Would a private equity fund vehicle formed in your jurisdiction be subject to taxation there with respect to its income or gains? Would the fund be required to withhold taxes with respect to distributions to investors? Please describe what conditions, if any, apply to a private equity fund to qualify for applicable tax exemptions.
A private equity fund formed as an ELP should not normally be treated as a separate taxable entity for UK tax purposes. There should therefore be no UK withholding taxes on distributions to investors and the ELP should not be subject to UK tax on income and gains from its investments. Instead, for UK tax purposes, investors in the fund should be regarded as holding their proportionate share of the fund’s income and gains as determined in accordance with the fund’s profit sharing arrangements. UK taxable investors will be subject to UK tax on their allocations from the fund in accordance with their personal tax positions.Local taxation of non-resident investors
Would non-resident investors in a private equity fund be subject to taxation or return-filing requirements in your jurisdiction?
Generally speaking, the investment strategy of most private equity funds is such that they should be regarded as carrying on an investment business rather than trading for UK tax purposes (though the strategy of some funds is less clear in this regard). Provided the fund is regarded as investing rather than trading for UK tax purposes non-UK resident investors should not, except in relation to UK land (see below), be subject to UK tax on their proportionate share of income and gains of the fund unless the non-UK resident investor holds its interest in the fund in connection with or for the purposes of a trade carried on by it in the UK through a UK branch, agency or permanent establishment.
Assuming that draft legislation in Finance Bill 2019 is enacted, from 6 April 2019 non-UK resident investors will be subject to UK capital gains tax (or, in the case of companies, corporation tax on chargeable gains) on the disposal of interests in UK land, and the disposal of shares and certain other interests in ‘property-rich’ companies (those that derive at least 75 per cent of their value from UK real estate), where the person making the disposal holds, or has held in the past two years, a 25 per cent or greater interest in the company. The taxable gain will be limited to the proportion of the gain arising from 6 April 2019 onwards, unless the taxpayer elects otherwise. The draft legislation also includes an exemption for gains arising from certain disposals of interests in UK property rich companies where the property is used for the purposes of a qualifying trade.
The draft legislation also contains a separate regime for UK property-rich collective investment vehicles, including real estate investment trusts, collective investment schemes and alternative investment funds.
Otherwise, a non-UK resident investor should only be subject to UK tax in respect of its participation in the fund to the extent of any UK tax deducted at source from UK source income (such as interest), if any, received by the fund. Investors resident outside the UK may be entitled, with regard to UK tax deducted from their apportioned share of any UK source income, to the benefit of any double taxation agreement between their country of residence and the UK.
The fund may be required to file a UK partnership tax return and non-UK resident investors will be required to provide basic details to the fund and register with the UK tax authorities in order to comply with any such requirement. Certain simplifications in respect of filing requirements were made in 2018: for returns from the 2018-19 tax year onwards, partners need not provide a UK tax reference if they are not chargeable to UK tax in the relevant period, the partnership did not carry on a trade, profession or UK property business in the relevant period and the whole of the relevant period is one in which the partnership is required to report information about the partner under certain international information reporting regimes. The Finance Act 2018 also included legislation intended to clarify certain other aspects of partnership taxation, including legislation dealing with the situation where partnerships have partners that are themselves partnerships.Local tax authority ruling
Is it necessary or desirable to obtain a ruling from local tax authorities with respect to the tax treatment of a private equity fund vehicle formed in your jurisdiction? Are there any special tax rules relating to investors that are residents of your jurisdiction?
It is not typical for private equity funds or their participants to obtain rulings from HMRC in relation to their treatment. There are no special rules applicable to investors in a UK private equity fund. However, it should be noted (as discussed in question 21) that the UK government has introduced rules specifically focused on the taxation of carried interest holders and those who perform investment management services for the fund.Organisational taxes
Must any significant organisational taxes be paid with respect to private equity funds organised in your jurisdiction?
There are no such organisational taxes payable by ELPs.Special tax considerations
Please describe briefly what special tax considerations, if any, apply with respect to a private equity fund’s sponsor.
Carried interest arrangements for UK private equity sponsors have typically been structured using a carry limited partnership (referred to as the Carry LP, often an SLP), which is admitted as an ELP partner. Each participant’s share of carried interest is delivered through an interest in the Carry LP. Accordingly, historically, subject to points in relation to the taxation of employees mentioned below, the UK taxation of participants in the Carry LP generally followed that which would apply to any other UK-resident investor in the fund. The carry participants’ share of the fund’s income and gains would be subject to UK income or capital gains tax according to the nature and character of the carried interest receipt (ie, whether it represented income - such as dividends or interest - or capital gains from investment realisations) and the individuals’ personal circumstances. However, the UK tax landscape applicable to private equity fund executives has changed significantly in recent years.
