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Like all good magicians, Margaret Connolly in her article 'Dialogue of the deaf?' in Taxation, 26 July 2007 page 97, referring to demystifying the great private equity kerfuffle, shows the illusion without revealing all of the tricks behind it. As I am not a member of the Magic Circle, I believe I am allowed to let the audience see a little more of what happens behind the scenes in the taxation of private equity.
In her article, Margaret refers to the taxation of super profits earned by those working for private equity organisations as being taxed at no more than 10%, because of the two memoranda of understanding agreed between the British Venture Capital Association and HMRC. As a result, these super profits benefit from being taxed at the effective 10% rate of UK capital gains tax after taking account of business asset taper relief.
Most investments by private equity funds will be in unquoted trading companies so are likely to meet the requirements relating to the investee company for taper relief purposes. However, the availability of the 10% tax rate assumes that the relevant person, say the executive, has held the investment for the requisite two years which is needed in order to obtain the benefit of that relief. In fact HMRC are likely, at least initially, to consider that the executive only acquired his interest in the investment at the time when the 'hurdle' is achieved and the entitlement to super profits is crystallised.
Achieving the hurdle
The hurdle is the moment in the life of the private equity fund when it has performed sufficiently well that the outside investors in the fund have received back their original capital and the required return on their investment in the fund. However, when the hurdle amount has been received by the investors, the fund is likely to wind up as quickly as possible, selling its remaining investments. In these circumstances there may well not be a two year period, or even a one year period, between the date of the hurdle and the realisation of an investment. Also, if the private equity fund is based around a single investment and the realisation of the investment is necessary for the hurdle to be reached, then on this analysis the executive cannot have held his interest in the asset for two years.
This concern about the length of time that the executive holds the investment has been a concern for tax planners for some time. There are probably as many solutions touted to this problem as there are lawyers drawing up private equity fund legal documentation. It could be argued, in order to increase the period that the executive has held the investment for taper relief purposes, that the executive's interest in the private equity fund's investments starts when he acquires his interest in the entity that will become entitled to the super profit or 'carried interest'. This entity is normally a Scottish limited partnership, into which the executive and other carried interest holders become limited partners and contribute a nominal amount of capital.
Co-investing
Other arguments include that the executive already has an interest in the investee company by virtue of also co-investing, where the executive is required by the private equity fund to invest personally in the investee companies alongside the fund. Executives' own personal tax returns are now likely to be increasingly reporting the disposal of investments acquired through the operation of carried interest where these relate to private equity funds set up with an eye on the taper relief position after 2000, and we can expect to start seeing the claims by executives to a 10% tax rate on their carried interest capital gains being challenged by HMRC before the Commissioners.
However, it is likely that in order to reach the hurdle, the private equity fund will have disposed of its best performing investments, so that what the fund continues to own after the hurdle are the poorer performing investments. The fund may accept offloading these investments with little or no gain on the equity in order to accelerate the winding up of the fund and, in those circumstances, it would appear that the 10% effective capital gains tax rate would have little relevance.
Other benefits
The concentration on the supposed 10% tax rate applying to private equity executives has distracted, as in the best magic shows, attention from other aspects of the way that such executives benefit from participating in private equity funds. The earlier memorandum of understanding between the British Venture Capital Association and HMRC, issued back in May 1987, was particularly concerned with agreeing the basis on which the private equity funds would be treated for tax purposes. This was because such funds are normally constituted as limited partnerships and there is very little legislation on how partnerships are taxed. One of the main points of the May 1987 memorandum was that HMRC agreed to apply the interpretation they had on the taxation of partnerships generally, as set out in their 1975 Statement of Practice, D12 (as amended), to the taxation of private equity fund partnerships, assuming that their structure was set up in a conventional way as set out in the memorandum.
One of the difficulties that arises with the taxation of partnerships is how to treat transfers of assets between the partners and in particular where partners change the profit sharing ratios within the partnership. Such a change is a disposal of an asset by one partner, giving up his right to profits, and an acquisition of an asset by another partner, or other partners. What is more, transactions between partners are transactions between connected persons, so should be, for capital gains tax purposes, taxed as if they were on an arm's length basis.
It would, however, be a particularly harsh tax regime that sought to apply tax where partnership profit sharing agreements were amended without consideration passing between partners, which will frequently be the case. Therefore in their 1975 statement of practice HMRC said that they would not tax changes in profit sharing ratios where there was no consideration passing between partners. Instead a partner whose profit share reduces will carry forward a smaller proportion of cost of the partnership assets to set against a subsequent disposal of the asset and a partner whose profit share increases will carry forward a larger proportion of cost, and the transfer itself is treated for capital gains tax purposes as having being made on a no gain/no loss basis.
Successful performance
The relevance of this for private equity fund partnerships was that when the hurdle is achieved, 20% (usually) of the private equity fund assets is transferred from the third party investors to the carried interest holders, typically the Scottish limited partnership referred to above, which then also becomes entitled to 20% of future profits, etc. There is no additional consideration for this transfer; it simply acknowledges that the private equity fund has successfully performed.
Under the 1987 memorandum, applying the 1975 statement of practice, this is treated as a change in profit sharing ratios and a no gain/no loss transfer between the partners, so that the carried interest partners are regarded going forward as holding 20% of the private equity fund, even though they contributed a negligible amount of the capital of the fund. When the assets representing the 20% interest in the partnership are disposed of, i.e. the fund's remaining investments, the carried interest holders, including the executives, are able to deduct the original amount paid for these investments by the third party investors in calculating their own personal capital gain.
