{"id":9278,"date":"2023-03-10T14:00:00","date_gmt":"2023-03-10T14:00:00","guid":{"rendered":"https:\/\/www.taxpolicy.org.uk\/?p=9278"},"modified":"2023-03-18T12:33:35","modified_gmt":"2023-03-18T12:33:35","slug":"carry","status":"publish","type":"post","link":"https:\/\/heacham.neidles.com\/2023\/03\/10\/carry\/","title":{"rendered":"Carried interest – the \u00a3600m loophole that doesn’t actually exist"},"content":{"rendered":"\n

Private equity fund managers pay only 28% tax on their income – the “carried interest loophole”. This wasn’t created by legislation, but by an impressive piece of lobbying in 1987 which resulted in an agreement between the industry and HMRC. A new analysis shows that the 1987 agreement is unlawful; there is no loophole, and the correct legal position is that most fund managers should pay tax at the full marginal rate of 47%. An interest group could start judicial review proceedings to require HMRC to apply the law correctly.<\/em><\/strong> But it would be much better for the Government to clarify the law.<\/em> <\/strong><\/p>\n\n\n\n

The new analysis is in a peer-reviewed paper authored by Dan Neidle and published in the British Tax Review<\/a>, the leading academic journal for UK tax analysis.1<\/a><\/sup>Carried Too Far?<\/em> [2023] B.T.R., No. 1, \u00a9 2023 Dan Neidle and Thomson Reuters, trading as Sweet & Maxwell, 5 Canada Square, Canary Wharf, London, E14 5AQ – the article is also on Westlaw here<\/a> if you have a subscription<\/span>2<\/a><\/sup>Full disclosure: I was a tax lawyer for 25 years, frequently advising on the question of whether an entity was carrying on a trade or investing; but I never advised a client on the availability of capital treatment for carried interest. As with everything I write, this article and the BTR article include no client-confidential information.<\/span> The FT is carrying the story here<\/a>, with comments from HMRC and other tax experts.<\/p>\n\n\n\n

UPDATE: <\/strong>There is now a short response<\/a> from Macfarlanes, who currently chair <\/a>the private equity industry’s tax committee. The response neatly illustrates the problem the industry has: it correctly notes that trading is a difficult grey area (the correct technical position), but then jumps a few paragraphs later to absolute certainty (unsupportable as a technical matter). I responded in slightly more detail here.<\/a><\/p>\n\n\n

What is carried interest?<\/h2>\n\n\n

Instead of receiving a salary, profit share, bonus, etc, private equity executives take a stake in the funds that they manage – called “carried interest<\/strong>“. It’s an unusual kind of stake, because they pay almost nothing3<\/a><\/sup>It’s sometimes said that the private equity executives pay the same price for their carried interest as outside investors, but the key difference is that they don’t have to commit any subsequent funding. That makes a huge difference in practice. See, for example, the example in paragraph 7.2 of this document.<\/a> where outside investors commit \u00a3100m to a fund, but the investment managers pay just \u00a310,000 for their carried interest, which could eventually give them 20% of the fund returns. That’s usually justified on the basis that the carried interest starts out as pure “hope value”. But one thing’s for sure – if I offered \u00a311,000 for the carried interest they wouldn’t give it to me. It is inextricably linked to the labour of the private equity managers – which is another reason why the status quo is so anomalous.<\/span> for it. The private fund will then typically acquire a mature business, and aim to make it more efficient<\/a> and then sell it at a profit. If that succeeds, then the carried interest can become incredibly valuable, with the management team receiving 20% of the profit. As the profits are often very large, and the team is pretty small, carried interest can make you seriously wealthy. At least \u00a33.4bn of carried interest was shared between about 2,000 people in 2021\/22 – and the true figure is likely significantly more.4<\/a><\/sup>That’s because many private equity managers are non-doms, and one of the effects of the BVCA statement is that there’s no UK trade, and so (to the extent their management activity is conducted outside the UK), they can hold their carried interest offshore and not be taxed on it. There are no stats on non-dom gains.<\/span> <\/p>\n\n\n

