The Chancellor of the Exchequer’s recent Summer Budget and the related legislation introduced a series of unexpected tax changes along with the promise of further changes to come. Shortly after the Summer Budget was issued Dechert published an OnPoint describing some of the most important points in the Budget which affect the private equity and investment management industry. This article is an updated version of that OnPoint and includes information with respect to the draft legislation released after the Summer Budget. One of the most significant proposed changes would subject to UK taxation carried interest payments to non-UK domiciled executives working in the UK.
Carried Interest and Performance-Related Returns
The Chancellor’s Autumn Statement in December 2014 led to the introduction of wide-ranging anti-avoidance rules designed to counter “disguised investment management fees.” This was primarily aimed at circumstances where a return from a fund had been structured as a guaranteed profit share instead of a fee, but was drafted in much wider terms. Despite the far-reaching legislation, there was an exemption for “carried interest” and – after a high volume of representations to H.M. Revenue & Customs (HMRC) – carried interest for these purposes was defined broadly. Not only did the term include performance-related returns from traditional private equity-style carried interest, but also carried interest arrangements relating to alternative funds (including profits reflected by unrealised gains). In the Summer Budget, presented to Parliament on July 8, 2015, HMRC has now turned its attention to the taxation treatment of carried interest and performance-related returns.
With immediate effect, the so-called “base cost shift” – which enabled investment managers to take advantage of a share of the capital invested by external investors in calculating a gain on their carried interest – has been swept away. Going forward, only actual investment by an individual participating in the carried interest will be taken into account in calculating the capital gain on realisation of underlying investments. Essentially, the effective rate of tax on carried interest will be a minimum of 28%, rather than a considerably lower rate which had generally been available. Furthermore, this measure will also put an end to “cherry picking” of income and gains attributable to the carried interest.
HMRC has also introduced in this measure a very material change to the traditional “remittance basis” of taxation for non-domiciled individuals. Essentially, carried interest will be treated as sourced in the UK (and therefore taxable for a non-UK-domiciled person) to the extent it relates to investment management (or related) services performed in the UK. This will therefore change the expected tax-free status of carried interest for non-domiciled individuals performing investment management services in the UK in relation to an offshore fund.
It is very surprising that such an important measure should have been introduced without warning and with no mention at all from the Chancellor in his Budget speech.
The changes also include a provision to capture and tax as a capital gain carried interest which arises to an individual in circumstances where there has been no disposal of an asset for capital gains purposes. Due to the broad definition of carried interest, this could cover a wide variety of things – such as income, or capital returns which would otherwise have been untaxed due to “base cost shift” or where unrealised gains form part of the carried interest. A tax credit mechanism has been introduced to credit tax paid on actual gains ultimately arising, although there are various technical concerns with how this might operate in practice – in particular, that double taxation may arise in some scenarios.
In addition, concerns exist in relation to the U.S. tax position of U.S. citizens working in the UK in the private equity industry. As tax could arise at a later date in the UK with respect to the receipt of carried interest (as compared to when tax needs to be paid in the U.S.), there may be issues with obtaining credit for the UK tax against the U.S. tax liability of the individual entitled to carried interest. There is also some uncertainty over whether gains would be recognised as being the same item of income for U.S. tax purposes in the context of obtaining credit against U.S. tax liability.
HMRC Announces New Consultation Exercise
Separately, HMRC has issued a consultation document to clarify the circumstances in which performance-related returns can benefit from capital gains tax treatment. There are, however, some positive assurances for carried interest related to traditional private equity funds, and HMRC has said that such arrangements should continue to enjoy capital gains tax treatment (albeit now without the benefit of base cost shift). Unfortunately, the underlying impression from the consultation document appears to be less positive for alternative managers, and it seems likely that there will be little scope for the hedge fund sector to benefit from capital gains tax treatment on carried interest once the changes take effect in April 2016.
HMRC has recognised that whether or not capital gains tax treatment is available in relation to carried interest currently turns on whether a fund is carrying on a “trading” or “investing” activity in relation to its underlying assets. As the case law in this area is limited with respect to the activities of modern-day investment managers, there is a great deal of uncertainty as to the boundary between trading and investing. HMRC has further indicated that it believes that some funds have taken an overly aggressive view as to the distinction and have incorrectly taken the position that the fund is carrying on an investment activity. While HMRC believes this planning to be ineffective, it has also indicated a degree of reluctance to challenge these arrangements, as such a challenge would be time and resource intensive. However, those who have implemented such planning will likely find that it will cease to generate appropriate capital gains tax treatment post-April 2016.
