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. But it would be much better for the Government to clarify the law.
The new analysis is in a peer-reviewed paper authored by Dan Neidle and published in the British Tax Review, the leading academic journal for UK tax analysis.1Carried Too Far? [2023] B.T.R., No. 1, © 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 if you have a subscription2Full 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. The FT is carrying the story here, with comments from HMRC and other tax experts.
UPDATE: There is now a short response from Macfarlanes, who currently chair 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.
What is carried interest?
Instead of receiving a salary, profit share, bonus, etc, private equity executives take a stake in the funds that they manage – called “carried interest“. It’s an unusual kind of stake, because they pay almost nothing3It’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. where outside investors commit £100m to a fund, but the investment managers pay just £10,000 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 £11,000 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. for it. The private fund will then typically acquire a mature business, and aim to make it more efficient 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 £3.4bn of carried interest was shared between about 2,000 people in 2021/22 – and the true figure is likely significantly more.4That’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.
What’s the loophole?
When I was an overpaid lawyer, I paid 47% on most of my income. Overpaid bankers pay about 53%5because they are employees, with their earnings subject to employer’s national insurance, the burden of which falls on employees in the long term. 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.6A 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.
Why? Because the private equity industry claims that carried interest in a typical private equity fund is taxed as capital, not as income. And whilst income is taxed at a marginal rate of 47%, capital gains are taxed at only 28%7Normal capital gains are taxed at 20%, but ever since 2015, carried interest has been taxed at the special rate of 28%.
The loophole8You can argue whether it is truly a “loophole”, but “carried interest loophole” is a common term and I’m using it for clarity is worth around £600m a year to private equity fund managers.9The 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. 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)
Why would Parliament create such a loophole?
It didn’t.
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 – it was created by an impressive lobbying effort by the private equity industry back in 1987. The industry said that if it didn’t get the low tax result it wanted, then it would move offshore. And the Government blinked.
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.
As a result, the Inland Revenue agreed a statement with the British Venture Capital Association 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.
People often call it the “carried interest loophole”.
Is the loophole good tax policy?
Over the last few years there have been many proposals to scrap 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’ll fly off to Zurich.
I confess I don’t find the debate over whether the loophole should exist very interesting. So I’ve been wondering about a different question. Things have moved on since 1987, and these days HMRC can’t give certain taxpayers special favours – it has to follow the law. And, if you follow the law, and ignore the 1987 agreement, does the carried interest loophole actually exist?
My view is that it does not.
Why doesn’t the loophole exist?
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.
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.
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.
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.
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). And the paper passed peer review by two (anonymous) tax experts, including a leading tax KC.
What does that mean for HMRC?
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.10People usually cite the 2003 Wilkinson case as authority for this proposition, but the Al Fayed case from 2004 is much more entertaining. It is not able to treat carried interest as capital if it is not in fact capital.
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%.
What happens next?
There are three ways this plays out:
- Everyone carries on as before, and we all pretend that private equity funds aren’t trading.
- 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.
- 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.11The 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).
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.
- 1Carried Too Far? [2023] B.T.R., No. 1, © 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 if you have a subscription
- 2Full 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.
- 3It’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. where outside investors commit £100m to a fund, but the investment managers pay just £10,000 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 £11,000 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.
- 4That’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.
- 5because they are employees, with their earnings subject to employer’s national insurance, the burden of which falls on employees in the long term
- 6A 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.
- 7Normal capital gains are taxed at 20%, but ever since 2015, carried interest has been taxed at the special rate of 28%
- 8You can argue whether it is truly a “loophole”, but “carried interest loophole” is a common term and I’m using it for clarity
- 9The 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. 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)
- 10People usually cite the 2003 Wilkinson case as authority for this proposition, but the Al Fayed case from 2004 is much more entertaining.
- 11The 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).
Comment policy
This website has benefited from some amazingly insightful comments, some of which have materially advanced our work. Comments are open, but we are really looking for comments which advance the debate – e.g. by specific criticisms, additions, or comments on the article (particularly technical tax comments, or comments from people with practical experience in the area).
It would be great to have comments on the technical points here, and not on the different question of how carried interest *should* be taxed as a policy matter.
