UK ’the biggest onshore tax haven in the world’

As the private equity industry prepares to face its critics today, some industry observers are warning that the substantial tax breaks enjoyed by practitioners on their carried interest could be their Achilles heel.

UK private equity’s success in taking advantage of a tax regime that is extremely benevolent to fund vehicles and practitioners could have disastrous consequences for the industry, according to city sources.

Tax experts believe that in the recent row over carried interest, commentators have failed to recognise other areas of the industry’s tax treatment that also help to defray tax bills significantly. As the true extent of these tax breaks becomes public, it is likely to increase the clamour for a clamp-down, they say. “We’ve been expecting this for some time,” said one.

The latest to attract mainstream media attention is the so-called “base cost shift”, an accounting procedure that allows private equity firms to offset the cost of their investments against their profits for that year, so they can minimise the tax they pay on carried interest.

This comes hot on the heels of an earlier row over the treatment of carried interest as capital gains, which qualifies it for the taper relief rules that can cut the effective rate of tax to 10 percent once an asset has been held for more than two years.

A further issue is that many leading buyout professionals are not domiciled in the UK for tax purposes. This means they will not pay tax on carried interest as long as it is held in an offshore trust. Indeed, under the current rules they can even bring the money back into the country once the trust pays out, and still pay no tax on it.

A combination of these factors allows advisers to cut the personal tax bills of leading professionals to minuscule levels. “That’s why the UK is often called the biggest onshore tax haven in the world,” said one lawyer.

The “base cost shift” rule applies to any kind of partnership, not just private equity firms. It has been applicable to the industry ever since 1987, when the Inland Revenue yielded to lobbying from the BVCA and included it under the remit of the law. As a result, almost all private equity fund vehicles created in the UK since that time will be structured in order to take maximum advantage of this rule.

The complex law effectively means that the fund only starts to receive allocations of profit when the GP becomes eligible for cash distributions, i.e. after the investors have been paid back their initial investment. After this time, 20 percent of the value of the assets left in the vehicle are re-allocated to the GP – the so-called “base cost shift”. However, the GP only becomes eligible for tax once it starts to show a profit.

When base cost shift is combined with taper relief, tax experts say this could cut the effective rate of tax on carried interest to less than 5 percent. “The industry has been asking for a bloody nose with this. It’s been incredibly greedy to try and get both,” said an accountant.