The carry debate just got personal

George Osborne, the British chancellor and man of the moment, may not be planning to redefine carried interest as personal income anytime soon, but walking the halls of HMRC’s headquarters just a few yards from the Treasury are those who believe a GP’s cut of the fund profits shouldn’t enjoy capital gains treatment, multiple sources close to the UK tax agency tell pfm.

While private equity and real estate managers may be exempt for now, officials are testing the waters to see how far carry taxes can rise without spooking fund managers into leaving London and taking their tax pounds and dollars with them.

Taken piecemeal, it’s difficult to point to any single recent tax reform aimed specifically at private equity and say the British tax authorities are having an unfair go at the industry. Earlier this year managers lost the ability to disguise management fee income by converting it into capital gains via some clever tax alchemy, a change that seems justifiable. We also agree with last month’s Budget item designed to change a quirk in the law that made it possible for managers to effectively use a portion of fund commitments as a tax deduction on their carry.

Together, however, some see these measures as HMRC adopting a tougher stance on GP compensation fueled by the belief that private equity has escaped its fair share of tax for too long.

Constraining HMRC are a few important forces. Chief among them is the fear that a sudden, radical tax hike on carry will prompt fund managers to finally make good on their threats of leaving the UK for tax friendlier jurisdictions such as Guernsey and Jersey (which have been rolling out the welcome mat for years). Some say the UK is also hesitant to reverse course on carry until the US makes the first move.

Moreover, without clear instruction from Parliament, the UK tax authority isn’t keen to reverse its position on an issue with longstanding precedent and heavy political undertones.

Still, HMRC’s dealings with private equity over the past two years show a resolve to draw additional tax from the community without appearing too large a threat. Disguised salary rules for limited liability partnership members and stricter measures on the tax treatment of non-doms (also contained in last month’s Budget) will be accepted after a customary round of bellyaching.

More curious, however, will be the tax agency’s new consultation to determine the criteria on which fund manager rewards are to be taxed as income, which looks set to redefine carry for private equity’s cousin the hedge fund.

The government intends to stop investment managers engaged in trading activities (as opposed to investment activities) from claiming capital gains on their profits. They propose two possible approaches: 1) create a white-list of investment strategies – including private equity, real estate, venture capital and other clearly investment-related activity – blessed to claim capital gains on their performance linked rewards; 2) focus on the length of time an investment is held, so that assets held for longer gradually move up a table with increasingly attractive tax rates.

To be sure, private equity and real estate are clearly meant to be exempted from the consultation proposals, but it’s yet another sign that HMRC doesn’t really feel carried interest is a capital gain and can be taxed as such. And once that’s made true for hedge fund managers, it becomes easier to envision a similar fate for private equity and real estate.