28 responses to “Carried interest – the £600m loophole that doesn’t actually exist”
There is a reason why a lot of countries tax it as lower rate than income: unlike a bonus it is only paid many years after the work performed for which it was given, depending on capital gains on an investment.
Carried interest is – similiar to some startup stock options – technically a bonus converted into options in a company. Wouldn’t it be most accurate to tax as income the value of that option (if it could be calculated…) and then the rest as capital gain?
Which then will probably result is a rate not too far from current system…
I’m going to ignore that as it’s a policy point!
Another point you might be interested in is that the carry MoU is now out of line with current HMRC practice on valuing “growth shares,” which are economically similar to carried interest. These days, HMRC will seek to apply an expected returns or option pricing model to growth shares, which can produce significant values rather than the low/ nominal values they used to accept. As you say, nobody would actually sell you an interest of this type for £10k or whatever they are paying, taking into account the “hope value”. However, provided you tick the right MoU boxes, HMRC will accept that carry only has nominal value.
Thanks, George. I should write about that at some point. Accepting a nominal valuation for something that clearly isn’t of nominal value is barking
“…if they have to pay tax at the same rate as everyone else, they’ll fly off to Zurich.”
I have a picky point on this and a more substantive one.
The picky point is that they won’t go to Zurich, which will tax carry as income. It’s Geneva that does the soft deals on carry. Or they could go somewhere like Dubai.
The substantive point is: do you want this to be based on “fairness” or what will raise the most revenue?
I did dispute the wisdom of a general CGT increase on another thread but, on this question, if you’re going with the former, there’s no argument from me. Carry is just a bonus and, if “fairness” is the right question, should be taxed as such.
However, if you’re going with the latter, there is a serious question about whether you want to do something which carries a serious risk of losing the Exchequer money, because there is little doubt in my mind that taxing carry as income will result in large numbers of PE execs jumping ship.
It seems that your argument about trading/ non trading is really about going after the execs for income tax on their quasi-bonus, as you don’t want UK pension fund investors to suffer the normal consequences of investing in a trading fund.
Just to add one more picky point – these days, carry gains realised by non-doms are sourced based on where the work to “earn” the carry was done, not on the situs of the asset.
In other contexts I have always understood that HMRC are reluctant to accept that gambling is a trade as this would lead to gambling losses being tax deductible. If Carried Interests were subject to income tax rather than CGT is there any possibility of huge tax deductible losses being claimed?
I don’t think so. The amounts paid for carry are so small as to be immaterial. So, unlike gambling, there is a clear net win for HMRC
The policy aspects of this cannot be overlooked. I can’t see how the PE industry (or the tax advisory industry) could operate having to make trading/investing determinations on a case by case basis and it would just force putting this on a legislative footing, like the IME or white lists. Which would then not address the fairness point. For me, the distinction between income/trading and capital, and the tax differential is at the heart of the problem, creating distortions that need patching up everywhere. And is a massive regressive force in tax, allowing the very rich to accumulate wealth through capital (including carried interest, ERS, etc) at very low tax rates compared to those that actually depend on an income.
Similar to Tigs point. Why is this more objectionable than ERS? With shares in a private company, a director/employee will get shares/options at a 70% discount typically. They will work in the business and when this is sold, may get a large profit, as a result of their efforts. A significant part of the profit is that they are acquired at a discount, but sold without one. Assuming a s431 election, all this is taxable as capital not income.
Carried interest is just a fancy name for the same effect, albeit where the interest is in a number of companies own by funds which might well be partnerships, not limited companies. You are right that the UK PE business is a trade in that it will actively seek to improve the underlying business. But the carried interest is linked to the ownership structure not the trading business.
What you are actually positing is a move away from the distinction between income and capital gains across a wide range of businesses, including those who are employee owned.
Is your objection the windfall element that is not taxed as much as labour, even though it comes from employment? Is it that its nasty private equity types that benefit rather than those in privately owned companies?
So rather than saying its all bad, how about the following (suggesting solutions, not just its a problem):
All capital gains derived from sales from employment related opportunities (so covers private companies and PE owned businesses) are taxed as follows:
Lifetime allowance: £1m @10% (removes BADR requirement; becomes personal, can include public companies as well where opportunity given to employees);
Second lifetime allowance: £1-5m, taxed at 42%;
Above £5m taxed at 47%.
