UK government announces carry tax hike

The immediate tax change is accompanied by a consultation on fund manager rewards. Also confirmed in the budget was the move to open up tax-free saving schemes to investment in marketplace lending assets.

The UK government has announced it will stop investment fund managers from using “tax loopholes” to avoid paying the full amount of capital gains tax (CGT) on carried interest.

The measure will require fund managers to pay the full 28 percent CGT rate, the government said in its Summer Budget announced on 8 July, its first since the election of the Conservative government in May. It will come into effect immediately.

The government considers that “carried interest should be subject to CGT, as it reflects the underlying long term performance of a fund’s investments” and asset managers will no longer be able to use tax planning to reduce the value of the gain.

The immediate change to the way carry will be taxed is a surprise given the discussions around disguised fee income rules that already took place last year, and concerns raised then about the lack of consultation with the industry, said Stephen Pevsner, tax partner at King & Wood Mallesons. “It’s unexpected,” he said.

Disguised management fee legislation came into effect in April.

Its immediate implementation and reference to loopholes is the usual approach to structured tax avoidance, when in fact there has been an understanding in place on how carried interest is taxed since 1987, Pevsner noted.

Under a partnership structure, currently the “base cost” of an investment made by an initial investor can be attributed to a second investor with the capital gain tax benefits attached. Under this change, this will no longer be the case.

In tandem, the government has launched a consultation to determine the criteria on which to decide whether investment fund manager rewards are to be taxed as income.

“This consultation aims to ensure that individuals who manage funds where the underlying activities are more aligned with trading than investing continue to pay full income tax on any performance fee/carried interest they receive,” the consultation document said.

The consultation is expected to focus on the definition of investment activity, Pevsner said. “Unfortunately, as with the disguised fee income rules, HMRC’s [HM Revenue and Customs'] starting point is to treat all performance-related returns as income and then identify specific fund activities to get back into capital gains treatment, rather than targeting the rules directly at the specific areas of concern,” he noted.

The consultation will result in tests to determine when a fund manager will be subject to capital gains treatment on carried interest, but it is not anticipated that “rewards which have historically been subject to capital gains tax will change as a result of this consultation,” the document said.

Responses are due by 30 September, with a summary of responses, draft legislation and guidance expected in the autumn. The legislation would be included in the Finance Bill in April 2016.

Responding to the budget announcements, British Private Equity & Venture Capital Association director general Tim Hames said in a statement: “The BVCA will work with HM Treasury and HMRC to achieve the smooth, sensible and simple implementation of the changes that the Chancellor has introduced in respect to the private equity sector and carried interest especially. The BVCA is confident that the Government appreciates the importance of ensuring that the UK remains Europe’s leading centre for fund management.”

The UK move mirrors the ongoing debate in the US over taxing carry. In June, the House Ways & Means Committee in the US House of Representatives proposed a bill that carried interest be taxed at ordinary rates, as previously reported by Private Equity International. If passed into law, carried interest could be taxed at 39.6 percent instead of the 20 percent capital gains tax currently applied.

MARKETPLACE LENDING BOOST

Also included in the budget was confirmation of a long anticipated move to allow savers using the ISA tax-free saving scheme to invest the money into peer-to-peer lending platforms. The Innovative Finance ISA will join existing cash and equity ISAs from 6 April 2016. 

The move is expected to significantly boost the size of the UK’s marketplace lending arena as more retail investors discover the alternative lending space. The government also published a public consultation on whether to extend the list of investments that qualify for ISAs to include debt securities as well as equity offered via crowd-funding platforms. 

The announcement follows rule changes to make bad debt relief available to investors using marketplace lending platforms, announced in the March Budget 2014, as well as new rules on withholding tax on the same assets flagged last year and due to take effect in April 2017.

Additional reporting by Rachel McGovern.