When the UK’s Chancellor of the Exchequer George Osborne warned fund managers that the UK government would put a stop on GPs “disguising guaranteed fee income” as capital gains, the industry was not too concerned. Not initially, at least.
The alchemy of turning income into more tax-favorable capital gains, known as general partner’s share or “GPS” diversion, is a losing battle for the industry, tax lawyers surmise. In a nutshell, GPs capture tax advantages by giving up fees in exchange for a priority allocation of future profits, a commonly-used tactic during tax planning.
“But people have to realize the party is over for the most exotic planning. Everyone must accept that it was good while it lasted,” observes one UK-based tax lawyer.
So why the non-reaction to Osborne’s Autumn Statement? Sources say that even though Osborne vowed to ban the practice, he assured fund managers that individuals’ investment returns and carried interest would not be impacted. However, attitudes soon changed when the draft language of Osborne’s new tax rules were released in December.
According to tax lawyers, the draft language narrowly defines terms like “carried interest” and “investment return”, and so leaves everything else broadly defined as a “management fee.” As a result, even some of the most vanilla tax arrangements structured by private fund managers could be subject to a tax hike.
Specifically, carried interest is defined restrictively as payments made “out of profits” only after investors have received the repayment of their initial investment plus a preferred return, which must be at least 6 percent compounded.
The standard preferred return in the industry is 8 percent, but “there is a concern from many managers that carry doesn’t always work that way,” says Mark Stapleton, tax partner at law firm Dechert, who adds that some firms have no hurdle at all or rely on IRR rather than compounded interest.
“If you are a venture capital firm there is often no hurdle, and in different asset classes like infrastructure and debt funds, it’s much more common to have an NAV-based carry or yield-based carry,” adds Laura Charkin, tax partner at law firm King & Wood Mallesons.
The second carve-out, return on investment, is also defined in a strange way, say tax lawyers. It’s defined as a return reasonably comparable to a commercial rate of interest. In the context of co-investments, any cash above that rate is treated as income, but critics counter that every dollar of co-investment returns is, by definition, a capital gain. Moreover, GPs co-investing with the fund must also receive a cash investment to meet the definition, which would make it impossible for partners, especially more junior executives, that want to use third party debt to invest with the fund.
The bad news doesn’t only impact fund managers in the UK either. Due to the broad drafting of the legislation, many tax experts say that overseas professionals who perform some type of investment management service while in the UK could be caught. Stapleton says that the drafting is so far-reaching that it covers: meeting investors, searching for potential deals, deal due diligence and more. This is because any income received by an individual will be viewed as having a UK source if any investment management services are conducted in the UK.
“Imagine you’re a partner at a US firm with a UK office and you happen to do some advisory activity in the UK. If your services as an investment adviser are performed partly, and to any extent, in the UK, then you are within these rules and you probably would think you wouldn’t be,” warns one UK-based tax lawyer.
All hands to the pump
In response to the legislation, tax experts say that considerable lobbying efforts are being undertaken by industry associations. Many law firms, the Big Four audit firms and other tax advisors are busy penning their grievances with the HMRC too as part of the draft’s consultation process.
Many are optimistic the campaign will bear fruit. “[HMRC] is willing to engage with the industry on these topics nowadays,” says the UK tax lawyer. “It’s fair to say they have indicated a willingness to hear where the drafting might need to be changed.”
Vimal Tilakapala, co-head of Allen & Overy’s tax practice, adds that the HMRC would be willing to admit it doesn’t know every single variant of common market practice and so will be open to suggestions. “They [HMRC] do tend to collaborate once they realize they have gone further than they aimed to.”
Tax lawyers say much of the lobbying campaign will center around explaining to HMRC the peculiar tax impact on carried interest and co-investments from the legislation. But failing that, the HMRC will be lobbied to write additional guidance clarifying the matter.
Most tax lawyers expect the final outcome to be a product of both strategies. “They might change the drafting on the carry and co-invest to make it less narrow but keep it still quite broad so that when they issue guidance they can keep updating the guidance when market practice and norms shift in the future,” says Chris Harrison, co-head of Allen & Overy’s tax practice. “In recent years they have gone down the route of saying less in the law and more in the guidance.”
Not everyone is quite so confident about the legislation being scaled back however. One tax lawyer says “it would be naïve to think this won’t happen in a pretty broad way.” He adds that the HMRC is determined to stamp out avoidance they deem abusive and they will “want to be absolutely sure it hits its target.”
There’s a timing issue for the industry to consider here too. The consultation closes on February 4 but the government will want to rush the bill before the UK’s general election in May, leaving less time for consultation and an exchange of ideas between tax experts and the government.
The uncertainty means that firms must adopt a “wait and see” approach. Until the legislation comes out in its final form, many managers will not know whether or not their current arrangements will be caught by the rules. Nonetheless, advisers are urging GPs to review their structures and consider their options in a worst case scenario. There will be some commercial implications to doing so, say tax lawyers, but by and large they should be mitigatable. For instance, a venture capital fund operating a carry structure without a hurdle can change the hurdle to the requisite 6 percent, but insert a performance fee so the end result gets the fund back to no hurdle carry. It will be interesting to see what other types of solutions GPs come up with in the event the bill realizes some of the UK industry’s worst tax fears.
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