(rates to change as income tax rates change)
This would also include profits from what are now unapproved options.
Payable through self-assessment, so no employers’ NIC.
All amounts CT deductible but at a reduced rate/amount to reflect the lack of e’ers NIC.
And takes pages out of the tax code
I’m making a technical point about the nature of the funds. They are very different from a director acquiring shares or options in their own company. In no sense is the director trading.
The policy questions are separate, and I should write a piece on them soon.
Sorry, I can’t see a “reply” link to reply directly to TJ for some reason.
Thanks, TJ. Even if the investment manager exemption or double tax treaties helped (if we posit the funds themselves as “trading” through a UK PE due to the activities the funds carry out on their own account, I am far from confident that is right) I suspect most UK advisers would struggle to give a clean opinion and most fund investors would not be prepared to take the risk of unexpected UK tax in a UK-based structure., and they would insist the funds are set up elsewhere. Which may be a boon to certain offshore financial centres but not so good for the UK.
Interesting analysis. A small point about framing: in the jurisdiction where I practice, we would describe the loophole as an “administrative concession” (which is perhaps the point you’re making). These are understood to be susceptible to change / revocation – the risk with “loophole” is that it gives more substance to the current HMRC position than perhaps is merited. Would also be very interested to hear about whether the disguised investment management fee rules or VAT have had any impact – there must be some concern that the carry is really a management fee on which VAT might be owing.
I’ve not read your journal article properly and so I am not going to comment on the trading aspect. However, it is not the only area where there seems to be a divorce between how private equity world takes a different view of the tax treatment of things compared with the rest of the world. For example, take what is the employment-related securities rules?
1. Carried interest is a security or an interest in a security for a number of reasons (e.g. https://www.gov.uk/hmrc-internal-manuals/employment-related-securities/ersm20110 and https://www.gov.uk/hmrc-internal-manuals/employment-related-securities/ersm20170).
2. An employment-related security is widely defined (s421B(1) and (3) ITEPA 2003). So an employee who gets a carried interest should have it reported to HMRC. Fine that happens. They would normally have to pay tax on the value on acquisition less the price they paid (because of the nature of the vesting rules or the almost inevitable s431 election(**)). As I note below, they almost always say that the value is the same as the nominal amount that they paid and well, there’s an MoU from 2003 that the Inland Revenue did that foolishly says that HMRC will accept it. [** note: the elections aren’t actually filed and so sometimes they happen to be found many years later at the bottom of someone’s drawer].
3. A partner in an LLP (who is not a salaried member) and had no other role would not have an employment-related security. Fine technically, but why from a policy perspective should the treatment be different to an employee?
4. But what of the partner who becomes an investor director of the business they bought. That’s an office (and treated as an employment for tax purposes) so what if they get carried interest? Well, they will tell you, it’s clearly not an employment-related security because when the new rules came in twenty years ago I’m sure we asked Martin F, or was it Michael S, at the Inland Revenue about it and I’m sure that they said that we were fine. Now obviously there is no record of that but well, it must have been the case that there was this conversation as otherwise we’d be wrong and it should have been reported but we are never wrong, are we?
5. So the partner who is busy working hard as a director of the company owned by the fund doesn’t worry about it and doesn’t pay income tax on acquisition of the carry and everyone is happy.
6. Then they do fantastically well. Make a fortune on their carry within a few years and hear that the 28% rate might not apply because of something called income-based carried interest and now they might have to pay income tax and NIC on their gain. So they then find out that there is an exemption for carried interest that’s an employment-related security, think for a few seconds and then decide it was an employment-related security all along and say phew, that was a close one (true story).
7. In terms of valuation, paying the £10,000 for the carry that you mention is very old fashioned. Nowadays people might pay £100 or £10 or less (especially if it is a US fund). I’ve seen situations where some employees get their carry for free and say that this is market value (and report it to HMRC as having no value) and HMRC accepts it.
Thanks – I don’t go into the ERS rules because (unlike trading/investment) it’s not an area where I have expertise. But it does seem anomalous, and the valuation very hard to justify. Agreed that the fact LLPs are out of the rules is highly convenient…
One thought on context (and apologies if this is mentioned and I missed it/its in the full paper which I have yet to read:
Back in the 1980’s before the introduction of the legislation on financial instruments and foreign exchange differences that aligned (to a large extent) the taxation of such items with accounting results, there was often a substantial incentive for tax payers who where making investments or using derivatives to seek to treated as trading. Conversely, it was very difficult to convince HMIT (as was) that any company other than a bank was carrying on a financial trade. Also, of course, shortly after the BVCA statement Nigel Lawson aligned the rate of CGT with IT.
