Taxation of carried interest: a view from the UK
December 2023 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
December 2023 Issue
It is unusual for tax lawyers to find technical parts of their practice making headlines, but in the UK, that is what has been happening in recent months. The excitement relates to carried interest: the portion of a private equity (PE) or venture capital (VC) fund’s profits that are allocated to the fund manager once the fund has achieved a certain level of return.
The question that has been posed is whether this return – which might represent a fifth of the fund’s total return, typically over a minimum hurdle rate to which investors are entitled – represents the profits of a trade, in which case it is taxable as income at a rate of up to 45 percent, or a return on the disposal of the fund’s underlying investments, in which case it is taxable as capital gains at a rate of up to 28 percent.
The taxation of carried interest is technical, but highly politically charged. In the UK as in the US, it has become the focus of debate about its place in the general scheme of taxation, taking in arguments about social justice and the broader competitiveness of the UK financial services sector. The Labour Party is committed to ‘close the loophole’, though we do not yet know exactly how it might do so.
Yet there are those who might not wait for the UK’s general election (which must take place before the end of January 2025) to try to change what they say is the unfair treatment of carried interest. Recent months have seen ‘public interest’ judicial review litigation about the tax treatment of carried interest. The purpose of this article is to unpack that litigation and explain its ramifications – which are much broader than simply for fund managers.
Taxation of carried interest: a potted history
Managers of PE and VC funds generate returns in two different ways. There is a ‘management fee’, typically 1 to 2 percent of the committed or drawn capital of the fund. That is the amount that ‘keeps the lights on’ for the fund manager. The other, much less predictable, element is ‘carried interest’, which is a return representing a share of the fund profits that is typically payable when the fund generates a certain minimum level of profitability. For example, a manager might be entitled to 20 percent of the fund’s profits when the fund has realised an 8 percent annualised return. If the fund does not reach that level of profit, the manager is entitled to no, or much less, carried interest.
In the UK, the position has long been that the management fee is treated as income and taxed accordingly – typically this will be income of a trading entity and taxable in the hands of that entity (or, if an LLP, its members) as trading profit. Equally, the UK has generally treated carried interest as a return generated from the underlying investments in the fund, taxed in line with the nature of those investments and how the return is sourced.
This framing was recorded in a memorandum of understanding (MoU) between HMRC, the UK’s revenue authority, and the British Venture Capital Association, which represents the interests of the UK’s PE and VC fund management industry dating back to 1987. The MoU says that: “Where a venture capital fund is run through the medium of a limited partnership and it purchases shares and securities with the intention of holding them as investments, any profits or losses on disposal of those shares and securities will not… be treated as income of a trade.”
The MoU now forms part of HMRC’s guidance on the taxation of investment funds.
The recent debate
The question that has been hotly debated in recent months is whether the MoU is a statement of law or a ‘sweetheart deal’ for the industry; and if it is a statement of law, whether it is correct or incorrect. If the answer is a statement of law and is incorrect or a ‘sweetheart deal’, that would suggest that HMRC might need to revisit its approach. Thus far, we have seen academic commentary focus on a correct statement of law versus an incorrect, but the focus of the judicial review case was very much on a statement of law versus a ‘sweetheart deal’.
The argument for ‘a sweetheart deal’ is based on the context in which the MoU was agreed. On the face of certain documents that were disclosed in the judicial review case, it appears that the UK’s Treasury ministers were keen in the months before the MoU was agreed in 1987 that something should be agreed. However, that does not demonstrate that there is any sort of special deal with the industry. HMRC has said categorically that there is no ‘special policy’ applied in this case.
HMRC’s clear answer that there is no ‘sweetheart deal’ means that the litigation is probably now over. It is not possible for a judicial review claimant to challenge primary tax legislation in court (in sharp contrast to, for example, the position in the US). For the litigation to go on, the claimant would have to argue that HMRC is misapplying the law: that is, to prove a statement of law is incorrect rather than correct. That would be likely to present real difficulties.
HMRC’s position
The debate has shed further light on HMRC’s approach to the trading versus investment approach. What we know of HMRC’s position comes from correspondence between parties published by the lawyers acting for the claimant in the judicial review proceedings. It is not, therefore, an official statement of practice, and taxpayers cannot rely on it. However, it is likely to provide an amount of insight to those advising investment managers on the trading and investing question generally. HMRC’s view on some of the trickier ‘badges of trade’ (a list of common features or characteristics of trade historically recognised by the courts and referenced in HMRC guidance, such as average holding periods, where shorter periods tend to point to trade, and frequency, where greater repetition tends to point to trade) appears to be generally helpful to managers.
HMRC’s position at high level appears to be that the mere fact that an asset is bought and then is (understandably) expected to be sold in the future by a fund does not mean that the fund is trading, so the question is what the fund’s intention was when it acquired the asset and what it does in the meantime. A typical buyout fund would during that time be looking to maximise the value of the asset, with the potential that income may be generated in the interim, and HMRC’s position appears to be that such activity is consistent with investment.
More generally, HMRC’s response highlights that a narrow approach based on the badges of trade is ‘not the approach taken in the modern authorities on trading’ and a more ‘holistic’ view is important. In the context of a buyout fund, HMRC suggests that acquiring a controlling stake, holding it for four to seven years and then selling it is not suggestive of a trading activity.
HMRC’s position would seem to have application to the trading and investing question as it arises in many other areas of taxation. Most immediately, this provides some clarity to partnership fund investors which would pay tax on trading income but benefit from an exemption on investment income and gains (such as UK pension funds).
In the future
It is up to the judicial review claimant to consider whether he wishes to take his claim on to the next stage, and at time of writing it is not clear whether he intends so to do. Taking any further action would be difficult in light of HMRC’s position, and his supporters have already (curiously) painted HMRC’s position as a victory for the claimant. It may therefore be that the judicial review goes no further. Anyone who needs to know whether they are investing or trading and wants certainty in this area of the law – which means many taxpayers in various contexts – could be forgiven for breathing a sigh of relief at that news.
For fund managers, however, this probably is not the end of the matter. The Labour Party’s commitment to the ‘closure’ of the ‘carried interest loophole’ is public and longstanding, and it may well form part of the first Budget of a new Labour administration. Such a change would need to be considered in the round with other matters of tax policy, and with an eye on global competitiveness.
Craig Kirkham-Wilson is a supervising associate at Simmons & Simmons LLP. He can be contacted on +44 (0)20 7628 2020 or by email: craig.kirkham-wilson@simmons-simmons.com.
© Financier Worldwide
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Craig Kirkham-Wilson
Simmons & Simmons LLP
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