Carried interest and private equity funds

The Good Law Project is reporting that, on the back of the threat of legal challenge, HMRC has closed a "loophole" which allows carried interest received by private equity fund managers to be taxed as capital. The truth appears to be rather more prosaic, however. It appears that HMRC has simply confirmed that each case must be looked at on its individual facts and the tax treatment depends on the private equity fund not trading, such that the 1987 BVCA agreement never represented concessionary treatment. In legal terms, therefore, nothing appears to have changed. In the longer term, whether the spotlight that has been shone on this tax treatment means that, in practice, HMRC feel obliged to risk assess this area more actively, remains to be seen.

The tax treatment of carried interest has long been a contentious issue, both in the UK and elsewhere. In the Private Funds Industry, there is a BVCA statement that records HMRC's agreement that typical venture capital funds are not "trading" for tax purposes, such that carried interest should be taxed as capital and not income.

Earlier this year, analysis was prepared by Dan Neidle of Tax Policy Associates suggesting that the BVCA agreement was out of date and that many private equity funds might be regarded as trading rather than investing based on their typical business model. On the back of this analysis, the Good Law Project threatened to bring judicial review proceedings against HMRC.

In May 2023, Good Law Project sent a pre-action letter to HMRC claiming that HMRC was acting unlawfully with regard to its treatment of carried interest in the private equity fund by "adopting a blanket approach" contrary to the legislative position and, except in exceptional circumstances, not treating carried interest arising in such circumstances as income based on the BVCA agreement.

Good Law Project has now announced that it has "won" its battle with HMRC over the tax treatment of carried interest by forcing the "UK tax authorities to admit that some private equity fund managers have been paying tax at the wrong rate for more than 35 years". The announcement suggests that "HMRC has now conceded the key argument... accepting that the money managers receive from buyout funds - known in the trade as their "carried interest" - "would be taxable as trading income in the hands of UK tax resident individuals"." The announcement suggests that up to £420m could now be recovered.

So, does this represent a sea change in the treatment of carried interest received by private equity fund managers? In reality, it seems not and this is mostly a case of "spin". Responding to Jolyon Maugham's tweet on X concerning the significance of this result, HMRC have responded that it is "untrue" and the suggestion that they took a blanket approach is a "irresponsible misrepresentation of HMRC's position". They go on to say that they have always taken the position that whether a fund is trading or investing depends on the facts of each case and they have never adopted a blanket approach based on the BVCA agreement.

In fact, in further documents published by the Good Law Project, including HMRC’s response to their pre-action letter, HMRC strongly rejects the claims made against them. As expected, HMRC’s letter denies the existence of any blanket approach and defends HMRC’s approach to the question whether such funds may be trading as proportionate and risk based. Indeed, the response states that Tax Policy Associates’ article “fails to articulate a convincing legal basis for the conclusion that a “typical” private equity buyout fund will in most cases be carrying on a trade”. The HMRC response also includes some interesting commentary on the original Dan Neidle analysis of the badges of trade (and indeed questions their relevance in light of subsequent authorities), which may merit some separate consideration

Maugham has however responded suggesting that, in reality, there has been an abandonment of the existing "sweetheart deal". In particular, he suggests that if HMRC were now to choose to enquire into the circumstances of such funds more aggressively (perhaps under a future Labour government), the funds would no longer have the protection of "legitimate expectation" based on the BVCA agreement.

Looking at the full correspondence between HMRC and the Good Law Committee seems clear that HMRC has largely done no more than confirm what was previously known - that the private equity fund must be able to demonstrate that it is investing and not trading in order to fall within the ambit of the BVCA agreement and that there never was any blanket concession for the industry as a whole.