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Dialogue of the deaf?

25 July 2007 / Margaret Connolly
Issue: 4118 / Categories: Comment & Analysis , Capital Gains
MARGARET CONNOLLY demystifies the great private equity kerfuffle

A huge amount of negative comment has appeared in the national press recently concerning the tax treatment of some of the super profits enjoyed by those involved in the private equity industry. To understand how this has arisen, it is worthwhile to recap recent developments.

Historical basis

Private equity and venture capital funds have existed for a great number of years. Indeed, it was way back in May 1987 that the British Venture Capital Association, the Inland Revenue, as it then was, and the Treasury entered into a joint memorandum of understanding on the tax treatment of the income and profits enjoyed by venture capital and private equity limited partnerships, in particular regarding carried interest. Carried interest is really another description for the shares of any super profits enjoyed by the private equity investors.

This memorandum provided that so long as certain conditions were met by the directors and employees of the general partner (or any corporate body providing services) and they were fully remunerated for their services as directors and employees, they would not be considered to have acquired their partnership interests or their shares in the super profits by reason of their employment. This meant that their shares of these super profits would be taxed as capital.

Until 2000, when the Treasury extended business asset taper relief to any investment in an unquoted company and indeed to most employee shareholdings, the differential between taxing partners' shares of such profits as capital or income did not really matter. Even more beneficial was the further change introduced back in 2002 that reduced the holding period relating to business asset taper relief from four years to two.

This meant that, provided their investments were structured in accordance with the conditions laid down in the first memorandum and the subsequent one issued on 25 July 2003, assuming they were UK resident and/or domiciled, partners could enjoy their share of such super profits at a tax rate of no more than 10% (as opposed to 41% if these monies were being subject to income tax and National Insurance as earnings).

Current position

Following the extension of business asset taper relief to such investments, an awful lot of private equity funds relocated themselves to the UK; London in particular. Many foreign governments became rather disgruntled because much of their private equity business was flocking to the UK and so began a relentless campaign against the UK Government. In addition, the GMB, Britain's general union, has been constantly campaigning against the activities of some of the private equity industry since it is concerned about job losses following acquisitions that are backed by the industry; some refer to the industry as 'asset strippers'.

The situation was not helped when Nicholas Ferguson, the head of SVG Capital, recently gave an interview to the Financial Times saying 'the latest capital gains tax laws were brought in by this Government not to make private equity executives very rich but to encourage investment and entrepreneurship'.

Knee jerk reaction?

There then followed what some would consider to be a knee jerk reaction by the Treasury Select Committee who subjected representatives from the British Venture Capital Association to a grilling in a rather aggressive and confrontational manner. Indeed, similar treatment was handed out to some senior partners in some of the leading firms and there has been much hostile press comment recently towards the private equity industry. Sir Ronald Cohen, a founder of the venture capital industry, has recently been quoted as saying that, in his view, the current taxation system is inappropriate for large buyouts and, indeed, the country's social fabric could be threatened by increases in the disparity between the wealthy and the poor.

However, only a very small minority of individuals in this country is involved in the private equity industry. In the United States, a private members bill has recently been introduced to the Senate which, if passed, would treat carried interest/share of super profits as compensation income and hence this would be subject to income tax rather than capital gains tax.

Change the tax treatment!

George Osborne, shadow Chancellor, has recently been quoted as saying 'if it looks like income then it would be peculiar not to tax it like income'. Changes are consequently expected in the UK. One should ask what these changes might comprise.

The following are possibilities:

  • Tax the super profits at the full rate of capital gains tax, i.e. 40%. However, this would likely lead to the major private equity houses relocating. In France such carried interest is only taxed at 27%.
  • The Treasury Select Committee could push for changes to the memorandum of understanding, insofar as the taxation of these profits is concerned. It could be argued that, due to the serial nature of the deals entered into by the private equity partners, they are in reality 'trading' as opposed to investing. If this is the case, then surely the profits should be charged to income tax and National Insurance. However, this too could lead to firms relocating overseas.
  • Shares of super profits could be taxed as 'compensation income'. However, some would suggest that if these monies are going to be taxed as such, then the transactions could be structured so that the payments are made via a body corporate. This way a corporation tax deduction at the rate of 30% could be obtained. In other words the Exchequer may be able to recover an additional 31% in tax and National Insurance, but they would have to give 30% relief at the corporate level — so the net effect would be minimal.
  • Amend the minimum holding period to qualify for full business asset taper relief back from two years to the old four years. Some would argue that a two-year investment period is too short and smacks of trading rather than investment in any event.
  • Another alternative would be to amend the effective rate of business asset taper and raise the minimal effective rate to 20% as opposed to 10%. However, many would argue that it would be unfair to single out such treatment for carried interest relating to private equity deals only. What about, for example, all the other UK taxpayers who can currently enjoy the benefits of full business asset taper relief after holding an investment for only two years? Such relief of course does not just apply to investments and private equity schemes, it applies to most trading assets including land.

It is worth noting that in some parts of the UK recently, individuals holding land and buildings have enjoyed phenomenal growth. Provided the ownership of such assets is structured properly, gains arising on the sale of such assets can be enjoyed at an effective rate of tax of no more than 10%.

Business asset taper relief was introduced initially to encourage and reward investment and entrepreneurship, and it could be argued that this is exactly what private equity investors are. They will contribute a certain amount by way of capital and an additional sum by way of loan. They would also argue that their investments are more risky and entrepreneurial than an investment in land.

Side effect

It is only after the repayment of the loans and any preferred returns that private equity investors become entitled, usually to a 20% share, in the net profits if the fund is successful — not all are. It is quite usual in a management buyout for private equity investors to take a stake in the business together with the existing senior management team. If the Exchequer continues to charge the super profits to capital gains tax, as opposed to changing the classification of such monies to say income or compensation, it is possible that they could apply similar rates to the investment taken by members of the management team. If this were the case, it is likely that the new rules would also apply to stakes taken by management buyout teams where the buyout is bank financed only.

This would be a pity, especially in the south east, where the buyout scenario has been particularly buoyant in recent years. Many of the buyouts that we see are commercially driven and bank financed only. They are often undertaken by philanthropic entrepreneurs who wish to retire and pass on their successful companies to loyal management teams.

It has been noted in the press that if the Government is going to revisit the taxation of private equity investors, it should also look at how the current UK system applies to non-domicilaries. Many of the partners in the private equity funds, if they have structured their investments in a certain way, are unlikely to be paying any UK tax whatsoever. The debate then becomes not one of is 10% too low but is 0% too low!

Margaret Connolly is partner and head of taxation services at Reeves + Neylan.

Issue: 4118 / Categories: Comment & Analysis , Capital Gains
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