In April 2015, the UK government introduced the disguised investment management fee rules which, broadly speaking, charge to tax as income everything arising to an individual who is providing investment management services in the UK to a collective investment scheme unless the amounts fall within legislative exemptions for carried interest or genuine arm’s-length co-investment. These changes were focused on structures designed to ‘stream’ part of what was in effect the regular management fee from the fund to the management team so that it was received by individuals as a profit share from the underlying fund (and so potentially subject to capital gains tax - the highest marginal rate of which applicable to carried interest is currently 28 per cent - as opposed to income tax - the highest marginal rate of which is currently 45 per cent). The rules are intended to ensure that ‘management fee’ type remuneration received by fund managers, in whatever form, should be subject to income taxation.
For those elements of remuneration that remain subject to capital gains tax (see above) additional rules were introduced in July 2015 to remove the benefit of ‘base-cost shift’. This was an arrangement by which UK-resident recipients of carried interest could, broadly, reduce the amount of their taxable capital gains by reference to costs borne economically by other investors. Furthermore, for non-domiciled UK tax residents the chargeable gain will now be treated as UK source to the extent the individual performs his or her investment management services for the relevant fund in the UK, meaning that, to the extent of their UK activities for that fund, such persons may be subject to capital gains tax on carried interest whether or not remitted to the UK.
Additionally, in April 2016 the UK government introduced legislation (the ‘income-based carried interest’ rules) to restrict the capital gains tax treatment of carried interest and other performance linked rewards received by UK residents and other individuals performing investment management services in the UK through a UK permanent establishment. This reflects a policy objective that capital gains tax treatment should be restricted to performance-linked rewards arising from long-term investment activity only. Under the new rules carried interest arising on or after 6 April 2016 can only be fully eligible for capital gains tax treatment (where such treatment would otherwise be available) if the average weighted holding period (AWHP) of the investments by reference to which the carry is calculated exceeds 40 months. If the AWHP does not exceed 36 months, all of the carried interest will be treated as ‘income based carried interest’ (subject to income tax and self-employed individuals’ national insurance contributions). If the AWHP is between 36 and 40 months, a graded scale of eligibility for capital gains tax treatment will apply. Complex rules apply the AWHP test differently in certain circumstances, including in relation to direct lending funds, funds that invest in controlling and significant stakes of unquoted trading businesses, venture capital and real estate funds and in respect of carried interest arising in the early years of the fund.
Carry participants who are employees (or members of a UK limited liability partnership (LLP) who are regarded as employees for UK tax purposes) are generally subject to the UK’s ‘employment related securities’ regime in respect of their carried interest. Under these rules, charges to UK income tax and national insurance contributions can arise if the amount paid for the carried interest is less than its ‘unrestricted market value’ at the time of its acquisition (ie, ignoring restrictions placed on the interest). The British Private Equity and Venture Capital Association (BVCA) and HMRC have, however, agreed a memorandum of understanding (MOU) with respect to the application of these rules to carried interest. If the carried interest arrangements relating to the fund are consistent with those in the MOU, HMRC will accept that the unrestricted market value of the carried interest acquired by an employed participant is equal to the amount actually paid for such interest (often nominal), assuming the interest is acquired on formation of the fund. Such participants should not then be subject to employment income taxation on the acquisition of the carried interest or in respect of their returns. Where, owing to the particular carry arrangements, the MOU is not thought to provide sufficient comfort, participants can also make a joint tax election with their employer (known as a section 431 election) the broad effect of which is to ensure future carry returns should not be subject to employment income taxation. Employed carried interest participants are outside the current scope of the income based carried interest rules discussed above.
Those involved in the structuring of fund sponsor incentives should also be alive to the two partnership anti-avoidance regimes introduced by the UK government in 2014, namely the LLP ‘salaried member rules’ and the legislation concerning the allocation of profits and losses in partnerships with mixed individual and non-individual members.
One other recent consideration for some UK general partners relates to the fact that they are often loss-making in the early years of a fund when their management fee expense exceeds the income generated through their profit share. Those losses have traditionally been useful in sheltering tax in later years when the profit share from the fund exceeds management fees. However, under rules having effect from April 2017, there is a restriction on the set-off of carried-forward losses, permitting them only to be set against 50 per cent of total profits exceeding an annual allowance of £5 million. The UK government has confirmed, following discussion between the BVCA and HMRC on the impact of these provisions on UK general partners, that no exclusion from the restrictions for the losses of UK general partners will be introduced. A possible workaround the BVCA has identified, for new funds or existing funds that are able to reorganise their structure for future years, is that if the ELP itself were to appoint the manager and pay the management fee directly to the manager (with the UK general partner not receiving a priority profit share), the UK general partner would no longer make profits or losses to which the rules would apply (but note the VAT consequences discussed in question 23).Tax treaties
Please list any relevant tax treaties to which your jurisdiction is a party and how such treaties apply to the fund vehicle.
