The Chancellor of the Exchequer delivered his much anticipated Post-Election Budget today which includes major changes to the taxation of carried interest which have immediate effect. These provide that capital gains tax at 28% will be charged on the entire amount of carried interest received less cash actually paid by the manager. In addition a consultation has been launched on the circumstances in which performance fees arising to fund managers from management activities will be taxed as income, although this is not intended to impact on private equity funds. This is an area where the industry will want to engage constructively on the detail to ensure that the legislation works as intended and does not go beyond its intended scope.
Tim Hames, Director General of the British Private Equity & Venture Capital Association, said in relation to these proposals that “The BVCA will work with HM Treasury and HMRC to achieve the smooth, sensible and simple implementation of the changes that the Chancellor has introduced in respect to the private equity sector and carried interest especially. The BVCA is confident that the Government appreciates the importance of ensuring that the UK remains Europe’s leading centre for fund management.”
Following the election, George Osborne was no longer constrained by the necessities of coalition government and therefore had greater scope for reflecting his priorities and beliefs. It was anticipated that this would involve setting out a road map in relation to tax matters for the next few years and increasing the extent to which deficit reduction would be met by decreases in public spending rather than by tax increases. However, unavoidably increasing tax revenues has to be part of the mix and measures intended to raise tax revenues by five billion pounds have been announced. In part because of election promises not to raise VAT, income tax or NICs much of this involves targeting perceived anomalies and avoidance.
The Finance Bill will be published on 15 July 2015. Some of the legislation is likely to reflect matters which were announced last December but for various reasons could not be included in the pre-election March Finance Act. It is not entirely clear when it is envisaged that this Finance Bill will become law.
The main tax announcements of particular interest to the private equity and venture capital sector are summarised below together with a discussion of an important Supreme Court decision on the treatment of Delaware LLCs for UK tax purposes.
In this issue
Funds and investment
Employment and incentives
UK tax treatment of Delaware LLCs
Funds and investment
It was announced that with effect from 8 July 2015 amounts which arise to investment fund managers by way of carried interest will be subject to the full rate of capital gains tax, with only limited deductions being permitted for sums actually given by the individuals as consideration for acquiring the right to that carried interest. The press release states that this change will not affect co-invest which is defined as genuine investments in funds made by managers on an arm’s length basis. It is assumed that this will follow the definition in the disguised fee income rules.
Performance linked rewards paid to asset managers
A consultation has been launched to establish the criteria for determining when rewards arising to investment fund managers are to be taxed as income rather than capital gains. The stated aim is to ensure that individuals who manage funds where the underlying activities are more aligned with trading than investing pay full income tax on any performance fee/carried interest they receive. The intent is to legislate in 2016. It is specifically stated that the intent is not to change the taxation of PE funds, and the industry will need to fully engage in the consultation process to ensure that this is the case. One major concern is that the intention is to assume that all performance linked award are income and then to legislate for exemptions from this treatment. Two options are proposed – the first is that certain defined activities will be stated to be investment activity and the alternative focuses on the time for which investments are intended to be held.
Amendments to rules for Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCT)
The Government confirmed that it will, subject to receipt of state aid clearance, amend the rules with effect from royal assent to the Summer Finance Act so as to require that all investments are made with the intention to grow and develop a business and that all investors are ‘independent’ from the company at the time of the first share issue. It appears that the negotiations in relation to state aid have already resulted in some changes. Additionally, it will introduce new qualifying criteria to limit relief to investment in companies that meet certain conditions demonstrating that they are ‘knowledge intensive’ companies within 10 years of their first commercial sale, and other qualifying companies within 7 years of their first commercial sale (previously 12 years had been proposed as the limit); this will not apply where the investment represents more than 50% of turnover averaged over the preceding 5 years. It is also proposed to cap the total investment a company may receive under the EIS and VCT regimes at £12 million (previously this was proposed to be £15m), or £20 million for companies that meet certain conditions demonstrating that they are ‘knowledge intensive’. In addition the cap on the number of employees for knowledge intensive companies is to be increased from 249 to 500. It is also proposed to introduce new rules to prevent EIS and VCT funds being used to acquire existing businesses, including extending the prohibition on management buyouts and share acquisitions to VCT non-qualifying holdings and VCT funds raised pre-2012, and preventing money raised through EIS and VCT from being used to make acquisitions of existing business regardless of whether it is through share purchase or asset purchase. It was reconfirmed that it will longer be necessary for 70% of Seed Enterprise Investment Scheme (SEIS) money to be spent before EIS or VCT funding can be raised for qualifying investments made on or after 6 April 2015.
Limited partnership consultation
It was announced that there will be a consultation in relation to technical changes to limited partnership legislation to enable private equity and venture capital investment funds to more effectively use the limited partnership structure. These changes have long been sought by the industry to modernise UK limited partnership law and bring it into line with the laws in other jurisdictions. The reforms will most likely include a “white-list” of activities which limited partners may engage in without losing limited liability, and abolition of the prohibition on return of capital. The full consultation document is expected to be published next week.
