
HMRC has consistently rebuffed the suggestion that it applies a blanket policy to all PE buyout funds, but in doing so it acknowledges that the facts should be considered on a fund-by-fund basis. The logical conclusion would be greater scrutiny in the process and the tax treatment corrected accordingly.
But with HMRC barely staying afloat, the likelihood of resources being conjured out of thin air and diverted to compliance investigations in this area is remote. The HMRC letter concludes “responding to [the proposed challenge] is using up substantial amounts of scarce resources, which could otherwise be deployed in service of HMRC’s statutory function of collecting tax”. As one commenter beneath Dan Neidle’s article put it, “This is a ‘whatevs’ from HMRC.”
But “whatevs” doesn’t quite cut it with an estimated £600m per year at stake. The clarification of the legal position means fund managers and HMRC can no longer, as Neidle says, “pretend that private equity funds aren’t trading”. Fund managers can’t fall back on the 1987 agreement and advisers will need to be absolutely clear on whether each fund is trading before determining the tax treatment.
There is a view within the PE industry that this is a political football, unlikely to lead to any tangible change. Tax structuring is a key element of the fundraising process and in the face of heightened scrutiny from HMRC, this will be enhanced to ensure buyout funds do not fall into the realms of trading.
A spotlight is now beaming down on a tax treatment that favours the fat cats and the government will be hard pushed to ignore it. The risk of course is that removing the tax break will push the industry overseas, with serious knock-on effects for the UK economy and entrepreneurship. Charities and pension funds also risk losing valuable exemptions if their PE investments are treated as trading, not investing.
But as Neidle asserts: “We can’t have a tax system where one sector gets special favours thanks to a politically driven technically suspect backroom deal 36 years ago. We should be taxed by law, not by lobbying or litigation.”
Legislative change seems likely, with one popular suggestion being to equalise the rates of capital gains and income tax. How that might work, particularly with the potential abolition of inheritance tax, is a topic for another article.
You might also be interested in
Consulting Tax Editor for AccountingWEB.
I have spent the last 10 years teaching the accountants of the future, mainly ICAEW advanced level corporate reporting. I also cover tax news and write and edit tax updates for other publishers including PTP Limited.