A regular briefing for the alternative asset management industry.
When the UK's new government delivered its highly anticipated first Budget on Wednesday, the focus was very much on fixing the public finances and increasing investment. The government had for some time been preparing the country to expect tax increases. And, since it had pledged not to raise income tax, corporation tax, VAT or employee national insurance contributions, the increases in capital gains tax (to 24% for higher rate taxpayers) and employer national insurance contributions (from 13.8% to 15%) were not surprising. (For more detail, please see our Budget website.)
But the private capital sector was also waiting to see how the incoming government intended to follow through on its manifesto commitment to abolish the carried interest tax "loophole".
Under existing rules, it is typically possible for carried interest deriving from funds pursuing various strategies (in particular, private equity and venture capital) to be subject to capital gains tax (CGT) at a headline rate of 28%. This is significantly lower than the top rate of income tax (45%) but pretty much middle of the pack in terms of tax rates potentially achievable for carried interest in other European jurisdictions. There was therefore significant concern in the asset management sector that, if the government intended to tax carried interest at income tax rates (with national insurance contributions potentially on top), there would be an exodus of managers.
The reforms announced in this week's Budget fall far short of that worst case scenario. Next tax year (beginning 6 April 2025), the headline rate of carried interest CGT will be increased to 32%. However, the position gets more complicated for subsequent tax years: in a fundamental change, carried interest arising from April 2026 will be taxed as trading income at marginal rates of up to 45% plus 2% national insurance contributions – although a discount mechanism will be introduced for so-called "qualifying carried interest". Under this mechanism, 27.5% of any qualifying carried interest will be taken out of the UK tax net, resulting in an effective total tax rate for additional rate taxpayers of around 34.1% (that is, 47% x 72.5%).
Carried interest will be "qualifying" if it passes the test set by the UK's income-based carried interest rules (IBCI), which require a fund to have held its assets for a sufficient period of time (broadly, an average holding period of at least 40 months). Importantly, the IBCI rules will be extended to apply to employees; currently they only apply to self-employed LLP members. The government has also launched a consultation on whether there should be one or both of two additional conditions for "qualifying" status: a minimum co-investment requirement and/or a minimum time period between the award of a right to carried interest and receipt of proceeds from the carried interest.
"Given the relatively modest amounts that the government expects the new carried interest rules to raise ..., any significant damage to the UK's asset management industry would be an own goal."
It be will important that the new regime is implemented with care. The rate of around 34.1% will put the UK at the top of the European mainstream, albeit not by much (the French rate is 34%). If new onerous conditions are introduced – and if the significant technical complexities that could potentially arise from the change from capital gains to income tax treatment are not addressed – this could materially reduce the attractiveness of the UK to the private capital sector. Given the relatively modest amounts that the government expects the new carried interest rules to raise – £300m in total over the five tax years to 2029/30 – any significant damage to the UK's asset management industry would be an own goal.
Other important changes in the Budget will also affect the sector. We have known for some time that the UK's current generous tax regime for UK resident but non-domiciled individuals (non-doms) will be replaced by a new residence-based regime. However, with the 6 April 2025 start date fast approaching, the technical detail for this complex reform was lacking. It is therefore welcome that the Budget contains a lot more information (including over 100 pages of draft legislation) on what the new landscape will look like.
The increase in employer national insurance contributions will be a cost for all businesses that have employees. This may increase the attractiveness of the UK limited liability partnership (LLP) as a business model, as the basic position is that LLP members are treated as self-employed for UK tax purposes. This basic position is disapplied if a member falls within the "salaried members" anti-avoidance rules, and so the rate rise may further increase the focus of HMRC (the UK tax authority) on those provisions. Indeed, as aspects of HMRC's approach to these rules have recently been held to be incorrect by the courts in the BlueCrest litigation (which is being appealed), or subject to industry criticism, it is perhaps a little surprising that the Budget contained no measures designed to increase their scope or support HMRC's positions.
In more positive news for the UK asset management sector, the government confirmed that it will be pressing ahead with the introduction of a new type of unauthorised fund, the Reserved Investor Fund (Contractual Scheme) or "RIF", which is expected to be primarily of interest to investors in commercial real estate (due to its VAT treatment). For the right investor base, the RIF could be a viable onshore alternative to the Jersey Property Unit Trust (JPUT).
Overall, the various announcements in the UK Budget that support stability, investment and growth will be welcomed by the private capital sector. The key question is whether those will be enough to offset the pain of some significant tax increases – including some that are specifically aimed at an industry that is likely to be a key driver of innovation and competitiveness.
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