The UK’s upcoming Autumn budget and the prospect of more tax on carried interest have provoked fresh talk of brain drain and capital flight from the UK. How much substance these warnings have is unclear, but some government compromise is likely.
Even before the current Labour government came to power there were promises of a crackdown on private equity profits—specifically on how carried interest is taxed. Shortly after they swept to power in June, there was talk in the industry of being ‘bag ready’ for these proposed changes.
Put simply, carry—the performance fee paid to the GP based on their fund’s performance—is currently taxed at the highest rate of capital gains tax, at 28%. One, and perhaps the most widely discussed, rule change is that carried interest is treated as income, which means a tax of 45%. The question is whether this change is enough for people to leave the UK.
“It falls into two camps,” said Henry Pepperell, a partner at Milestone Search Partners, an executive recruitment firm. “Some people will be happy to pay their fair share, but I think you see a lot of senior fundraisers— especially if they work for European GPs and a lot of their cash comp is tied up in carried interest—who will say this is unfathomable.”
At the time of writing, it is uncertain what exactly the government—which launched a consultation on carried interest taxation in July—will do. UK finance minister Rachel Reeves—who has previously been hawkish with regards to closing PE’s tax ‘loophole'—has a few options. Treating carried interest as income is one.
Alternatively, carry could be taxed at a new higher band of capital gains tax, but lower than if it was treated as income. Another option is that PE managers are expected to put more of their capital into a fund to access favorable tax rates. Furthermore, whatever is announced in the impending budget could change later down the line.
Regardless, the UK government has a significant budget gap to fill, and has further limited its room for maneuverability by promising not to increase taxes on “working people.” There will be a strong incentive to take into account the vast income generated by carried interest in the UK which, according to HM Treasury figures, was worth £5 billion (around $6.5 billion) in 2022.
“The likelihood is that whatever is announced in the budget is not necessarily going to be a final position,” said Christy Wilson, a tax associate at law firm Katten Muchin Rosenman. “It might be that there’s some sort of legislation that is put out that is then further consulted on.”
Greener grass?
Wilson adds that whatever the government decides to do it, will need to remain competitive with other jurisdictions to stem both the risk of both capital flight and talent moving away.
The British Venture Capital Association, a UK industry body, has warned that any change will be viewed in the light of carried interest tax regimes in key competitor jurisdictions, such as the US, France, Italy and Germany. As it stands, many competing jurisdictions treat carried interest as a capital gain or at a lower rate that is broadly in line with the UK regime in its current form.
However, given the complexity of Europe’s myriad tax codes, it is not clear which country might be the best alternative tax domicile.
For example, Italy—which is often cited as a favored escape route due to its flat-tax rate regime—taxes carried interest under a preferential regime at 26%, or 43% if the regime does not apply—one exception is if GPs don’t commit at least 1% of the fund’s capital. France, on the other hand, can tax carried interest up to 49% unless certain conditions are met—for example, if holding periods are less than five years from when the carried interest shares were issued.
Ultimately, the level of relocation will depend on the extent of the changes in their final form and on the ability of firms to relocate. Wilson was not the only legal expert who remained relatively sanguine about the changes.
“I think there’s been a shift in mood from one of fear to one of, not quite complete relaxation, but one that is more cautiously optimistic,” said Sarah Gabbai, a London-based corporate tax lawyer with McDermott Will & Emery. “We’ve had more suggestions that any changes that will be made to the tax treatment of carried interest will be more nuanced and limited to those scenarios where the managers have not put capital at risk.”
Featured image by VictorHuang/Getty Images
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