Will Britain stand alone?

When the UK’s pre-Budget report was released earlier this month, the British private equity industry breathed a collective sigh of relief over the fact that it was not targeted for an increase in the rate of capital gains tax. However, if the US goes through with its own capital gains hike, the UK government may be pressured to follow suit.

The US House of Representatives approved on 9 December a bill that would prevent fund managers from paying taxes at capital gains rates on investment management income that was received as carried interest. Instead, the gains would be treated as ordinary income, which would more than double the tax on carried interest from 15 percent to as high as 39.6 percent.

As PEM previously noted, if passed the bill would ironically make the US – despite its traditional reputation for pro-market policies compared to Europe – far less hospital to the industry tax-wise than other major European markets, as American GPs will be paying twice the tax rate of their peers in France and the UK.

In April 2008, the UK raised its effective tax rate for carried interest from 10 percent to 18 percent, in part to stay in sync with the US, according to Dechert tax partner David Gubbay. And if the US increases its rate of tax on carried interest, this may lead to a similar response in the UK.

“I think one of the reasons why this was in play two and a half years ago, and why the UK decided not to go further in increasing the tax from 10 to 18 percent, was probably because the US wasn’t seriously contemplating taxing carried interest as income,” Gubbay said. “If the US change does come in it will certainly put some pressure on the UK, and with tax revenues being very tight the UK government is likely to be looking at ways of raising revenue.”

While Jan Birtwell, a tax partner for O'Melveny & Myers, said the treatment of carried interest is not at the forefront of the political agenda at the moment, she agrees that the UK government will be watching what happens with the US legislation. So will fund managers in the UK, some of whom – such as Terra Firma’s Guy Hands – have fled the country to lower-tax jurisdictions such as Switzerland and Guernsey.

With plans to raise top personal tax rates to 51 percent and potential curbs on banker’s pay among the items hurting the UK’s competitiveness, Gubbay said the 18 percent carried interest rate may be one of the few advantages the country could offer, which is why groups such as the British Private Equity and Venture Capital Association (BVCA) may look to step up its lobbying efforts to keep it even if the US increases its own rate.

“All of the news in the UK is negative – increases in tax rates, tightening of non-domiciled rules, bankers’ pay – and causing people to look at whether the UK is an attractive local,” he said. “If the UK were to retain its preferential carried interest tax treatment, perhaps that is something that would balance things out a bit more and make the UK attractive from the perspective of private equity managers.”

But with officials such as London mayor Boris Johnson already warning about the risks being posed to the country’s status as a financial centre, following the US’s move may be costly. “People will only put up with so much, and then there is something that will tip the balance, and I think for a number of people if we change the carried interest tax situation that could be the straw that breaks the camel’s back,” Birtwell said.