Investment managers may now legitimately avoid Income Tax and National Insurance Contributions (NICs) by having their profits taxed as capital gains. Some might consider that this loophole is extraordinary given the government's commitment to deficit reduction.

What is a carried interest?

This following definition comes from Washington, DC, based Private Equity Growth Capital Council:

"Carried interest is the share of profits that a general partner of an investment fund receives from his or her ownership interest in the fund’s assets. Typically, private equity funds are structured as partnerships to align the interests of managers and investors."

Simply put, if a fund is a building site under development, the carried interest is the developer's share of the profits excluding his management fee. The pressing issue for both the UK and the US is that whereas a developer pays Income Tax, a fund manager's share of profit is treated a capital gain and subject to Capital Gains Tax.

Whilst it could be argued that a fund is very different to a building developer, in reality, many funds are investors in real estate and development. The funds involved are not simply share portfolios.

How is a carried interest and other profits taxed?

  • The carried interest is subject to Capital Gains Tax. It is taxed as if it were an equity investment.
  • The fund manager's return on his investment is also taxed as capital, as if he were a third-party investor.
  • The investment manager is nevertheless subject to Income Tax on the part of this investment profit that can be shown as his fees from self-employment, or if he is engaged via a company employment income. These fees are hard to define, as using the example of the developer, above, the whole profit could, if it were any other business, be taxed as income. It does not take too much imagination to see that these rules are pretty flexible.

Taxing investment managers' fees as income: Finance Act 2015 

Section 21 Finance Act 2015 adds a new chapter 5E into ITA 2007. Sections 809EZA to 809EZH are designed to tax any 'Disguised investment management fees'. Under section 809EZA a fund manager is treated as carrying on a trade and any fee for management of the fund is taxable as income. Trying to work out how much profit is a management fee is a problem that has yet to be tested by HMRC.

The effect of the chapter is good for fund managers and saves a few red faces at HMRC. It effectively legitimises HMRC's previous treatment of carried interest that, up until 8th July 2015 was based only on a 'gentleman's agreement' in the form of a non-statutory memorandum of understanding agreed between HMRC and the British Venture Capital Association.

Tax rate on the carried interest, just 28%: Finance Act 2016

New clauses are inserted by  Finance Act 2016 which aim to beef up the tax charged and ensure that investment fund managers will pay at least 28 per cent tax on the economic value of the carried interest they receive. Arm’s length investments made by the fund manager will not be caught by the new rules. 

Why is the loophole still allowed and what do the changes mean?

The loophole is allowed because parliament appears to think that it is acceptable to have some individual's income taxable as capital and it wishes to attract fund managers to the UK. The opposition parties are less keen, it appears.

The Chartered Institute Of Taxation kindly summarised the debates in Parliament on the Finance Bill 2015-16 and provide a glimpse into the government's thinking on this matter:

"During the debates clauses 40-41 in the Finance Bill 2015-16 Financial Secretary to the Treasury David Gauke explained that, for investment funds, carried interest is the portion of the fund’s value that is allocated to the manager in return for their long-term services to the fund. Up until now, it has been possible for fund managers to pay tax on amounts much lower than their actual economic gains. However, clause 40 would stop this. Where the carried interest represents capital receipts, it will be taxed at 28% for higher rate and additional rate taxpayers. There will be no extra deduction on account of what is known as base cost shift, which would reduce the amount taxed in the hands of the manager."

The SNP proposed a new clause that would require a review after six months of what performance returns should be charged to income and would define an investment fund manager for the purpose of the new clause. Justifying his clause, SNP spokesman Roger Mullin said: “Executives have been able to bring tax rates on their carry-down even further by claiming Entrepreneurs’ Relief*. As has been indicated already, private equity fund managers currently shrink their tax bills by arranging to pay 28 per cent Capital Gains Tax, rather than 45 per cent Income Tax on their carried interest. The fund managers’ ability to pay Capital Gains Tax instead of income tax also allows them to avoid paying national insurance contributions on a major part of their income.” He concluded: “Surely it cannot be right that people on much more modest incomes have effective tax rates that are higher than those for some of the highest-paid people in our society.”

For Labour Rob Marris said the Opposition welcomed the changes but does not think that clauses 40 and 41 go far enough, because the carried interest is still treated as a capital gain. “Treating carried interest as capital gains is a bad idea and the Government should not permit it. It certainly appears to be a tax loophole—again, not illegal, but immoral—and we think that it should be closed,” he said, adding, “To those of us who are not taxation experts, it appears that calling it a chargeable gain is a manoeuvre to lessen the tax paid by those who benefit from that form of remuneration.” He said Labour might support the SNP’s new clause but not until Report stage. The SNP spokesman said he would not press the new clause to a vote at this stage but will return to it on Report.

Opposing the new clause David Gauke said that the Government had already consulted in this area to ensure that awards will be charged to Income Tax when it is correct that they are, according to the activity of the fund. He explained that carried interest was “a reward for a manager that is linked to the long-term performance and growth of the funds they manage. It is therefore, capital in nature and should continue to be charged against Capital Gains Tax.” He said it was “not the case that Entrepreneurs' Relief* can be accessed by investment managers, as the activity of the underlying fund is investing, not trading.”

Clauses 40 and 41 were approved without a vote."

*Entrepreneurs' Relief was renamed Business Asset Disposal Relief from 6 April 2020. 

What do they think in the US?

Across the 'pond', US president Donald Trump and his predecessor President Obama have both wished to close the loophole that some estimate costs the US economy somewhere between $1.8-18 billion annually, according to the International Business Times.

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