Agreement reached – but how safe is your carry?

When the BVCA and the Inland Revenue came to an understanding on carried interest taxation in July, some commentators suggested it was business as usual for carried interest holders in the UK. This is not the case, says Robert Mellor at PricewaterhouseCoopers.

Within the UK there has been an agreed basis of taxation of carried interest since the 1987 BVCA / Inland Revenue Agreement. This broadly established that carry would, assuming certain conditions were met, be taxable as capital gains and not as employment income.


On July 25, the BVCA and the UK Inland Revenue issued a Memorandum of Understanding (MOU) on the income tax treatment of venture capital and private equity partnerships and carried interest as a result of the 2003 Finance Act.


As reflected by the extent of the press coverage on this issue, there was a real fear within the private equity industry that the 1987 Agreement would be abandoned and that carry would fall to be taxed as employment income.


The MOU was issued following extensive lobbying by the BVCA to avoid the detrimental impact that certain stipulations made by the Finance Act (specifically Schedule 22, more on which below) would have had on the private equity industry. 


Since the MOU was issued, some commentaries have essentially indicated that it is business as usual for carried interest holders. This is in fact not the case: whilst the MOU is good news for the industry, urgent steps need to be taken by each private equity house to ensure the tax position of their executives is protected.


This article provides an overview of the treatment of carry prior to the Finance Act 2003, the changes as a result of the Finance Act and what measures are necessary to protect the tax position of carry for carried interest holders.


Carried interest prior to Finance Act 2003


Prior to the Finance Act, the tax treatment of carried interest under the 1987 Agreement was that, providing certain conditions were met (including that employees receive an arm’s length rate of remuneration for their employment activities), where a person had an interest in the return from a private equity fund through being a carried interest partner, then any gains realised as a consequence of holding such interests were taxed under the capital gains regime.


This position stood the test of time over the intervening years despite changes to the employment income tax rules.


The result of this was that carried interest paid to executives could be taxed to capital gains in recent years at a rate potentially as low as 10 per cent as opposed to 40 per cent (plus National Insurance) as employment income.  This favourable tax treatment came under threat when the Finance Bill was introduced in April 2003.



The introduction of schedule 22, 2003 Finance Act


Schedule 22 deals, inter alia, with the taxation or interests in securities received after 16 April 2003 where those securities were:

  • not acquired at open market value because, for example, there are restrictions or conditions attached to the shares, and
  • those shares arise as a result of a person’s employment (or through the action of deeming provisions in the legislation are deemed to arise from a person’s employment).

The extensive nature of the income taxing provisions in Schedule 22 conflicted with the established position under the 1987 Agreement so that the Inland Revenue and BVCA were faced with a situation where the draft legislation acted to treat carried interest as arising from a person’s employment source. On a worst-case scenario, each acquisition by a carry holder of an indirect interest in an underlying investment of a private equity fund could have been subjected to the Schedule 22 provisions. This was because the acquisition of that interest in the underlying securities of such a fund would have been subject to restrictions which would typically include:

  • carry vesting provisions, or
  • changes in profit sharing entitlement, or
  • carry reallocations between carry partners through the action of good and bad leaver provisions,
  • restrictions on transferability.

So what does this mean?  If an individual receives restricted employment related securities, there are two alternative bases of taxation:


  • The legislation seeks to tax as employment-related income the discount on any shares issued at undervalue or any employment-related increase in the value of shares. For example, if the market value of a share is £10 but because of restrictions on rights attached to the particular shares received by the employee (for example the right to sell the shares) those shares are valued at £8 and the employee only pays £2 per share, then there will be an immediate income tax charge on the discount of £6.


In addition, there will be a further income tax charge in respect of any increase in value when the restrictions on the shares lapse (i.e. on sale of the shares) or are lifted or reduced. This future income tax charge will arise pro-rata to the relative original market value of the shares taking into account the impact of any restrictions to the open market value of the shares at the point of acquisition and there could be multiple charges (e.g. at each partial vesting date). So, in our example on the future disposal by the employee of the shares, 20 per cent (which is the percentage difference between the £10 of open market value and the £8 restricted value) of the future profit will be charged to income tax. The 80 per cent balance will be chargeable to capital gains.


