PRINT THIS PAGE The pre-budget report – the UK private equity industry heaves a collective sigh of relief 14/11/2007. Source: Weil, Gotshal & Manges. Jane Scobie
On 9 October 2007 the Chancellor of the Exchequer, Alistair Darling, delivered his first Pre-Budget Report. Prior to delivery of the PBR there had been fervent speculation that it would herald major changes to the taxation of the private equity sector in the UK, writes Weil Gotshal and Manges, particularly as the UK government had launched a review of private equity in March 2007 in response to increasing media speculation that individuals in the sector gain an unfair advantage from the existing tax legislation. While the PBR does contain measures that, if enacted, will undoubtedly have a negative effect on individuals involved in the private equity industry in the UK – namely, reforms to the capital gains tax regime (CGT) and changes to the tax treatment of nondomiciled individuals – the changes are not as drastic as initially predicted.
CGT Reform
Under the current UK tax rules gains on disposals of chargeable assets, including shares, are subject to CGT at a rate of 40% for higher rate tax payers. Taper relief (i.e., a reduction in the amount of gain on the sale of a business asset depending on the period of ownership) can currently operate to reduce the amount of the gain chargeable, such that gains on the disposal of business assets (which include all shares in unlisted trading companies) are currently taxed at an effective rate of 10% if the business asset has been held for at least two years.
If the reforms announced in the PBR are implemented however:
- all disposals made by individuals on or after April 6, 2008 will be subject to a single 18% rate; and
- taper relief will be abolished for disposals after that date.
The changes are not aimed specifically at private equity executives, but will apply to all individuals, personal representatives and trustees realising gains on disposals of chargeable assets after April 6, 2008. There is little doubt, however, that the reforms were suggested with private equity executives in mind.
Carried Interest
The main repercussion of this CGT reform in the UK private equity sector will be in relation to carried interest. If certain requirements are met carried interest gains are subject to CGT rather than income tax. Currently, full business asset taper relief is often available, effectively reducing the tax payable on the carried interest gains to 10%. As a result of the proposed changes, however, private equity executives will pay a flat rate of 18% on carried interest gains after April 6, 2008.
While an effective 8% increase in the rate of CGT is not good news, it is also not entirely negative. For example:
- Carried interest gains (provided certain conditions are satisfied) will continue to be treated as capital in the UK and will therefore continue to be charged to tax at a considerably lower rate than if they were treated as income;
- Executives will no longer have to hold their interests for at least two years in order to secure the lowest available tax rate as any period of ownership will suffice; and
- Executives will no longer have to worry about structuring carried interests to ensure that they have a beneficial interest in the carried interest from the time of acquisition.
Possible Repercussions in the Market
The proposed UK CGT reforms relate to disposals on or after April 6, 2008, even if the assets disposed of were held before this date. The lack of grandfathering provisions to reflect accrual of entitlement to taper relief until April 6, 2008 will mean that those affected by the change must decide if they should sell their business assets before next April. This may not be an easy decision as current market conditions are obviously not ideal, but it is anticipated that there may be a ‘mini boom’ in the UK M&A mid-market as people bring forward disposal or restructuring plans to avoid the higher costs that will be incurred from next April. In the longer term, the flat 18% rate on capital gains may encourage individuals to seek to make investments with capital (as opposed to income) returns. Indeed, it is possible that carried interest arrangements may even start to be used outside the private equity arena.
Non-Domiciliaries
In addition to CGT reform, proposed changes to the tax treatment of individuals that are not domiciled in the UK will affect some private equity executives.
Currently, UK residents who are not domiciled in the UK can be taxed on a remittance basis. This means that they are only taxed in the UK on certain income and capital gains arising overseas when that income or gain is remitted into the UK.
Under the proposed changes, however, from April 6, 2008 a nondomiciled individual will only be able to claim the remittance basis of taxation for seven years. After this point s/he will have to pay an additional tax charge of £30,000 per annum to benefit from the remittance basis. If an individual decides not to pay the additional tax charge s/he will be taxed in the UK on all their worldwide income and gains whether or not they are remitted to the UK.
Again, this change is perhaps not as bad as it might otherwise have been, given that the benefits achieved by paying the £30,000 tax charge are likely to substantially outweigh the payment, but there is a sting in the tail in that years of residence in the UK prior to April 6, 2008 will be taken into account for the purposes of calculating the seven year period for which an individual can claim the remittance basis without incurring the £30,000 tax charge.
A Word of Warning
While the proposed changes may not be as draconian as anticipated, particularly given that there has been no reform to the deductibilty of interest by portfolio companies, the PBR sounds an alarm bell that the UK government will continue to monitor the operation of the transfer pricing rules in relation to shareholder debt in leveraged transactions. It also states that the government “remains interested” in the ways in which those involved in the private equity industry are rewarded. As such it appears that the UK government’s focus will remain on the private equity sector and further changes could be afoot in the future. 1. The purpose of the PBR is to outline the new tax measures that the government intends to implement in the next budget in an effort to encourage debate on the proposals under consideration. As the PBR is effectively only a statement of the government’s intention, the following discussion is subject to changes made to the proposals prior to the next budget. Indeed, as the wider business community has generally reacted with hostility to the changes proposed in the PBR, the government may well amend the finer detail of these proposals before implementation.
Weil, Gotshal Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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