Did the Good Law Project just kill carried interest?

The “carried interest loophole” means private equity executives pay tax at the low, low, capital gains rate of 28%, and not the 47% rate that an equivalent banker would pay. Earlier this year I wrote a slightly controversial paper, published in the British Tax Review, which suggested that the loophole didn’t actually exist. I said that the 1987 agreement between the DTI, Inland Revenue and British Venture Capital Association (which created the loophole) got the law wrong, and it was unlawful for HMRC to stick to it.

The Good Law Project brought legal action against HMRC using these arguments. That has now ended. The Good Law Project say it’s won. HMRC say nothing’s changed.

Who’s right?

Carried interest

Private equity executives take a special interest in the funds they manage – “carried interest”. It’s very different from the investments that third parties make in their funds, because they don’t pay for it¹Or they pay a very small amount. Or they pay a larger amount, perhaps even as much as 5% of the total capital of the fund, but that is provided by a non-recourse loan which means they’re not actually out fo pocket. Either way, the executives are getting a deal that isn’t available to anyone else.. But if the fund performs past a pre-determined “hurdle”, then the carried interest usually pays out 20% of everything over the hurdle. For a successful fund that can be multiple £100m, shared between a relatively small executive team.

Bankers receiving bonuses pay income tax/NI at the full marginal rate of 47% – and the bank pays employer national insurance at 13.8%. But private equity executives receiving carried interest are taxed at 28%.

The reason goes back to 1987.

The 1987 deal

In 1987, the British Venture Capital Association reached a deal with the Inland Revenue (as it was then) and the Department of Trade and Industry on how private equity funds were taxed.

Here’s the key paragraph:

This created the “carried interest loophole”.²Not really a loophole; because that and successive Governments have known and approved of it. However that’s the term often used, and so I’m afraid I will use it in this article. My apologies to purists. As long as the fund is structured as described in the statement, and the executives say their “intention” is to hold the fund’s shares etc as investments, the fund is not “trading” (a key tax concept). Meaning that executives get capital gain treatment on their return when the fund performs – their “carried interest”.

It’s this that enables private equity executives to pay tax at a lower rate, because (at least for now) the rate of capital gains tax is so much lower than the rate of income tax. Overall, the “loophole” is worth over £600m a year to private equity fund managers.³The source for the £600m figure is this FOIA, which shows £3.4bn of gains in the most recent tax year. The difference between CGT and income tax/NI on £3.4bn is £600m. This will be a significant under-estimate, because it doesn’t include the very substantial amount of unremitted carry received by non-dom investment managers. But there are also obvious factors the other way, as some private equity managers will undoubtedly respond by leaving the UK (particularly non-doms, although they mostly aren’t in that £600m figure). Where managers leave there would be knock-on effects throughout the City and the wider economy, for good or for bad, which I am not competent to assess. Some would say these effects mean we shouldn’t change the way carried interest is taxed. Some would be sceptical about these effects. Others would say, as a matter of principle, everyone should pay tax on their employment income (which is realistically what it is) at the same rate. This article isn’t about these arguments.

The background to the deal

The FT published an illuminating history of the background to these discussions; you’ll see that it’s heavy on policy justifications, and light on technical tax justifications.⁴That continues to be the case. I think it’s fair to say that most of the pieces disagreeing with my original paper spent at least 25% of their time justifying the loophole on policy grounds; which is irrelevant to the point at issue. Now, thanks to documents disclosed by HMRC to the Good Law Project, we also know that senior HMRC personnel (writing two years later) believed it was created “in the face of considerable political pressure” and was “technically suspect”:⁵The prediction about the structure being “capable of exploitation” was very far-sighted. There have been multiple schemes, most egregiously the “base-cost shift”, which was common across the industry until 2015, and which enabled private equity fund managers to achieve an effective rate of tax on their carried interest in the single digits.

I wrote a paper, published by the British Tax Review earlier this year, saying that I too believed the 1987 deal was technically suspect.⁶Although I wasn’t aware of that memo at the time. I wrote a summary of the paper here.

The paper said that classic venture capital – acquiring a minority interest in a startup business – is unlikely to be trading. But the term “private equity” usually refers to “buyout funds”, which buy mature businesses, and later flip them at a profit. In my view, a typical buyout fund is likely trading. So I thought it was wrong, and very possibly unlawful, that HMRC permitted buyout funds to rely on the 1987 statement. It follows that managers of most buyout funds should pay tax at 47%.

The value of the deal

The beauty of the 1987 statement is that it reduces the capital gains vs trading question to just two boxes you can tick off: have the right structure and have the right intention. Compare with the HMRC guidance on trading, which goes on forever. Then tell me with a straight face that the 1987 statement is just a bland statement of the law.

In practice, everybody knows that paragraph 1.4 of the 1987 statement is a “cheat code” which enables private equity to skip the careful and cautious positions on trading taken by tax advisers on almost every other type of business.

When I was a practising lawyer, I would often be asked to issue opinions on whether an entity was trading.⁷Disclosure: I didn’t issue an opinions on this point to private equity firms, and this article and my other work in this area reveals no client-confidential information. At that point, I would suck my teeth in and say it was all very difficult, and the best I could do would be to say that I didn’t expect it to be trading, but it was a question of fact and HMRC might take a different view. My analysis would then proceed on the prudent basis that it either might be trading, or it might not be trading, and the client had to be happy with both outcomes.

This is how tax lawyers usually approach trading questions. What they never do is make deals or get clearances from HMRC: there are no sector-level deals apart from the 1987 BVCA statement, and in my experience HMRC would always refuse to give clearances on trading.

Private equity is completely different. There, the 1987 statement means that most⁸Certainly not all. advisers are supremely relaxed. In fact fund managers often don’t even ask for detailed specific advice on the point.

