Will the prospect of a 51 per cent tax lead to an exodus of US private equity money?

Carried interest is the long-term performance reward that investment managers receive once they have returned investors’ money and outperformed a hurdle. For decades, private equity execs have enjoyed paying capital gains tax on ‘carry’ (as it is known) rather than income tax. The Labour Party call this the ‘Mayfair Loophole’. Curbs on the benefits of carried interest have been introduced over the last seven or eight years. Further changes have also been predicted with each impending Budget.

However, the change introduced by HMRC in January was entirely unexpected: HMRC updated its manuals to remove non-UK taxes from a ‘no double tax’ provision. This will make the UK a less attractive place for international fund managers to do business – directly opposing one of the main defences of the special Carried Interest regime.

When tax on carried interest was overhauled in 2015, the new legislation included a ‘no double tax’ provision. At the same time, HMRC issued a ‘draft’ technical note referencing ‘tax’ to include UK and non-UK taxes. The inclusion of non-UK taxes was an important clarification and provided a generous fall-back for investment managers as any tax paid overseas on their carry could be credited against their UK CGT liability to avoid double taxation. This was particularly welcome for UK-resident US nationals who would also pay US worldwide tax on their carry, but this can impact investment managers in any jurisdiction.

In the US, carried interest is taxed early in the life of the fund before cash distributions are received. In the UK, the same carry is taxed later (broadly) when the cash is received. The US/UK double tax treaty gives HMRC primary taxing rights on the carry and the treaty provisions should also prevent double tax through the availability of credits. However, the US rules are complicated and restrictive, and in almost all cases block claims for UK credits against US tax bills. It’s difficult to claim a credit against a US tax bill in 2022 when the UK tax isn’t paid until 2027. Therefore, UK investment managers previously fell back on the ‘no double tax’ provision included in HMRC’s guidance. It was commonly referred to by industry and HMRC as the ‘credit of last resort’.

The change in HMRC guidance at the end of January, to exclude non-UK taxes from the ‘no double tax’ provision, immediately removed this fall-back. The impact could be staggering for some UK investment managers, with the prospect of whopping US/UK double tax charges, and an extraordinary 51 per cent tax rate (28 per cent previously).

The British Private Equity & Venture Capital Association (BVCA) and the wider investment management industry are engaging with HMRC on this. For its part HMRC has indicated a willingness to find a resolution – after all, this move is counter to policy. The method of the change was also very odd, as returns submitted in December will have correctly claimed tax credits that would not be allowed on a tax return submitted late in January. We suspect the debate will rumble on and we urge HMRC to consider the wider economic impact this could have if US private equity money starts to take flight from the UK.