Regardless of whether the 10% rate of tax applies to any gain above the amount of base cost 'shifted' to the executive, this will inevitably reduce the capital gain that the executive pays tax on when the investment is disposed of. Also, even if the investment was acquired by the fund through a very high proportion of debt, as is usually the case with private equity investments, it does not matter that the carried interest represents a tiny proportion of equity, the transfer of assets and base cost shift will apply equally to debt investments that the private equity fund has made, so if most of the value is in the debt invested, the private equity executive is still receiving a tax free transfer.
However, while this base cost shift might be a very valuable tax free benefit, it may not be. If the private equity fund has disposed of most of its assets in order to reach the hurdle, i.e. the private equity fund has had to return most of its value to the third party investors to satisfy the return that they are entitled to, then it might have very few assets left of which the private equity executive receives 20%. 20% of not a lot is very little. In these circumstances the 10% rate of tax, assuming it was even available, is of academic interest to the executives. Also if the 20% profit entitlement results in income in the future, this is subject to income tax on the private equity executive under normal tax rules. It is not the case that carried interest is entirely subject to capital gains tax.
The catch up
But even now not all of the mysteries of private equity taxation have yet been considered. There is a further area to consider, that of the 'catch up'. Many private equity funds provide not only for the 20% base cost shift, but specifically provide for a catch up by the carried interest holders as well; the intention is that if the private equity fund has performed as required, then the carried interest holders will be treated as if they had been 20% partners in the fund from its commencement. So, not only is there a 20% base cost shift of the remaining assets of the fund once the hurdle has been reached, but there is also a catch up payment due to the carried interest holders of (usually) 25% of the profits of the fund already paid to the third party investors, so that 20% of the total past distributions of profit is paid to the carried interest holders. This could therefore augment the base cost shift benefit for executives.
How much this is worth depends on how much was previously distributed to the third party investors, but the usual requirement of the private equity fund partnership agreements is that third party investors receive about 7% to 8% a year compound of the amount of capital they invest in the private equity fund. Given the amounts of capital invested in private equity, the amounts an individual executive can receive through catch up payments to him can be large. What is more, the partnership profits that these distributions to the executives represent, have already been assessed for tax purposes on the third party investors; they should not be taxable in the hands of the executives.
If the third party investors are not subject to UK taxation, e.g. because they are not UK resident or are an exempt UK tax body such as pension funds, then they will not be particularly interested in the UK tax treatment of the catch up payments, nor indeed of the base cost shift referred to above. They are only interested in their commercial return, which is that they have received a good rate of return on their investment and that their capital has been safely returned to them. Not surprisingly these are the categories of investors that make up a good part of the investors into UK private equity.
Indeed the third party investors may not care if the conditions in the 1975 statement of practice and the 1987 memorandum were not met, so that the no gain/no loss tax treatment did not apply (typically because of a revaluation in the partnership accounts or other consideration given for the change in profit sharing ratios) to the transfer to the carried interest holders and executives of their 20% of the fund assets. After all if the third party investors do not pay UK capital gains tax, they will not mind that their disposal to the executives is regarded as being at market value, while the tax base cost of the assets for the executives is then not based on the original cost, but a current higher market value. Again this could be of significant value to the private equity executives.
The root of all evil?
It is sometimes said that the 2003 memorandum of understanding between the British Venture Capital Association and HMRC on the treatment of carried interest is the root of all evil. It is this statement which gives rise to the 10% tax rate and that if it were abolished all would be well in the land of private equity. I do not believe that this is true.
As previously indicated, the tax treatment of private equity executives is more complex than the 10% effective capital gains tax rate, even assuming that it is actually available. But, in any case, the 2003 memorandum only seeks to apply the provisions of the restricted securities provisions introduced by FA 2003, Sch 22 to the treatment of acquisitions of carried interest. As a general statement those provisions, and the existing provisions regarding the treatment of benefits received by employees, mean that if they pay full market value for a security received by reason of their employment, ignoring any restrictions that reduce the value of that security, any subsequent profit is subject to capital gains tax, not income tax.
The 2003 memorandum effectively set safe harbour provisions to enable an executive, and HMRC, to see if the executive was paying the unrestricted market value for his future carried interest entitlement. The memorandum does not therefore change the law and arguably does not alter the rules regarding the need for the executive to pay full market value for his carried interest at the start of the fund to bring it wholly within the capital gains tax regime in the future.
The real issue is that, historically, the value at the commencement of a private equity fund of the future carried interest entitlement has been very often seen as very low, as the executives are entitled to nothing until the fund has performed, thus enabling them to pay a nominal amount for their carried interest, while saying that they are paying full market value for this. It might be more appropriate not to argue about the valuation of carried interest, but to see it as a form of deferred remuneration, and that it should be taxed as and when the executives receive it. It is after all in reality, in effect, part of their remuneration package. This might also avoid needing to answer the question the Government finds so difficult concerning the tax treatment of those resident or domiciled outside the UK, but working in the UK.
Whether the industry would stand for its executives being taxed at 41%, like the rest of us employees, as Margaret Connolly referred to in her article, is another issue. It would result in interesting possibilities for the structuring of carried interest. What if the executives are not employees, but members of a limited liability partnership ...? Another magic trick?
Richard Palmer is tax manager with Grant Thornton, e-mail: richard.palmer@gtuk.com. Any views expressed in this article are the author's own.
