Impact of Proposed UK Tax Reforms on Carried Interest in Private Equity.

In private equity, "carry" or carried interest is a central component of compensation for fund managers. It’s a share of the profits that general partners (GPs) receive after limited partners (LPs) have been paid back their capital and an agreed-upon rate of return. While carried interest has proven to be a highly lucrative form of compensation, the tax treatment of carry has long been a subject of scrutiny, debate, and potential reform in the UK, as well as in other major jurisdictions. 

With the UK government’s proposed tax reforms on carried interest, the implications for private equity firms, fund managers, and investors are substantial. The changes aim to address tax fairness but could also impact the structure, incentives, and financial returns within the private equity industry. 

In this blog, we’ll explore the current tax treatment of carried interest in the UK, the implications of the proposed tax reforms, and how these changes could affect private equity professionals and the industry at large. 

Understanding Carried Interest and Its Current Tax Treatment in the UK 

Carried interest is typically 20% of the profits a private equity fund generates, paid to GPs as performance-based compensation. This share of the profits comes only after LPs, who provide the majority of the capital, have received their capital back plus a preferred return, often called a hurdle rate (commonly around 8%). 

Current Tax Treatment of Carried Interest in the UK 

In the UK, the tax treatment of carried interest has historically been favourable. Most of the income from carried interest is taxed as capital gains rather than ordinary income, which results in a significantly lower tax rate. 

• Capital Gains Tax (CGT): For private equity fund managers, carried interest is subject to capital gains tax at a rate of 20% (as of 2023) for higher earners. This is significantly lower than the top marginal income tax rate of 45%.

• Investment Holding Period: The UK government introduced reforms that link the tax treatment of carry to the length of the investment holding period. If a private equity fund holds an investment for more than three years, the gains are taxed as capital gains. If the holding period is shorter, some or all of the carry may be taxed as ordinary income at the higher rate.

• Base Cost Shift: The base cost shift mechanism in the UK allows for some of the profits from carried interest to be calculated in a way that further reduces the tax burden on GPs. This is one of the elements targeted for reform in the UK.
  
  

Proposed UK Tax Reforms on Carried Interest 

The UK government’s proposed tax reforms on carried interest aim to increase tax revenues and address concerns about fairness in the tax system, particularly in light of the rising focus on income inequality. Carried interest, due to its preferential tax treatment, has been criticized as allowing high-earning fund managers to pay a lower effective tax rate than other income earners. 

Key Elements of the Proposed Reforms:

1. Longer Holding Period for Capital Gains Treatment: The UK government has proposed increasing the holding period for carried interest to qualify for capital gains treatment. Currently, the requirement is for assets to be held for three years to benefit from the 20% capital gains tax rate. The proposal suggests extending this period to five years, potentially reducing the number of investments that qualify for the lower tax rate. 

2. Elimination of Base Cost Shift: One of the reforms under consideration is the elimination of the base cost shift. This would remove the mechanism that reduces the amount of carried interest subject to taxation, effectively increasing the overall tax burden on GPs by requiring more of the profits to be taxed.

3. Increasing the Capital Gains Tax Rate: Although not officially confirmed, there have been ongoing discussions about raising the capital gains tax rate to align more closely with income tax rates. This could mean capital gains, including carried interest, being taxed at rates closer to the top income tax rate of 45%, compared to the current rate of 20%. 

4. Treatment as Ordinary Income: While no concrete proposals have been made, there has been speculation about taxing carried interest as ordinary income altogether, which would mean applying the top marginal tax rate of 45% on carried interest. This would drastically reduce the financial benefits of carry for fund managers and could reshape compensation structures in the industry.
   
   

Implications of the Proposed Reforms 

The proposed tax reforms on carried interest in the UK will have far-reaching implications for the private equity industry, impacting fund managers, investors, and the broader market. Let’s examine the potential consequences in more detail. 

1. Impact on Fund Managers’ Compensation: One of the most immediate impacts of the proposed tax reforms would be felt by private equity fund managers. Currently, carried interest is an attractive form of compensation due to its favourable tax treatment. However, increasing the holding period to five years or taxing carry as ordinary income could significantly reduce the after-tax earnings of fund managers. 