And that’s because of the BVCA statement.

Buyout funds therefore rely on the BVCA statement

That wasn’t the original intention. The 1987 statement the statement refers to “venture capital”, not private equity generally, or buyout funds. But at some point it started being extended.

We now know, thanks thanks to another document disclosed by HMRC to the Good Law Project, that some people at HMRC saw this happening, and were unhappy. This is a 1989 memo from a tax inspector⁹Not the same person who wrote the memo excerpted above bemoaning the extension of the 1987 statement to buyout funds, and saying that this wasn’t the original intention:¹⁰Also far-sighted – look at the complaint about excessive leverage, well before it was fashionable.

But, whether that tax inspector liked it or not, it happened. The 1987 BVCA statement has, for the last 36 years, been used to extend the carried interest loophole to the whole private equity industry. They say this themselves:

Here’s how the BVCA’s website presents the document. Note “venture capital and private equity fund managers“:

Here’s the BVCA’s response to my paper. Note “PE/VC“, and the reference to the industry as a whole:¹¹We can also pause to raise our eyebrows at the two contradictory claims: it was just a statement of the law, not not a “special deal”. But it also gave the industry such confidence that it’s been an enormous success for the industry. Can’t be both.

That has now changed

The Good Law Project recently commenced legal action against HMRC regarding the legality of the 1987 statement and its current policy. There’s lots to say about this, but here’s the key passage in HMRC’s response to the original Good Law Project letter:

Now HMRC contest everything, and that’s to be expected, but check out (a) and (b).

HMRC say the 1987 statement doesn’t apply to buyout funds. I spoke to a senior industry figure this morning and read this out to him, and he initially thought I was joking.

This gives the Good Law Project what they wanted, and so they don’t need to take the legal action any further.

And it puts private equity in a brave new world. Buyout fund tax advice can’t just rely on paragraph 1.4 of the 1987 BVCA statement. It has to consider the law. The fund managers will ask the advisers how confident they really are that they’re not trading (and if they don’t, investors¹²Investors because one of the silly consequences of the 1987 statement is that many investors’ own tax position will blow up if a manager does something that results in a fund trading will). And the advisers will have to say it’s not completely clear. HMRC is now able to open enquiries on individual funds – currently it seems they don’t have appetite to do this, but that could easily change within the 4-6 year lifetime of a fund. Any adviser who gives a clear opinion that a buyout fund isn’t trading is being commendably courageous.

That results in a level of uncertainty that managers may regard as unacceptable, and well-advised investors certainly will.

Some people will blame the Good Law Project, or even me, for this situation. They’d be right in that I don’t think lawsuits from campaigning groups are the answer. But we can’t have a tax system where one sector gets special favours thanks to a politically-driven “technically suspect” backroom deal 36 years ago. We should be taxed by law, not by lobbying or litigation.

It’s now in everyone’s interest for the taxation of carried interest to be put on a proper footing. Government should have the courage to take a position (one way or another) and Parliament should legislate.¹³And we should detach the tax consequence for the management team, whatever it may be, from the tax position of third party investors – their investment should never be on trading account for tax purposes.

• 1
  Or they pay a very small amount. Or they pay a larger amount, perhaps even as much as 5% of the total capital of the fund, but that is provided by a non-recourse loan which means they’re not actually out fo pocket. Either way, the executives are getting a deal that isn’t available to anyone else.
• 2
  Not really a loophole; because that and successive Governments have known and approved of it. However that’s the term often used, and so I’m afraid I will use it in this article. My apologies to purists.
• 3
  The source for the £600m figure is this FOIA, which shows £3.4bn of gains in the most recent tax year. The difference between CGT and income tax/NI on £3.4bn is £600m. This will be a significant under-estimate, because it doesn’t include the very substantial amount of unremitted carry received by non-dom investment managers. But there are also obvious factors the other way, as some private equity managers will undoubtedly respond by leaving the UK (particularly non-doms, although they mostly aren’t in that £600m figure). Where managers leave there would be knock-on effects throughout the City and the wider economy, for good or for bad, which I am not competent to assess. Some would say these effects mean we shouldn’t change the way carried interest is taxed. Some would be sceptical about these effects. Others would say, as a matter of principle, everyone should pay tax on their employment income (which is realistically what it is) at the same rate. This article isn’t about these arguments.
• 4
  That continues to be the case. I think it’s fair to say that most of the pieces disagreeing with my original paper spent at least 25% of their time justifying the loophole on policy grounds; which is irrelevant to the point at issue.
• 5
  The prediction about the structure being “capable of exploitation” was very far-sighted. There have been multiple schemes, most egregiously the “base-cost shift”, which was common across the industry until 2015, and which enabled private equity fund managers to achieve an effective rate of tax on their carried interest in the single digits.
• 6
  Although I wasn’t aware of that memo at the time.
• 7
  Disclosure: I didn’t issue an opinions on this point to private equity firms, and this article and my other work in this area reveals no client-confidential information.
• 8
  Certainly not all.
• 9
  Not the same person who wrote the memo excerpted above
• 10
  Also far-sighted – look at the complaint about excessive leverage, well before it was fashionable.
• 11
  We can also pause to raise our eyebrows at the two contradictory claims: it was just a statement of the law, not not a “special deal”. But it also gave the industry such confidence that it’s been an enormous success for the industry. Can’t be both.
• 12
  Investors because one of the silly consequences of the 1987 statement is that many investors’ own tax position will blow up if a manager does something that results in a fund trading
• 13
  And we should detach the tax consequence for the management team, whatever it may be, from the tax position of third party investors – their investment should never be on trading account for tax purposes.