In relation to the fund itself, an ELP is not typically able to rely on UK tax treaties as it is not a taxable entity for UK tax purposes. The UK does, however, have an extensive network of tax treaties with various jurisdictions that may be relevant in relation to downstream investment structuring including in relation to assets that generate UK source income. The availability of treaty relief for entities owned by investment funds should, however, be considered in light of the amendments to double tax treaties to be introduced by the OECD’s multilateral instrument, discussed in question 23.Other significant tax issues
Are there any other significant tax issues relating to private equity funds organised in your jurisdiction?
Typically, in the UK, private equity funds do not qualify as special investment funds, the management of which is exempt from VAT. Investment management (and, if applicable, advisory) fees may therefore be chargeable to UK VAT (at 20 per cent). However, (as discussed above) ELPs have, in the past, generally been structured so that the GP receives a priority profit share (not subject to VAT on first principles) rather than a management fee, with a separate investment manager receiving a management or advisory fee that is paid out of the GP’s profit share (though see the discussion of the restrictions on carried-forward losses introduced in April 2017 in question 21: funds with a UK general partner may now wish to have the ELP itself paying a management fee, with the UK general partner not receiving a priority profit share). The ELP is typically then organised with a GP in an ‘offshore’ jurisdiction (such as Delaware or Jersey) so that such fee may be paid outside the scope of VAT or, alternatively, the UK fund manager and its UK subsidiary (acting as the GP of the fund) form a VAT group with the result that there is no supply between those entities for VAT purposes. Where the ‘offshore’ GP route is followed, it is of course necessary to maintain sufficient substance in the chosen jurisdiction and to consider the GP structure in light of the Accounts Regulations (see question 3).
Where a UK general partner receives no priority profit share and the management fee is instead paid directly by the ELP (see the discussion of the restrictions on carried-forward losses in question 21), that fee would be subject to VAT, unless the ELP and the manager are in the same VAT group and, as a result, there is no supply between those entities for VAT purposes.
In certain circumstances, a written instrument of transfer relating to an interest in an ELP may be subject to UK stamp duty where the interest is being transferred by way of sale. The amount of stamp duty payable should be limited to 0.5 per cent of the market value of any stock or marketable securities held by the fund.
Readers may be aware that the global tax landscape is in a state of change in light of the OECD’s Base Erosion and Profit Shifting (BEPS) project. The UK government has already implemented UK laws designed to address certain practices that form the subject of the project (such as the ‘diverted profits tax’, the ‘hybrid mismatch’ rules and a limit on corporate interest expense deductions). In November 2016, the OECD also published a multilateral instrument (MLI) designed to enable all OECD countries to meet the treaty-related minimum standards that were agreed as part of the final BEPS package, including changes to the manner in which the entitlement to benefit from double tax treaties is determined and permanent establishments are recognised. The MLI has now been signed by at least 80 countries and entered into force in the UK on 1 October 2018. The MLI has effect in relation to a particular treaty where it has also come into force for the other country which is party to the treaty, and will apply to these treaties with effect from January 2019 for withholding taxes, and April 2019 for corporation tax, income tax and capital gains tax. It will be important to consider the MLI and other BEPS related legal changes in relation to both fund and downstream investment structuring and management.
Also of note for funds investing in the UK are some changes that have been made to the UK’s participation exemption for the sale of ‘substantial shareholdings’ (the SSE). The changes include relaxation of the SSE rules where the UK entity making the disposal is owned (directly or indirectly) by ‘qualifying institutional investors’ (including pension schemes, sovereign wealth funds and certain UK authorised and retail funds).
A further tax-related law in the UK that funds and their portfolio companies need to be aware of and react to is the introduction from the end of September 2017 of new criminal offences for failure to prevent the criminal facilitation of tax evasion. The new law can expose UK companies and partnerships (and some non-UK companies and partnerships) to unlimited fines, and ancillary orders such as confiscation orders, if their employees, agents and some service providers criminally facilitate UK or non-UK tax evasion while acting in their capacity as employee, agent or service provider. Since the offences are ‘strict liability’ in nature (ie, they do not require any knowledge or intention), it will be important to ensure that steps are taken to access the defence of having reasonable prevention measures in place.