UK Government Calls for Evidence on the Reform of Carried Interest

On 29 July, the UK government issued a call for evidence in connection with its proposed reform of the UK taxation of carried interest. Noting that the tax treatment of carried interest is the subject of considerable debate, the government has restated both its belief that the current tax treatment of carried interest does not reflect its economic characteristics and its commitment to reform.

The government has not yet published any formal proposals for reform; the call for evidence is intended to inform the government’s policy decisions. The three questions posed are as follows:

• Question 1: How can the tax treatment of carried interest most appropriately reflect its economic characteristics? The government notes that there are a range of circumstances in which carried interest is received, and that the characteristics of the reward will not be the same in all cases.
• Question 2: What are the different structures and market practices with respect to carried interest?The government is particularly interested to understand how these differences should be taken into account as part of its reforms.
• Question 3: Are there lessons that can be learned from approaches taken in other countries?While many other countries have specific regimes for the taxation of carried interest, their detail and conditions for access vary.

The call for evidence closes on 30 August 2024, following which it is expected that the government will announce its policy objectives and start a formal consultation process to coincide with the Autumn budget.

Comment

The appropriate tax treatment of carried interest has been debated by tax practitioners for a number of years, but it was not until 2007 that it came to the attention of the media and public at large when it was reported that a UK private equity executive had claimed to pay “less tax” than domestic staff at his firm—a reference to the rate of tax paid on capital gains qualifying for then-available business asset taper relief (then 10%) as opposed to income tax on employment income (the basic rate of income tax was then 22%).

Since then, the debate (and public interest in the topic) has ebbed and flowed but has recently been brought to the fore by tax campaigners who have expressed a number of concerns about the current tax treatment of carried interest, including the appropriateness of a Memorandum of Understanding agreed between the Inland Revenue (now HM Revenue & Customs) and the British Venture Capital Association which underpins the UK tax treatment of carried interest and preserves capital gains tax treatment provided that certain conditions are satisfied.

Successive governments have made changes to the tax treatment of carried interest, for example by changing the way the gain is quantified, increasing the rate of capital gains tax on carried interest (carried interest is subject to higher capital gains tax rates of 18% or 28%), and introducing the income-based carry rules, which prevent capital gains tax treatment where assets have not been held for a sufficient amount of time. However, the general principle that “genuine” carried interest should be taxed as capital has not been disturbed.

Following the Labour Party’s victory in the recent UK general election, a change to the status quo now appears more likely than ever: in its election manifesto, the Labour Party committed itself to closing what it described as the carried interest “loophole,” commenting that “Private Equity is the only industry where performance related pay is treated as capital gains.” This call for evidence forms part of a larger package of closing loopholes and tackling the “tax gap.”

Although it is speculation at this stage, some options for change that could be explored by the government include the following:

• Extending the income-based carry rules, perhaps by extending the applicable holding period to qualify for capital gains treatment. Given the government’s stated view that carried interest is a loophole, it seems unlikely that this would fully address the government’s concerns.
• Requiring carried interest holders to “buy-in” by investing a certain proportion of their own resources alongside other investors in funds in order to secure capital gains treatment. This is an approach adopted in other jurisdictions, and on the face of it does go some way to address the government’s concerns. A key policy point for this would be determining the appropriate level of buy-in.
• Treating carried interest returns as income, for example as a performance fee, trading income, or employment income (depending on the status of the recipient). While superficially this addresses the concern that carried interest is a loophole to be closed, it appears incompatible with the government’s statement that it will seek to “protect the UK’s position as a world-leading asset management hub.”

Given the importance of the asset management industry to the UK’s economy, it is hoped that the government will adopt a collaborative approach with stakeholders to ensure that any reforms to the taxation of carried interest are measured and proportionate.

HOW WE CAN HELP

We would be happy to discuss the call for evidence and are interested in hearing the views of clients and contacts with a view toward making a composite submission to the government. If you would like to discuss this or participate in our response, please contact the authors or your usual Morgan Lewis contact.