UK Budget Takes Aim at Carried Interest Tax Loophole

Jul 10 2015 | 4:47pm ET

Private equity partners and other managers of alternative investment funds in the United Kingdom are facing the threat of higher takes after changes to the country’s budget were announced earlier in the week.

Aimed squarely at the carried interest tax loophole, the so-called Summer Budget contains provisions that would tax carried interest at the full capital gains tax rates of 18% for short-term gains and 28% for long-term gains. At the moment, managers often pay much lower rates through a variety of tax and estate planning steps. 

Carried interest has been a hot topic for several years, especially in nations like the U.K. and U.S. with high numbers of hedge funds and private equity companies.

These countries have embarked on an aggressive set of measures aimed at curbing tax avoidance, while hedge fund managers have increasingly become the target of political aspirants criticizing low tax rates paid by billionaire hedge fund and PE managers whose income is primarily drawn from carried interest.

Carried interest is essentially a share of the profits of an investment or investment fund. For a private equity or hedge fund, the GP is itself a partnership that is owned by investment managers, who normally receive a small fee for managing the fund but a much higher percentage of the profits they generate. Particularly for private equity partnerships, those profits are often realized through large dividends or asset sales. 

Management fees, typically 1-2% of assets under management, are usually taxed as wages, while carried interest is taxed as investment profit, return of capital, or dividend income, and can build up over time. On gains that can climb into the billions, the difference can be significant. In the U.K., the tax rate on carried interest can be as low as 10%.

The U.K. measure will come into force on after July 8, and will not impact fund managers who are considered employees in their funds.

“It’s clearly a very relevant change for the U.K. asset management industry, particularly those investing into alternatives such as PE (private equity), real estate and hedge funds – it’s a material part of their pay,” said Gavin Bullock, a partner at Deloitte, in a Reuters article. 

The U.K. Treasury estimates the new measure will raise £265 million in 2016/17 and £375 million 2017-2018, and it remains to be seen how the British asset management industry reacts to the new rule. But hedge funds there claim they have been unfairly singled out in a budget environment looking to penalize money managers who have relied on a totally legal tax loophole.

Moreover, they argue, few British funds are actually set up in a manner that favors carried interest. UK firms often run investment strategies based almost exclusively on trading, rather than holding assets for long periods to generate capital or other types of gains. 

“We were disappointed to see hedge funds referenced in the budget documents in relation to carried interest. Active hedge fund strategies produce trading profits which managers receive as fees that are taxed as income at standard income tax rates - as we have said before - and not as capital gains,” said Jack Inglis, chief executive of the Alternative Investment Management Association, in the Reuters article.

In the United States, the tax treatment of carried interest has repeatedly come under fire in recent years, but efforts to reform it have been unsuccessful. However, legislation introduced in June by two democratic Congressmen would, like earlier proposals, tax carried interest at ordinary income rates.

Their efforts may be emboldened by the U.K. steps amid popular support for generally populist measures in the runup to the U.S. presidential election.

Should the U.S. rule change, the revenue generated would be significant. The four largest publicly traded private equity fund managers - Apollo, Blackstone, Carlyle and K.K.R. – earned $24 billion in carry over the last three years, or $8 billion a year, according to an article in The New York Times by University of San Diego professor Victor Fleischer.

By Fleisher's calculations, switching to full capital gains treatment of capital gains would raise $1.2 billion in revenue just from the employees and investors of these four companies. When applied to the industry as a whole, which in addition to PE encompasses real estate, hedge funds, and venture capital, the revenue gains to Washington could be large indeed.

Although there is little chance of the new U.S. legislation passing through a Republican-controlled Congress this year, the new U.K. budget measures undeniably send a warning shot across the bow of alternative asset managers who have relied on favorable treatment of carried interest. For managers in the U.S. and elsewhere, the news is a clear sign that the era of low tax rates on large sums may be nearing an end. 

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