Comment: Carry under threat in the UK

The HMRC is being pulled in different directions as it determines which criteria to use when taxing carry as income, writes industry tax expert John Davison. 

As slowly-slowly as its approach has been, HMRC’s attempts to reform the basis of taxation for private equity managers has not gone unnoticed.  Starting with the Disguised Investment Management Fee (DIMF) regime last year, and capped by a series of additional announcements around carried interest in Osborne’s emergency budget, the larger pattern emerges clear: HMRC thinks that at least some GP income currently subject to capital gains treatment should instead be taxed as income.

However one of the proposals – a consultation on the basis of taxation of carried interest – is being regarded by some as explicitly exempting the private equity and real estate industries. This is an overly optimistic interpretation, to say the least.

The consultation invites opinion on two fundamentally different ways of handling capital gains vs income tax treatment for carried interest, with it being highly likely that one will become UK law. Option One takes the approach of treating all carried interest as income, except a prescribed list of  “good” activities which will count as ‘investment’ and thus be subject to capital gains treatment. Option Two treats all activity equally, focusing on the length of time underlying investments are held (for instance, the proportion of return eligible for capital gains tax treatment is 25 percent for average period investments held between six months and a year, and only reaches 100 percent for average period investments held for longer than two years).

It is possible that the relaxed attitude towards this consultation from some stems from a belief that Option One will triumph, and that the whitelist will be explicitly designed to exempt the entire private equity and real estate industry. Any whitelist will certainly cover a lot of typical private equity activities. But it won’t cover everything.

That’s if Option One wins out. But of course private equity managers aren’t the only ones affected by all of this – hedge fund managers are too. And from the perspective of a typical hedge fund manager, Option Two is the preferable a solution as it gives far more certainty for tax planning purposes (as well as a better possibility of retaining capital gains treatment for some carried interest). Many in the industry are aggressively lobbying for Option Two for these precise reasons, and private equity managers should be aware of this.

Of course, under Option Two a lot of private equity activity would still be exempt from any danger of carried interest being taxed as income – a typical fund will have an average investment holding period of two years plus. But again, not all – some trading will certainly be affected. And either way it adds a significant new consideration when planning investments from a taxation perspective. Very few are going to be able to simply ignore these changes, whatever emerges.

Another aspect to remember is that, unlike Option One, Option Two establishes a clear principle for whether carried interest should be subject to income tax. Depending on their final formulation it may well turn out that private equity managers get to keep more of their income under Option One than Two. But that privilege will rest on what will essentially be an arbitrary list – more vulnerable to further future changes than a clear and universal principle. This consultation appears to be firmly aimed at the private equity industry – after all, hedge fund managers typically take most of their income as trading income already. It would be a dangerous assumption for private equity fund managers to assume that theirs are the only voices being heard in this process, and the outcome of the consultation is by no means certain.

John Davison is a London-based tax partner at Cordium, a compliance consultancy firm.