So, at the time maybe HMIT thought of the BVCA statement as “a win”
That’s a very interesting points – given CGT/IT were taxed at the same rate, the benefit was not what it is now. It’s possible the industry had it’s real aim of maintaining the “base cost shift”, which resulted in effective tax rates in the low single figures – and that was only achievable under CGT. But indeed query what HMT thought the BVCA were trying to achieve…
I should footnote the article to be clear that the tax advantage in 1987 was very different to what it is now…
Don’t forget your point about non-doms, the key benefit to such a person from the BVCA agreement was the agreement to treat any profit as capital. The ability to in turn hold the Carry offshore made the CGT rate irrelevant.
Picking up the point on non-doms, is it worth clarifying in footnote 4 that, since 2015, non-doms should only be able to claim the remittance basis on the portion of carried interest gains that are attributable to investment management services that are provided outside of the UK? This also assumes that the ICBI rules do not apply. Presumably therefore the stat we are “missing” is the value attributed to the non-uk portion of these individuals’ activities.
thanks – I’ll do that!
With enhanced base cost shift you didn’t need to be a non-dom. When you got a carry payment you got a capital loss and so you were well sorted.
If your contention is that most private equity funds – the limited partnerships into which investors put their money either directly or through feeder vehicles – are trading then I respectfully disagree.
Investment versus trading is a classic fact-specific cliff-edge, so we have to talk about generalities.
In that context, I can see the 1987 guidelines were put in place to give certainty about the tax treatment of fund structures: essentially the Inland Revenue (as it then was) was saying “if you structure your funds like this, then we will accept they are not trading”. (That significantly pre-dates the 28% tax rate by several decades.) Just as more recent BVCA/HMRC memoranda agree a practical approach to the tax treatment and valuation of management equity and carried interest for employment related securities purposes.
Typically the fund limited partnership is fairly passive (acquires, holds for years, realises), and keeps its holdings of debt and equity (loans and shares) in investee companies for the medium term (as you say, perhaps four to seven years) to derive income in the meanwhile (interest and dividends) and ultimately sell at a price greater than they paid (return of principal with or without premium/discount, and sale of shares or liquidation proceeds).
Just as most owners of real estate are not trading – particularly if they hold for the medium term, and are not active property developers in the meantime – also most shareholders and most lenders are not active enough to be trading either. This is not a stockbroker or a bank.
I accept that this is a point about which reasonable people can reasonably disagree.
But if the above it right, it means the carried interest will be in the same vehicle which is investing not trading, in the main. Few fund partnerships are active enough, in my view, to be trading (as distinct from hedge funds which are usually trading – buying and selling frequently, on a short term basis – unless their strategy is unusually “long”). Carry vehicles may be trading, but again that is unlikely. The vehicle will usually do little from day one until a realisation.
The manager of the fund – usually an LLP or a limited company – will have a investment management or advisory trade, and the relevant executives may have an active role as directors or advisers to investee companies. But that is not the fund (the limited partnership, its general partner and limited partners). The fund does not get the fee income.
But let us assume you are right, and fund partnerships are trading. What is the tax position of the limited partners? They are also in receipt of income which is probably derived from a trading activity. Is it conducted through a permanent establishment in the UK. If fund investors are subject to UK tax on their fund returns as trading income, you can wave goodbye to private equity entirely.
As it happens, I agree that carried interst is in reality part of the reward paid to the fund manager and the individuals running it, and should be taxed as income not capital gains, even if the taxman currently says something different. Not because the fund itself is trading, but because this is part of the fee structure paid to the fund manager for the active work it does. (As I understand it, it can be traced back to the share of the profits that the captain of a Venetian ship would be entitled to take from a trading voyage, even though the captain does not provide the capital to buy the merchandise on the voyage. Profits from work, not gains from investments.)
Co-investment (and sweet equity, or sweat equity) is a different beast.
