The Chancellor of the Exchequer’s Summer Budget on 8th July introduced a series of unexpected tax changes affecting the private equity and investment management industry along with the promise of further changes to come.
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 widely. Not only did it 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 recent Summer Budget 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 an investment manager 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 28% rather than a considerably lower rate which had generally been available.
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 on 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 such 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 return.
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 wholly carrying on such activities. HMRC has invited comments on the list of qualifying activities. However, the proposal looks 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 3 years;
- the holding of real property for rental income and capital growth where, at the point of acquisition, it is reasonable to suppose that the property will be held for at least 5 years;
- the purchase of debt instruments on a secondary market where, at the point of acquisition, it is reasonable to suppose that the debt will be held for at least 3 years;
- equity and debt investments in venture capital companies, provided they 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 greater period of time (e.g. 25% relief if assets are held for more than 6 months, 50% relief if held for more than 1 year, 75% relief if held for more than 18 months and full relief if held for more than 2 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 tax payer 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 is 30 September 2015 and Dechert will be making representations in relation to the above proposals through its involvement with the Alternative Investment Management Association (AIMA).
New restrictions have been introduced for those who are UK tax resident but not UK domiciled:
- it will no longer be possible for a person 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; and
- 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 LLP’s as the vehicle of choice, particularly following the tax changes to LLP’s 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 30.6% under current law). 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 existing and future structuring.