Over the last six years, private equity executives have seen significant change in the way their income is taxed. These changes give rise to a number of practical considerations.
Private equity continues to make a significant contribution to the British business landscape.
The latest statistics, reported by the British Venture Capital Association, show that 4,290 UK companies, of which 87% are SMEs, are currently backed by UK private equity and venture capital. In the past five years, the industry has attracted investment of £43 billion in more than 3,230 UK companies. With an average annual return of 14.2%, private equity investments continue to be an extremely attractive option for institutional and individual investors alike.
However, in 2015, the Government sought to address anomalies in the way private equity executives were taxed, amid concerns about favourable treatment. New legislation was introduced and changes have continued to be brought in, either by amendments to legislation or through HMRC guidance. The timeline below sets out the rule changes for private equity executives to date:
Disguised investment management fees
Anti-avoidance legislation was introduced to charge income tax and national insurance contributions on management fees paid to individuals providing investment management services– an effective rate of up to 47%.
Carried interest and co-investment returns will be excluded from charge if specific conditions are met.
Legislative changes to the taxation of carry came into effect
Higher-rate taxpayers now pay at least 28% tax on the receipt of carried interest.
For non-domiciled individuals, carried interest can no longer be classified as foreign source where it relates to services performed in the UK.
Extension of new carried interest rules
The changes introduced from 8 July 2015 were extended to carry arising to corporate and other structures where an individual has the potential to benefit from that carry.
Further changes to introduce “income based” carry came into effect
Where ‘income based’ carried interest arises from a fund in which the average holding period of the investments is less than 40 months, the carry will be taxed as trading income at up to 47%.
Changes to the taxation of non-domiciled taxpayers
Non-domiciled taxpayers who have been resident in the UK for 15 out of the past 20 years will be deemed UK domiciled for income tax and capital gains tax purposes.
Rebasing of foreign assets to their value at 6 April 2017 is available in specific circumstances.
Tightening of anti-avoidance rules relating to offshore trust gains
Gains arising within offshore trusts can no longer be “washed out” by making distributions to non-UK resident individuals.
New anti-avoidance rules also tax UK residents on receipt of gifts from non-UK residents, where they derive from distributions from offshore trusts.
HMRC publishes and then updates its guidance on the taxation of carried interest
The guidance includes information on the mechanism for relief of double taxation, which is most often relevant in cases where carried interest arises in a trust.
The guidance highlights the necessity for a distribution to be made by the trustees to beneficiaries ‘without delay’ in order to avoid double taxation.
The guidance can be found here.
Reporting in full
Quality of reporting is key when it comes to an executive protecting their position with HMRC. Full disclosure on a tax return in the year in which any carried interest entitlement is allocated to the executive is crucial. Usually, no taxable event will arise until the carry is paid out, but delaying disclosure until that point can open up the risk of a discovery assessment, whereby HMRC has the power to reopen tax years that may otherwise be closed for enquiry purposes.
We have found that HMRC does not always have a full understanding of the private equity industry and the tax issues arising from it. This can result in unnecessary enquiries being opened into the tax returns of private equity executives. Full disclosure on tax returns can help to reduce the risk.
Non-UK domiciled taxpayers may have additional complications. For those wishing to benefit from the remittance basis, it is advisable to review account structuring before any carried interest is paid. Otherwise, executives may find that they cannot access the UK taxed portion of their carry without triggering a further tax liability on bringing money into the UK. This issue can be overcome by careful monitoring of UK and non-UK duties over the life of the fund and by ensuring appropriate segregation of funds on payment of carry.
The right structures
Early in their careers, private equity executives should consider how their private equity interests are held and managed. This can include establishing structures to hold carry and co-investment interests, ensuring efficient management from the outset. This can help with managing future cash flow requirements - from marriage and children, to future philanthropic endeavours, or retirement and succession. Amid the tax complexities of private equity returns, it is not surprising that many of these considerations are missed or postponed.
The COVID-19 pandemic has seen a dramatic rise in remote working. Many individuals previously located in the UK are now choosing to relocate overseas. The residency status of these individuals, especially those making key investment decisions, can have far-reaching implications. It is a good idea to review their residency status regularly to avoid inadvertently triggering double taxation issues.
The UK is undoubtedly a less forgiving taxation environment for private equity executives today. The pandemic has also brought additional complexities. However, these changes can be managed through the right structures and disclosures.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Tax legislation is that prevailing at the time, is subject to change without notice and depends on individual circumstances. Clients should always seek appropriate tax advice before making decisions. HMRC Tax Year 2021/22.