Hi Andrew,
The real estate comparison is I think telling. If a real estate investor did as much work on the property as a typical PE fund, and with a view to selling it at a profit afterwards, I think we’d readily concede it was trading.
I’m not too fussed about the position of foreign limited partners, because I expect they’ll benefit from the investment management exemption or a tax treaty exemption. UK pension funds and a few others could have more of a problem – which is why I recommend a statutory fix. However strictly this is not relevant to the question of whether the fund *is* trading.
Dan
I mentioned real estate as another obvious example of the sort of asset (like shares) that can be held as an investment or as a trading asset, depending largely on what the holder does (or intends to do) with them.
The parallel is not exact though – I just don’t think a private equity fund (that is, the limited partnership) is usually doing appreciable work on the assets that it holds (the shares and loan receivables in the investee companies). Certainly not at the level or nature that a property trader or developer would do with or on the real estate interests that it holds directly.
Certainly, there is active work being done by the fund manager up above (perhaps the parallel here would be a separate entity that undertook construction work) and there is active work being done by the investee companies down below. But neither is determinative of the tax treatment of the fund as a separate entity. The activity of the fund is closer to that of a holding company, it seems to me.
I’d give the same answer if the investees companies held real estate and were traders or developers themselves – what those companies they do with their own assets does not determine the nature of the fund’s business.
Buyout funds’ ostensible value proposition to their investor LPs – and above stock picking – (particularly the strategy of LBOs on public companies) is that they acquire, transform through superior management skill and corporate strategy implementation, and then sell.
It is the middle bit (arguably the entire justification to the investor for paying the massive fees in the first place) that has the paradox of being fairly obviously a trade/service for business model/commercial marketing purposes but not for tax purposes.
I accept some funds will run strategies that are much closer to investing than trade, however the big bucks are made mostly in LBOs as I understand it.
Andrew, I made a similar point about the outcome of such a change in a comment on the FT article. And it wouldn’t just be the private equity funds that would leave. The management consultants, lawyers and accountants would have to relocate too (PE guys are too fond of having their advisers round the corner). So would the leverage financed teams in banks. The management fees (which are taxed here,, and, despite Dan’s claims, are not small beer) would leave as well. £400m inflow to HMRC (per Dan’s analysis) would rapidly turn into a much larger outflow.
Trying to reply to OG (link not working again)
I think we need to be a little careful about who is doing what.
The basic value proposition is “give us your money and we will try to give you a return exceeding the hurdle over the life of the fund”. How that return is achieved is by identifying underperforming assets, and selling them when they have gone up in value. The bit in the middle involves requiring the businesses of the investee companies to be restructured to address the underperformance, perhaps closing down loss-making bits, or expanding or bolting on new bits, or something else.
But who is doing all of the “work” on the underlying business? Typically, the existing management team of the investee companies will be given new direction, and/or a new management team will be brought in, typically with new performance incentives. The executives at the fund adviser / manager level might provide strategic direction and oversight, but they would not usually be running the business on a day to day level. They are mainly identifying new companies to buy, monitoring performance of current investees, and deciding when to sell. The limited partnership as such is not doing any of that “work” at all.
Now that base cost shift and cherry picking have been attacked, it seems to me that much of the concern would go away if capital gains were taxed at the same rates as income, as was the case for the decade before taper relief was introduced.
I was wondering about this point, too, Andrew. If the activities of the fund GP are viewed in isolation from those of the investment adviser LLP, then IMHO Dan’s point about work done on the assets would largely fall away and the fund GP could not be said to be trading. The LLP is, of course, accepted as trading and its members should pay income tax on profits from advisory fees. I don’t think he has explicitly addressed this point, but in a different context the paper states:
“The fact the debt is borrowed at the level of a fund’s SPV subsidiaries and not borrowed by the fund itself is not thought relevant, as whether a person is trading is a question of economic substance and not legal form.”
I can’t speak for Dan but I wonder if he is applying a similar analysis to the fund GP/ advisor LLP. The two entities will typically be under common control. Could an entity which would otherwise be trading (say, a property development company owning property) pay a fee to an entity under common control to do all the work on the asset, ‘ringfence’ any trading activity in this company, and take the view that the property owning company is investing rather than trading?
That is indeed my view! Realistically it is one trade, with elements split between different entities.