• Reduced Incentive for Long-Term Investments: Extending the holding period for capital gains treatment could reduce fund managers' flexibility when deciding when to exit investments. If they are required to hold investments for longer periods to benefit from the lower tax rate, this could potentially lead to less efficient investment decisions. In some cases, managers may prefer shorter-term profits to secure carry more quickly, even at a higher tax rate. 

• Potential Shift to Other Compensation Structures: To compensate for the higher taxes on carried interest, private equity firms may consider restructuring their compensation packages. This could include higher base salaries or bonuses, which would be taxed as ordinary income, but could provide more certainty for fund managers in a less favourable tax environment.

2. Impact on Fund Structures and Investment Strategies: The proposed reforms could also lead to changes in how private equity funds are structured and how they approach investment strategies. 

• Altered Fund Lifecycle: With a longer holding period requirement for carry to qualify for capital gains treatment, private equity funds may have to adjust their investment timelines. This could lead to longer fund lifecycles, impacting liquidity for investors and the timing of returns. 

• Fewer High-Risk Investments: As carry becomes more heavily taxed, there could be a reduction in appetite for high-risk, high-reward investments. Fund managers may prioritize more conservative investments with quicker returns to ensure they realize carry before tax rules change or their personal financial situation is adversely affected. 

3. Impact on Investor Returns: Investors, particularly LPs, could also feel the effects of higher taxes on carried interest. 

• Lower Overall Returns: If GPs are subject to higher taxes on carry, they may require higher fees or a greater share of profits to compensate for the increased tax burden. This could reduce the overall returns for LPs, who already pay management fees and a percentage of profits to the GPs. 

• Shift in Fee Structures: LPs may also push back against higher fees or seek to negotiate different compensation structures with GPs to mitigate the impact on their returns. This could lead to more performance-based fee structures or alternative approaches to carried interest that are more tax-efficient. 

4. Impact on the Competitiveness of the UK Private Equity Market: The UK’s private equity market is a global leader, attracting both domestic and international capital. However, the proposed tax reforms could impact its global competitiveness. 

• Attraction of Talent and Capital: If carried interest becomes subject to significantly higher taxes, the UK may become a less attractive market for talented fund managers. Top-performing professionals might seek opportunities in countries with more favourable tax regimes, potentially leading to a talent drain in the UK.

• Offshore Fund Structuring: In response to higher taxes, private equity firms may explore offshore fund structures in jurisdictions with more favourable tax regimes. While this could reduce the tax burden, it also introduces compliance risks and may attract regulatory scrutiny.

5. Legal and Compliance Considerations: Private equity firms will need to stay up-to-date on the latest tax developments and ensure their fund structures comply with new regulations. 

• Increased Tax Audits and Compliance Costs: As the UK government tightens tax rules around carried interest, private equity firms may face increased scrutiny from tax authorities. This could lead to more frequent audits, higher legal costs, and a greater need for tax planning expertise.

• Reputation and Transparency: The private equity industry has already faced criticism for its perceived low tax rates. Firms will need to consider the reputational risks associated with tax planning strategies that are seen as aggressive or unfair, particularly in the current political climate focused on tax transparency and fairness.
  
  

Conclusion 

The proposed tax reforms in the UK could significantly alter the landscape of carried interest in private equity. While the reforms are aimed at ensuring tax fairness and increasing government revenues, they could also have far-reaching consequences for fund managers, investors, and the overall competitiveness of the UK private equity market. 

With the ongoing political focus on tax reform and inequality, the private equity industry must remain proactive in addressing the implications of these proposed changes and preparing for a future where the tax treatment of carried interest may no longer be as favourable as it once was.  

As tax rules evolve, private equity firms will need to adapt by re-evaluating their compensation structures, investment strategies, and compliance frameworks. Legal and tax professionals within the industry will play a crucial role in navigating these changes and ensuring that firms remain compliant while still delivering strong returns to investors.  Ensuring that these functions are resourced with leading world-class talent will be a key requirement to the long-term sustainability and success of these companies.