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Categorized | Financial

Private equity faces bigger tax on profits


Posted on March 31, 2016

LONDON, ENGLAND - MARCH 16: British Chancellor of the Exchequer, George Osborne holds up the Budget Box as he poses for photographs outside 11 Downing Street on March 16, 2016 in London, England. Today's budget will set the expenditure of the public sector for the year beginning on April 1st 2016 against the revenues gathered by HM Treasury. (Photo by Dan Kitwood/Getty Images)©Getty

Britain’s private equity executives are adjusting to a new era after legislation revealed how much more tax they will have to pay on their profits.

After the Budget in March, the opposition Labour party attacked UK chancellor George Osborne for “looking after a wealthy minority” by cutting the higher tax rate on capital gains from 28 per cent to 20 per cent.

    However, Mr Osborne kept the old rate for “carried interest”, the cut of profits — often one-fifth — that private equity managers share with their investors when deals come to fruition.

    Historically, carried interest has been considered capital rather than income, which attracts a higher tax rate. This preferential treatment has attracted criticism from politicians on both sides of the Atlantic.

    Details in the government’s finance bill published last week showed that Mr Osborne was making changes that meant tax authorities would treat carried interest more like income — a big change for the UK’s sizeable private equity industry.

    As of April, the Treasury will tax carried interest wholly as income if deals last fewer than three years, and partly if groups withdraw from them within 40 months.

    Treasury forecasts expect the rule to be a big earner, raising £210m for the exchequer in the 2017-18 tax year.

    Tim Hames, director-general of the British Private Equity and Venture Capital Association, a body representing the industry, said it welcomed the changes that would be “incremental” for most companies.

    Industry executives say the measure is unlikely to affect most investments, which are usually planned to last for at least four to five years. Their investors also expect private equity takeovers to outperform public markets by taking a long-term view.

    But some accept that the taxman sees carried interest as the Achilles heel of private equity compared with other areas of finance.

    The new rules revise a draft last year that would have extended the minimum holding period to four years. Mr Osborne has also tweaked carried interest taxation in other recent Budgets.

    Last year’s Summer Budget, for example, closed loopholes that allowed some managers to pay less than the full capital gains rate.

    “At times, the blend of absurdity bordering on surrealism which has characterised some of the proposals has lent a distinctly Kafkaesque feel to the proceedings,” Richard Ward and Ceinwen Rees, lawyers at Debevoise & Plimpton, wrote in a note to clients last week.

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    PE believes investors do not grasp their long-term cash flow generation capabilities

    Part of the problem is how to apply the holding period to the increasingly diverse world of private markets — beyond old-fashioned buyouts — where the meaning of “long-term” investment becomes harder to define.

    Venture capitalists investing in the next generation of British start-ups will have to justify how far they control the boards of companies they invest in, and whether they ultimately intend to list their investments, for example.

    Funds that invest in private debt, meanwhile, will not fall foul of the new regime if they sell pieces of a new deal to other investors, as part of a syndication.

    But carried interest on direct loans to companies — a growth area for funds since UK banks have reduced their lending — is now presumed to be taxable as income.

    Fund managers from buyouts to real estate private equity also say they have a duty to get the best price for their investors when withdrawing from an investment. In some cases that may mean selling or listing years earlier than planned.

    Mr Ward and Ms Rees ask: “What is wrong as a policy matter with an investment doing well and being realised quickly?”

    When it comes to new investments, the industry is also grappling with separate changes that make interest payments on debt less tax-deductible.

    This is part of efforts to bring in OECD-approved reforms to tax profits where economic activity takes place.

    In depth

    UK Budget 2016

    Chancellor George Osborne delivers his eighth Budget at a time of political turbulence for the Conservative party

    A new rule tying deductions to 30 per cent of a company’s UK earnings before interest, tax, depreciation and amortisation is meant to stop large multinationals loading their UK arms with debt, for example.

    But private equity investors are likely to be hit by the measure. They tend to use high levels of leverage in transactions to enhance returns.

    “It’s a trade-off between interest costs and the time and effort involved [to come up with new structures],” Tom Whelan, a partner at Hogan Lovells, says.

    Companies may have to rejig the share of debt used in future deals — although that skill is in part what investors pay them for. “The great beauty about private equity is that it is so adept,” Mr Whelan adds. “These guys are clever.”