  • Both the employer and the employee can elect that the employee is taxed as if the restrictions did not apply at the point of acquisition of the security. This will result in income tax and NIC being payable on the full amount of the difference between the open market value of the share less the price paid (in our example above, £10 less £2 equals £8) with any future growth being taxed under the capital gains regime.


The timing of this is also critical.  At the time of writing, for securities acquired post 15 April 2003, elections will need to be made by 15 September 2003. 


Workings of the MOU


Below is an outline of the taxation of carried interest following the introduction of Schedule 22 Finance Act 2003 and the MOU.


Carried interest – new fund


The MOU establishes that the carried interest, in the form of a “unit” held in a limited partnership, is an employment-related security including cases where such interests are held through a feeder partnership or received via a corporate assignment route (the MOU does not address the position where carry is held through a trust structure). Of significance for the private equity industry is the agreement in the MOU that, for the purposes of Schedule 22 only, it is the “unit” in a limited partnership which is treated as the employment related security and not the underlying interest which each carry holder has in each underlying investment.


Where a newly established fund meets the criteria established in the MOU, the amount actually paid for the carried interest on inception of a fund will be considered to be the unrestricted market value (looking back to our earlier example, if the carry holder has paid £2 for his carry, the action of the MOU will be treat the carry holder as if they had paid the £10 open market value). No income tax charge will arise in respect of the carried interest and future growth will be chargeable to capital gains tax. A decision will need to be made as to whether an election should be made for protective purposes.


Where a newly established fund falls outside the scope of the MOU, income tax will be due on the difference between the price paid for shares and the restricted market value. Consideration will need to be given as to the open market value of the carried interest at inception so that it can be determined whether an election should be made in order to secure future capital gains treatment for the carried interest holders (the making of an election could, depending on valuations, trigger an income tax charge). Equally, the consequences of not making an election need to be carefully considered in view of the potential liability to income tax and NIC, again depending on initial valuations, on the future disposal of the interest or on each date when restrictions are varied (such as partial vesting).


Other factors to be considered include how will any upfront income tax and NIC charge be funded and how robust are valuations undertaken. 


Carried interest – existing fund with underlying investments


For carry acquired pre 16 April 2003, no element will be subject to an upfront income tax or NIC charge. Future growth should be chargeable to capital gains tax on realisation.  If there is any additional carry allocated to a person as a result of the reallocation of the carried interest of a leaver, Schedule 22 will apply to treat this additional interest as arising from the employment; however the technical position in this regard is not clear cut so that careful consideration will need to be given to such circumstances. 


Co-investment schemes


Co-investment schemes are not covered by the MOU on carried interest and hence each and every instance of co-investment will potentially be caught by Schedule 22.


Therefore, for all co-investment schemes it will be necessary to review all of the scheme documentation (including subscription agreements, scheme rules, side letters etc) to determine the extent of the restrictions that apply to the securities.


What do you need to do now?


Where elections are required in respect of events since 15 April, such elections will need to be completed by 15 September 2003. This means that action needs to be taken now to ensure that there are no unwelcome tax surprises.


It is essential that you seek advice and carry out a review of your existing arrangements, particularly if subsequent to 15 April 2003 there has been a grant of carry in a new fund, if there have been any new joiners who have received a carried interest or any leavers resulting in a reallocation of carry.


In addition, any co-investment schemes need to be reviewed urgently (particularly if since 15 April there have been follow on investments, restructurings or refinancing of underlying portfolio companies which may trigger Schedule 22 consequences).


One outcome from the enactment of such a complex piece of legislation such as Schedule 22 is that private equity houses might wish to consider a movement away from employment relationships and adopt alternative structures for their advisory vehicle.

Robert Mellor is a London-based director of the Private Equity Funds Group at  PricewaterhouseCoopers LLP.

This article has been prepared as a general guide to a complex area and does not constitute professional advice.  It is not comprehensive or exhaustive and it may omit information relevant to particular users and their circumstances. Readers should not act upon this article without obtaining specific professional advice.  Accordingly, to the extent permitted by law, PricewaterhouseCoopers, its members, employees and agents, accept no liability, and disclaim all responsibility, for the consequences of any reader acting, or refraining from acting, in reliance on this article or for any decision on its contents.

©2003 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to the United Kingdom firm of PricewaterhouseCoopers LLP (a limited liability partnership) or, as the context requires, other member firms of PricewaterhouseCoopers International Ltd, each of which is a separate and independent legal entity.