A commonly-voiced criticism of changes to the way carried interest is taxed in the UK, introduced in the government’s Budget in mid-March, is that the new stipulation of a minimum holding period to qualify for capital gains tax (CGT) treatment creates a misalignment of interest between the GPs and their limited partners.
Under the new rules that take affect after 6 April, “eligibility for capital gains tax treatment will be determined by the length of time for which the underlying scheme holds its investments on average. Full capital gains tax treatment will apply where the average hold period is 40 months or more (rather than 48 months specified in the draft legislation published on 9 December 2015),” read the draft legislation issued after the Budget statement.
Investments held for less than three years will now be taxed as income at a 45 percent rate, rather than the CGT rate of 28 percent.
“As a result of this tax change, managers may be encouraged to hold onto assets for longer in order to obtain capital gains treatment on profits,” says Eamon Devlin, managing partner of private equity-focused law firm MJ Hudson. “Leading to the following distortion: IRR numbers will be reduced as the holding period of assets will likely be increased.”
One limited partner, who asked to remain anonymous, says that this misalignment of interest would not only damage returns, but also the UK’s standing on the world stage: “We will be known for this perverse misalignment of interest and it will dissuade international fund managers from using the UK.”
A tax lawyer and specialist in fund formation, who also asked to remain nameless, says that the increased complexity these changes would introduce would put smaller managers, who don’t have the accounting and tax planning resources of larger buyout firms, at a serious disadvantage. “This will be really tough going for first-time fund managers to comply with,” she says.
The UK Chancellor George Osborne further singled out carry recipients when he confirmed that even in long-term investments, where carry will qualify for CGT treatment, managers will not benefit from the general drop in CGT to 20 percent. Private equity managers will still be taxed at the existing 28 percent rate.
The British Private Equity and Venture Capital Association described this latter move as a “mistake” and “an entirely illogical position”.
“We believe he should reconsider this stance as the Finance Bill moves to parliamentary consideration,” the group said.
The Finance Bill, due to be published as this magazine went to press, will cement the changes. No doubt industry participants – particularly turnaround investors which typically hold assets for shorter periods of time – are hoping for tweaks to the language before then.
The true impact of the change in the rules governing the tax on carry will play out over the years to come. Both managers and LPs will be alive to the consequences of holding an asset for more than three years, but for different reasons.
Additional reporting by Nicole Miskelly