What’s the loophole?<\/h2>\n\n\n

When I was an overpaid lawyer, I paid 47% on most of my income. Overpaid bankers pay about 53%5<\/a><\/sup>because they are employees, with their earnings subject to employer’s national insurance, the burden of which falls on employees in the long term<\/span>. But overpaid private equity fund managers only pay 28%. One of the pioneers of the UK private equity industry famously said that he paid less tax than his cleaning lady<\/a>.6<\/a><\/sup>A pedant would say that, unless she was very well remunerated, his cleaning lady paid tax at the basic rate of 20%. However, Ferguson was writing at a time when standard private equity structuring (the “base cost shift”) meant that in practice fund managers enjoyed an effective CGT rate in the single digits. That game was ended in 2015.<\/span><\/p>\n\n\n\n

Why? Because the private equity industry claims that carried interest in a typical private equity fund is taxed as capital<\/strong>, not as income<\/strong>. And whilst income is taxed at a marginal rate of 47%, capital gains are taxed at only 28%7<\/a><\/sup>Normal capital gains are taxed at 20%, but ever since 2015<\/a>, carried interest has been taxed at the special rate of 28%<\/span>.<\/p>\n\n\n\n

The loophole8<\/a><\/sup>You can argue whether it is truly a “loophole”, but “carried interest loophole” is a common term and I’m using it for clarity<\/span> is worth around \u00a3600m a year to private equity fund managers.9<\/a><\/sup>The source for the \u00a3600m figure is this FOIA, which shows \u00a33.4bn of gains<\/a> in the most recent tax year. The difference between CGT and income tax\/NI on \u00a33.4bn is \u00a3600m. Determining the actual revenue that would be raised if the loophole disappeared is complicated. This is a “static” figure, and would be reduced if private equity managers responded by leaving the UK. On the other hand, there could be additional revenue from the loss of the remittance basis for non-dom fund managers (as their carried interest would be income from a UK trade and hence UK situs)<\/span><\/p>\n\n\n

Why would Parliament create such a loophole?<\/h2>\n\n\n

It didn’t. <\/p>\n\n\n\n

Most loopholes are created when Parliament accidentally leaves a small chink in tax legislation that a careful taxpayer can carefully squeeze through. This one is different \u2013 it was created by an impressive lobbying effort by the private equity industry back in 1987. The industry said that if it didn\u2019t get the low tax result it wanted, then it would move offshore. And the Government blinked.<\/p>\n\n\n\n

The FT published an illuminating history of the background to these discussions<\/a>; you’ll see that it’s heavy on policy justifications, and light on technical tax justifications.<\/p>\n\n\n\n

As a result, the Inland Revenue agreed a statement with the British Venture Capital Association<\/a> saying that typical private equity funds were not “trading” for tax purposes, with the consequence being that carried interest was taxed as capital. Since then, the Inland Revenue has faithfully followed the BVCA statement, and private equity funds rely on it as a matter of course.<\/p>\n\n\n\n

People often call it the “carried interest loophole”.<\/p>\n\n\n

Is the loophole good tax policy?<\/h2>\n\n\n

Over the last few years there have been many<\/a> proposals<\/a> to scrap<\/a> this favoured treatment of carried interest, and it seems this is now Labour Party policy. The debate is somewhat predictable: campaigners say the loophole is unfair; the industry says that if they have to pay tax at the same rate as everyone else, they\u2019ll fly off to Zurich.<\/p>\n\n\n\n

I confess I don\u2019t find the debate over whether the loophole should<\/strong> exist very interesting. So I\u2019ve been wondering about a different question. Things have moved on since 1987, and these days HMRC can\u2019t give certain taxpayers special favours \u2013 it has to follow the law. And, if you follow the law, and ignore the 1987 agreement, does the carried interest loophole actually exist?<\/p>\n\n\n\n

