Carried Interest under a Labour Government: UK Private Equity Professionals Beware

Carried Interest – "carry" has been one of the most common and tax efficient ways for UK-based private equity professionals to receive compensation, owing to the fact that they have, in most cases, been able to benefit from a special regime which treats carry as being subject to capital gains tax (CGT) at a rate of 28% as opposed to income tax, currently at a maximum rate of 45% plus national insurance contributions, which applies to most forms of remuneration.

The special carry regime – the end of an era?

The regime has been the subject of recent media attention owing to a March 2024 report from the UK Treasury showing that the UK's top private equity dealmakers earned c.£5b in carry in the 2021/22 tax year alone: a record high for the country, and an inevitable source of low hanging fruit for politicians.

Ending the special carry regime, branded a "tax loophole" by its critics, has been one of Labour's core financial policy objectives.  Under Labour's proposals, carry would become subject to a rate of tax that is aligned more closely with current income tax rates.  It is not clear at this stage whether this will be achieved through implementing a special CGT rate specifically on carry, or if carry will simply be treated as "income" in the same way as, for instance, salary would. 

Although it is a Labour proposal to attack the special tax regime associated with carry, and the likelihood of a successful election campaign could make this a reality, that would not preclude the Conservatives proposing to adopt a similar policy to dampen Labour's proposed tax reform.  

Putting the political noise aside, UK-based private equity professionals are faced with assessing the cost to them of a "worst-case scenario" and with the question of how to react in light of this material regime shift. 

Bracing for the worst – should I stay or should I go?

The most drastic (but perhaps straightforward) option for UK-based private equity professionals is to leave the UK now in search of more tax-friendly shores where carry is either taxed at very low rates or exempt from tax altogether.  Importantly, though, the UK tax efficiency of such a move would require both ceasing to be non-UK tax resident by reference to the UK Statutory Residence Test and ceasing work duties in the UK.  Additionally, double taxation risk may require attention if there is overlap of residency between two jurisdictions whose tax years are not aligned and/or cessation of UK tax residence occurs after acquisition of tax residence in the destination jurisdiction.

It will be a practical and commercial question whether the employer firm has the ability to re-locate managers to a foreign office or whether such a move necessitates the managers existing the firm.  For those managers who are willing and able to give up their UK links and lifestyle, but cannot remain with their existing firms, whether such a move remains attractive is likely to depend on where they sit on their carry curves. 

Italy

Like the UK (currently), Italy has special rules relating to carried interest and, if the requirements are met, the carried interest will be taxed as capital income at a flat rate of 26%.  

Italy has also introduced a Non-Domiciled Regime to encourage wealthy individuals to move and invest in the country.  Eligible individuals are able to opt to pay a flat-rate tax of €100,000 annually on their foreign source income rather than being subject to the standard personal income tax rates which are as high as 43%.   To the extent that carried interest is non-Italian source, no additional tax should be due beyond the €100,000 flat-rate.

Portugal

The taxation of carried interest in Portugal is complicated but carried interest associated with certain participation units received directly by Portugal resident individuals should be taxed at a final withholding tax rate of 10%.  

Until recently, Portugal had a Non-Habitual Residents scheme which allowed individuals who relocated to Portugal to access a special tax regime.  Subject to the fulfilment of certain legal requirements, the regime provided a reduced level of taxation of pension income and of employment and self-employment income deriving from ‘high added value’ activities, as well as a tax exemption over non-Portuguese income received.  

The abolition of this regime may make Portugal a less attractive jurisdiction of choice, notwithstanding that the tax rate on carried interest may be lower than in other European jurisdictions.

Greece

Greece has a non-dom regime for non-domiciled individuals transferring their tax residence to Greece.  To qualify for the regime the individual must make an investment of at least €500,000 in real estate, business, or transferable shares or securities in legal entities based in Greece.  Individuals taxed under this regime will pay an annual lump sum tax of €100,000 irrespective of the amount of income owned abroad.  

For non-Greek source carried interest, provided that carry is kept outside of Greece, no Greek tax should arise on the carry save for the €100,000 flat tax rate.

Alternative approaches to accessing return?

Currently, private equity professionals are compensated through a mix of salary, bonus, long term incentive plan payments, carry, and co-investment participation.  While most of these compensation sources will, under Labour's proposals, be swept up generally as "income" and taxed at the 45% marginal income tax rate (plus national insurance), profits made from co-investment participation are, and will continue to be, treated as "capital" for UK tax purposes and benefit from the 20% CGT rate on their realisation.

Introducing share schemes may be an option, as future disposals of shares may be treated as capital for UK tax purposes.  However, such schemes might present some practical structuring challenges particularly if arranged through a partnership (as opposed to limited company, where share schemes are more typically seen).  Nonetheless, these are an increasingly common and tax-efficient means of incentivizing private equity professionals and should not be ruled out completely.

Increasing co-investment participation may, if the opportunity is available, be an option for those private equity professionals who are able to access more liquidity.  However, it may not be so favourable for those who are relatively illiquid or do not have as strong relationships with prospective co-investors.  Furthermore, such co-investments can often be quite complicated to obtain in practice.

Trust planning – a potentially short window of opportunity?

For UK resident private equity professionals who have a domicile outside of the UK, placing carry into a non-UK trust (i.e., an excluded property trust) was traditionally an effective way of shielding profits from IHT, CGT and income tax.

The Chancellor indicated in the Spring Budget announcement that, under the Conservatives' proposed changes to the UK tax regime, excluded property trusts set up by UK non-domiciled individuals between now and 5 April 2025 will be protected from IHT in perpetuity, but that any set up thereafter will be ineffective.  However, Labour has indicated that they would seek to include all assets (including foreign assets) held in trust within scope of IHT, income tax and CGT, whenever they were settled.

It is therefore advisable that private equity professionals take caution in their trust planning and not set themselves up for failure by effectively gambling on this potentially short window of opportunity created by the Chancellor.  It is also advisable that those with current excluded property trusts consider the impact of the potential changes to the current regime under the proposals of both parties and whether they would benefit from restructuring these now.

Looking ahead – fail to plan, plan to fail

While the abolition of the special carry regime appears to be very likely under a Labour government, the outcomes of elections and party pledges are never certain.  As a result, it remains to be seen whether the party will remain true to their promise, particularly in the face of worrying financial forecasts.

Indeed, a recent opposition policy costing report from the UK Treasury has indicated that scrapping the regime could cost the Exchequer nearly £4b in lost tax revenues over the next five years if private equity professionals decide to leave the UK.  Like the abolition the non-dom regime, this pledge may not be as big a financial win as Labour hope.

If you are entitled to receive carried interest and you have concerns about how that carry will be taxed, whether now or in the future, we would recommend that you take legal advice.  As an international firm with presence worldwide, and experience dealing with the taxation of fund managers, Withers is perfectly placed to help you navigate a potentially turbulent couple of years if Labour are elected.

First published by AlphaWeek on 4 June 2024.