The Consultation Document Proposals
HMRC has suggested two proposals to determine the circumstances in which capital gains tax treatment would be appropriate for performance-related returns.
Proposal 1: To focus on certain types of activities and classify only those activities as being capable of qualifying for capital gains tax treatment. A fund would need to be wholly or substantially carrying on such activities. HMRC has invited comments on the list of qualifying activities. However, the proposal seems rather restrictive and the examples given refer to the following:
- Controlling equity stakes in trading companies intended to be held for a period of at least three years.
- The holding of real property for rental income and capital growth where, at the point of acquisition, it is reasonable to assume that the property will be held for at least five years.
- The purchase of debt instruments on a secondary market where, at the point of acquisition, it is reasonable to assume that the debt will be held for at least three years.
Equity and debt investments in venture capital companies, provided the investments are intended to be held for a specified period of time.
Proposal 2: To focus on the average holding periods of investments held by a fund and to allow capital gains treatment where this exceeds a certain period of time. A suggestion is that this might be on a graduated basis to avoid a “cliff edge” test which would otherwise represent “all or nothing” treatment. The example given in the consultation document is that relief could be granted on a graduated basis – allowing for a greater percentage of relief where assets are held (on average) for a lengthier period of time (e.g., 25% relief if assets are held for more than six months, 50% relief if held for more than one year, 75% relief if held for more than 18 months and full relief if held for more than two years).
Looking at the first proposal, aside from the lengthy holding periods envisaged, there is no mention of portfolio equity holdings outside of venture capital companies, nor holdings in derivatives or loan origination no matter what the holding period might be following acquisition. As to the second proposal, the focus is on actual holding periods rather than focusing on the intention of the taxpayer at the point of acquiring assets, which is a key feature of the current case law test of whether a person is trading. Such an intention test appears to have been rejected by HMRC on the basis that it would not produce a “robust and principled basis for tax and performance linked returns.” Accordingly, notwithstanding that a fund might have been established with the intention to hold assets for the medium to long-term, it may not give rise to capital gains treatment on a carried interest arrangement if in fact there is a short-term sale of a significant proportion of the assets (possibly due to a favourable offer emerging unexpectedly).
The closing date for the consultation was September 30, 2015. Dechert has been making representations in relation to the above proposals through its involvement with the Alternative Investment Management Association (AIMA). Our view is that proposal 2 would be preferable in terms of certainty of treatment of carried interest.
Aside from the very significant changes affecting non-domiciled individuals with respect to carried interest referred to above, new restrictions have been introduced for those who are UK-tax resident but not UK-domiciled:
- It will no longer be possible for persons to be treated as non-UK-domiciled for UK tax purposes if they have been resident in the UK for more than 15 of the past 20 years.
Those who were UK-domiciled at birth but who have since acquired a domicile elsewhere will automatically become UK-domiciled for tax purposes if they return to the UK and become UK-resident again.
These changes will come into effect from April 2017. Non-UK-domiciled individuals who are affected by the changes will want to consider appropriate planning before such date, which might include advance realisation of unrealised offshore profits.
UK Companies and Their Shareholders
Despite the fact that the UK has one of the lowest corporation tax rates in Europe, the government has announced that corporation tax will reduce further to 19% in 2017, and then again to 18% in 2020. While lower rates of corporation tax have encouraged investment managers to reconsider the use of companies rather than LLPs as the vehicle of choice – particularly following the tax changes to LLPs implemented in 2014 – the Summer Budget has also introduced further adverse changes to the taxation of dividends. While the tax credit system for dividends will be abolished from April 2016, the relevant tax rate on dividends for higher-rate taxpayers will rise to 32.5% and for additional rate taxpayers to 38.1% (compared to equivalent effective rates of 25% and approximately 30.6%, respectively, under current law). In addition, basic rate taxpayers will no longer receive dividends without further tax (save the first £5,000, which will be exempt in addition to the personal allowance), but will incur tax at a new 7.5% rate. These changes will affect shareholders in companies and will now need to be factored into assessing the tax efficiency of the limited company structure.
The tax landscape for private equity and investment management has shifted considerably over the last few years and, as noted above, the Summer Budget continues this trend and provides significant food for thought in relation to the existing and future structuring.