After four long months, it became safe to say that taxes on carry and co-investment returns would not be going up in the UK. Except maybe for some fund managers. We think.
Tax concerns first surfaced last year when UK Chancellor of the Exchequer George Osborne made a vow, during the Autumn Statement, to stop GPs from “disguising” their management fees – by converting them into capital gains via some clever tax alchemy – but promised not to touch carried interest or executive investments. Panic set in after the original rules were written so sloppily that they appeared to catch all types of fund distributions, including legitimate carry and co-investment returns. But thanks to industry lobbying efforts spearheaded by the British Private Equity & Venture Capital Association, the final rules released in the March budget appear to exempt most carry structures from their scope, as promised.
Always safe were funds that paid investors a 6 percent preferred return, which virtually all private equity funds do (the standard hurdle being 8 percent). But the final finance bill provided relief to venture capital managers by removing the hurdle requirement, and to many infrastructure and debt managers as well by including funds that base carry off of yield or NAV.
Interesting questions start to surface, however, when examining the finer points of the rules. Obviously when carry allocation rights are first granted, there’s a very real risk that the fund will disappoint and won’t produce a single performance-driven dollar. A fund three or four years along however, and showing signs of promise, all but guarantees some carry is coming the manager’s way. So, could a right to carry granted at that time (say to a new joiner) really be considered at risk? If not, HMRC may very well interpret it as ordinary income under the new rules, notes Laura Charkin, a tax partner at law firm King & Wood Mallesons.
A similar type of curiosity and relief arises from the rules on co-investments. After dialing back from a nonsensical rule that raised taxes on co-investment returns exceeding an interest rate-based “commercial return” (whatever that means in the private equity context), HM Treasury will treat co-investments as capital gains so long as it’s the fund manager’s own money at stake. Unclear is if “money at stake” includes non-recourse loans made by the fund to, say, junior principals who need the cash to finance their “skin in the game.”
A last point worth making relates to the reduced effort it will take HM Treasury, if it so chooses, to redefine carry as ordinary income. Carry was never really enshrined in law, instead codified as a capital gain through memorandums of understanding and side agreements. The new rules give the tax authority a platform for change. Parliament would still have to approve a tax hike this huge, but HMRC no longer needs the legislature to pass a new act to have its way. Considering the lack of public sympathy for fund manager pay, and the amount of revenue at stake – between £280 million to £700 million, according to some estimates – it’s a tempting plum to pick.
None of this is to downplay the significance of the achievements made in the final rulemaking (even if you don’t agree carry is a capital gain, the purpose of the legislation was something else). But hidden amongst the details are ways carry taxes can still go up for some. Concerning, but not as scary as things were before.