Private equity firms globally have faced a clampdown from governments and regulators worldwide over what many see as overly favourable tax treatment. The industry has also come under increased commercial pressure from investors, who are keen for firms to spend some of the estimated US$1.1 trillion (and rising) they have accumulated, and to provide more transparency on fees and expenses.


Following their re-election, and coming  as a surprise to some in the private equity market, the  Conservative Government has moved quickly to implement extensive changes to UK tax legislation that  will have a significant impact on the private equity industry.

Base Cost Shift

Before the July 2015 Budget, PE fund managers were treated as taking a share of the investors’  chargeable gains base costs when the carried interest became payable – essentially a “base cost  shift”. This significantly reduced the effective rate of tax payable by PE managers.

In the Budget, the use of base cost shifting has been stopped, with the effect that more tax will  be paid on carried interest. While the changes do not abolish capital gains treatment, for carried interest arising on or after 8 July 2015, a capital gains tax deduction will only be given for sums that a PE fund manager actually pays to acquire a carried interest right in the managed fund. The Chancellor  resisted calls for carried interest to be taxed entirely as income, and stated that “carried interest should be subject to capital gains tax  as it reflects  the underlying long term performance of a fund’s investments”.

Non-Dom Fund Managers The July 2015 Budget also introduced draft legislation that removes the ability for PE fund  managers who are UK- resident but non-domiciled to claim the remittance basis in respect of their carried interest entitlement, unless they perform their  investment management activities entirely outside the United Kingdom. Affected PE fund managers  will have to pay capital gains tax on carried interest, even if they keep the carry proceeds  offshore.

This change brings the treatment of non-domiciled fund managers into line with UK-domiciled fund  managers,   but it is feared in some quarters that it will encourage another exodus of private equity fund managers to a low tax, low regulation  jurisdiction such as Switzerland, as happened (to an extent) in 2009 in response to higher taxes and public anger over bonuses.

Disguised Investment Management Fees

Prior to the Budget, PE managers were also affected by legislative changes that took place with  effect from 6 April 2015 on disguised management fees. These rules arose because Her Majesty’s Revenue & Customs became aware that some private equity funds had been using structures known as GP LP and GP LLP planning to avoid income tax on annual management fees, which  are typically set at 1.5 per cent to 2 per cent of assets under management and intended to cover  the costs of managing and investing the fund’s money. These structures involved the fees being paid  as priority partnership shares and were intended to secure capital gains tax treatment instead of  income tax treatment. The new legislation ensures that any such fees are taxed as income, although the legislation still allows for carried interest to preserve its treatment as a capital gains tax asset.

Disguised Remuneration

The UK Government has also recently published a consultation paper on how to determine when  performance fees arising to PE fund managers should be taxed as capital or as income. The broad thrust of the government’s thinking in this area seems to be  that fund managers should not automatically be accorded capital gains tax treatment on performance-  linked returns. Instead, this should be dependent upon the fund in question pursuing a strategy of  an investing (rather than trading) nature. The consultation proposes a default rule that all performance-linked rewards be subject to income tax, with a carve-out expected to be  included for carried interest and genuine co-investment.

There is also a proposal to include a white list of certain activities that would be automatically treated as investing rather than trading.  The government proposes to publish a response document as part of the Autumn Statement later this  year, and plans to legislate any changes in 2016.


Increased legislative pressure is not just limited to the United Kingdom; the wide ranging and extensive changes to both US and EU private  equity regulation enacted by, amongst others, the Dodd- Frank Act, the Foreign Account Tax  Compliance Act and the Alternative Investment Fund Managers Directive have created mounting pressure on private equity firms to deliver greater transparency, better reporting and tighter accounting controls. 

In addition, regulators worldwide have shown a willingness to bare their teeth in order to increase transparency in the private equity  industry. The US Securities and Exchange Commission (SEC), for example, has been conducting investigations into fees charged by  private equity firms,  and found that more than half of those it examined were  either breaking the law or had “material  weaknesses” in fee control. In connection with these investigations, the SEC has issued fines to PE  firms for numerous deemed offences, including misallocation of expenses, changing distribution  calculations without adequate disclosure and failing to properly inform investors of management fees to be charged.

Fees, Transparency and Opportunity

As well as regulatory pressure, PE firms have increasingly faced scrutiny from investors over fees and transparency. A recent study by  SunGard found that 78 per cent of GPs and LPs believe private equity fees will fall over the next two years, while 42 per cent of GPs say investors have  become more demanding in terms of the information they seek.

Further, pension funds, sovereign wealth funds and family offices, increasingly fed up with high  fees, are also increasingly looking to run their portfolios internally and invest directly. These  direct investors are now competing for buy-outs, infrastructure and property investments with PE  funds, or looking for a co-sponsor role on bigger transactions.

The recent mass exits by private equity firms looking to capitalise on the rally in the market has left many private equity firms with  large reserves of cash and a dearth of attractive assets to invest in. Recent figures from Citi  suggest that purchase price multiples for quality  assets are at an all-time high, and because many  institutional investors engaging in direct investment can finance deals with minimal leverage, a  longer  term outlook and a willingness to settle for attractive rather than the aggressive returns,  they can afford to do deals at the top of the market.

The Future is Bright The private equity industry is facing a changing landscape in both the UK and globally. Whilst new  tax rules will certainly mean that private equity firms will need  to review the use of certain investments vehicles and fund structures, to account for UK and global legislation changes, it is important to note that the rules in the United Kingdom are specifically tailored so as not to  affect the tax treatment of genuine carried interest, which the government supports. In addition,  the United Kingdom is still a very attractive jurisdiction for private equity, as higher taxes and  regulation are counterbalanced by a strong and fair court system, flexible employment legislation,  an active and open banking market and its status as an established gateway into the rest of Europe.

The increased pressure from investors will inevitably lead to structural changes in the way in which PE firms operate, and should be  embraced. For example, Terra Firma recently announced, that it intends to put more “skin in the  game” by deploying €1 billion of its own money into co-investments, and increasing the link between the fund managers’ reward and performance by removing fees on uninvested capital,  with a view to remaining competitive and attractive to key investors. Although this is not  an  approach that will suit all PE firms,   it is indicative of a shift away from the traditional model.