What are the current carried interest rules?
Managers in private equity firms and certain venture capital and real estate funds typically receive a large proportion of their 'remuneration' through so-called carried interests. These give managers a share in the underlying profits of the fund (typically through partnership vehicles).
As the returns on the funds themselves are largely capital in nature, it naturally follows that the returns on the carry are treated as capital as well (absent any specific statutory overrides). This would be the case even where the carried interest is only in respect of profits and "super"-profits and involves little or no capital risk from the managers themselves.
While this treatment is, to an extent, simply the logical outcome of how the arrangements are structured, the tax benefits of receiving capital rather than income are clear. This was already partially addressed by the Coalition government in 2015 with the introduction of the 'disguised investment management fee' (DIMF) regime which treats parts of that otherwise capital return as income. The existing DIMF rules still allow for carry in respect of most longer-term interests to be taxed as capital, albeit at a special 28% rate, which is higher than the standard rate of capital gains of 20%.
What Labour's proposals might mean for the carried interest rules
In its manifesto, the Labour Party stated: "Private equity is the only industry where performance-related pay is treated as capital gains. Labour will close this loophole". The Labour Party expects to raise £565 million a year by tax year 2028-29 by changing the rules for fund managers.
It is perhaps telling that Labour describes the current regime as a "loophole" rather than simply the fortuitous (for the private equity industry) but the natural outcome of basic taxing principles. Much has been made of the 1987 memorandum of understanding between the BVCA and HMRC, often seen as a special deal for the private equity industry. The 'MoU', as this document is universally known, is a more limited arrangement than is sometimes appreciated and its simple abolition is unlikely to achieve Labour's stated outcome.
More likely, the closure of the "loophole" will involve the extension of the current DIMF regime, recharacterising capital as income through statutory override, rather than by ending special deals and non-statutory concessions. Detail is lacking but the Shadow Chancellor has confirmed in subsequent press commentary that capital at risk would still be taxed at capital rates and has promised to consult on any changes, which gives at least some comfort that Labour may adopt a more nuanced approach. Labour has confirmed that they still expect most carried interest returns to be caught by the new approach but there may be scope to preserve capital treatment by increasing the amount of any co-invest.
It is reported that approximately 3,000 people receive carried interest per year, so while it represents a small number of individuals, those affected could see a significant rise in their tax bill. Additionally, if any of these individuals are also non-UK domiciled, they may also have a significant increase in the UK tax, they pay as a result of other proposed changes.
Those in the investment and asset management industry will be keen to remind any future Government about the critical role of private equity, venture capital, and real estate funds in the UK economy, including investing in many aspects of our economy including infrastructure. There are concerns that a tax hike could deter investment or encourage managers to move to another jurisdiction with more favourable carried interest taxation rules. This would have a knock-on effect on the wider financial services sector. That said, London is home to a sizable community of hedge fund managers who manage to operate on 47% personal tax.
One further point to note is that these proposals might give comfort to those outside private equity, venture capital, and real estate funds that Labour is not planning more widespread increases in capital gains tax rates. CGT is suspiciously missing from the list of taxes Labour has guaranteed not to raise. The proposals to recharacterise carry as income only make sense, however, if there is still a meaningful differential in rates between capital and income.
If you would like to discuss what this means for you or your business, please speak to Ravi Longia, Jon Stevens, Tom Rank, or your usual DWF contact.