My view is that it does not.<\/p>\n\n\n

Why doesn’t the loophole exist?<\/h2>\n\n\n

Because, on a proper analysis, the way most private equity funds work means that they are probably “trading” for tax purposes, and so carried interest cannot be “capital”. The premise of the 1987 BVCA statement is incorrect.<\/p>\n\n\n\n

The analysis in the BTR paper is somewhat detailed, but essentially it’s that investment is a passive activity – a mutual fund which buys a portfolio of stocks\/shares is investing. A classic venture capital fund is also likely to be investing. But most UK private equity isn’t venture capital – most funds are “leveraged buyout funds”. Their typical activity is buying an entire business in a complex M&A process, actively managing it to maximise its value, and then selling it a few years later (in another complex M&A process). Then doing this again and again. In my view that course of activity is likely trading. <\/p>\n\n\n\n

There’s much more detail on the argument in the paper, linked above. It’s important to note that I’m not saying all private equity funds are definitely trading; I’m saying that most classic LBO funds are probably trading, and therefore that HMRC should be investigating each one on a case-by-case basis before accepting that carried interest is taxed as capital.<\/p>\n\n\n\n

This is not a very radical conclusion. One of the oddities of the tax world is that, whilst the private equity world operates on the assumption none of its funds are trading, in other contexts tax lawyers take a much more cautious view of what “trading” means.<\/p>\n\n\n\n

And it’s not just my view – it’s also the view of most (but not all) of the other tax experts I spoke to when writing the paper (and has support from the prominent tax specialists the FT spoke to in this article<\/a>). And the paper passed peer review by two (anonymous) tax experts, including a leading tax KC.<\/p>\n\n\n

What does that mean for HMRC?<\/h2>\n\n\n

HMRC appears to regard itself as bound by the 1987 BVCA statement. But the courts have repeatedly held that, whilst HMRC has some discretion in how it applies the law, it cannot depart from the law.10<\/a><\/sup>People usually cite the 2003 Wilkinson<\/em> case as authority for this proposition<\/a>, but the Al Fayed<\/em> case from 2004<\/a> is much more entertaining<\/a>.<\/span> It is not able to treat carried interest as capital if it is not in fact capital.<\/p>\n\n\n\n

So what HMRC should be doing is individually assessing whether each private equity fund is trading and, if it is, taxing the “carried interest” at 47%.<\/p>\n\n\n

What happens next?<\/h2>\n\n\n

There are three ways this plays out:<\/p>\n\n\n\n

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  1. Everyone carries on as before, and we all pretend that private equity funds aren’t trading.<\/li>\n\n\n\n
  2. Someone judicially reviews HMRC to require it to follow the law. I explain in the paper why in my view such a judicial review would have good prospects for success. I understand it’s now quite likely this will happen.<\/li>\n\n\n\n
  3. The Government decides that a major industry can’t operate under such tax uncertainty, and legislates to either clearly tax carried interest as capital, or clearly tax it as income.11<\/a><\/sup>The uncertainty goes to more than the treatment of carried interest – if UK-managed private equity funds are trading then that could adversely affect their investors too. In some rare cases their foreign investors could become subject to UK tax on their profits (if the investment management exemption or treaty exemptions don’t apply). In other cases UK institutional investors could have a bad tax outcome, e.g. pension funds’ usual tax exemption might not apply. The position for this result risks damaging the UK private equity industry and so, however the Government decides carried interest should be taxed, any legislation should explicitly protect the position of investors (including, in my view, investment management executives who acquire “normal” interests in the fund, as opposed to carried interest).<\/span><\/li>\n<\/ol>\n\n\n\n

    The sensible outcome is option 3. We shouldn’t be taxed on the basis of lobbying and concessions, and tax policy shouldn’t be driven by litigation. The Government should act.<\/p>\n\n\n\n

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