Property investments funds and Stamp Duty Land Tax
It was reconfirmed for at least the third time that it is proposed to make changes to the SDLT rules for property authorised investment funds (PAIFs) and co-ownership authorised contractual schemes (CoACSs) so as to encourage the creation of such funds. If enacted, they will provide relief from SDLT on seeding PAIFs and CoACSs and an exemption from SDLT on the issue, transfer and redemption of units in CoACSs. There will be detailed anti avoidance provisions which will seek to prevent the reliefs being used for SDLT avoidance in the same way as the previous seeding relief for unit trusts.
As anticipated, it was announced that major changes will be made to the non-domicile tax regime which will come into effect in April 2017. The proposed changes are that people born in the UK to parents domiciled here will not be able to claim non-domiciled status, those resident for 15 out of the last 20 years will not be able to claim non-domiciled status and residential property held through non-resident vehicles will be treated as having a UK situs for IHT purposes.
Major changes to the taxation of dividend income were announced which are intended to be introduced with effect from 2016. The first £5,000 of dividend income will be exempt from tax but the dividend tax credit will be abolished and dividend income above £5,000 will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. One aim of this proposal appears to be to reduce the attractiveness of using personal service companies to reduce the effective rate of tax.
Employment and incentives
A consultation has been launched in relation to proposals to restrict tax relief for travel and subsistence for workers engaged through an employment intermediary, such as an umbrella company or a personal service company. The changes will take effect from 6 April 2016. This is designed to counteract arrangements that connect travel and subsistence payments to salary sacrifice by converting salary into allowances or specific expense payments into benefits in kind that are neither taxable nor chargeable to Class 1 National Insurance Contributions.
It was announced that there will be a review of the IR 35 legislation which can treat people providing their services through a company as employed for tax purposes with a view to making the legislation more effective.
It was announced that a supplementary tax on banking sector profits of 8% will be introduced with effect from 1 January 2016. The tax will apply to banks’ corporation tax profit before the use of any existing carried-forward losses. It was also announced that the bank levy rate will be gradually reduced over the next five years to 0.1% in 2010 and will only apply to UK operations with effect from 1 January 2021.
Relief for releases of debts in certain circumstances
A provision to prevent a tax charge arising when debts of companies in financial distress are released, or the terms modified, will apply to releases and modifications on or after Royal Assent to Summer Finance Bill 2015 where arrangements are made to restructure the debts of a company in financial distress with a view to ensuring its continued solvency.
Currently companies can write off goodwill and other intangible assets acquired on an asset deal at 4% per year. It is proposed that this relief will be withdrawn for all purchased goodwill and customer related intangible assets, except in respect of acquisitions made before 8 July 2015 (or acquisitions made afterwards pursuant to an unconditional obligation entered into before then).
It was announced that the rate of corporation tax will be reduced to 19% in 2017 and 18% in 2020. However, where a group has profits in excess of £20m then in 2017 they will be required to pay corporation tax in quarterly instalments in the third, sixth, ninth and twelfth months of their accounting period.
Business tax roadmap
The government will publish a business tax roadmap by April 2016, setting out plans for business taxes until the next election. It is hoped that this will provide some level of certainty for business.
A general anti-avoidance rule which is designed to counter arrangements entered into with a main purpose of obtaining a tax advantage by way of the loan relationships or derivative contracts rules will be introduced with effect from Royal Assent. As a consequence, a number of existing specific anti-avoidance rules will be repealed.
VAT and certain exempt services used and enjoyed in the UK
It was announced new VAT ‘use and enjoyment’ provisions will be introduced so that from next year, it will be clear that all UK repairs made under UK insurance contracts will be subject to VAT in the UK. In addition, the government is considering undertaking a wider review of off-shore based avoidance in VAT exempt sectors, with a view to introducing additional use and enjoyment measures in 2017.
UK tax treatment of Delaware LLCs
Last week the UK Supreme Court gave its judgement on the long-running Anson case and decided in favour of the taxpayer (overturning the decision of the Court of Appeal). They ruled that he could claim relief for US tax paid on his share of a US LLC's profits against his UK tax liability on distributions from that LLC under the terms of the UK/US double tax treaty. This is a welcome decision for UK residents who are members of US LLCs which carry on active trading operations (such as investment management and advisory services) since it reverses HMRC’s current position that results in an extremely penal combined tax rate on the LLC profits to which UK residents are entitled.
HMRC’s position has long been that a US LLC is treated as a company for UK tax purposes and that distributions from it to a UK resident member of the LLC are treated as dividends. From a US tax perspective, LLCs which have not elected to be taxed as companies (which will be the case for most US LLCs carrying out active operations) are taxed as partnerships and all members (whether or not US tax resident) are subject to US federal and state income tax on their distributions as a share of underlying profits. Because of the difference in tax treatment, HMRC has historically not allowed UK resident members to claim relief against their UK tax liability on their LLC distributions for the US tax charged on those distributions unless they held at least 10% of the voting power of the LLC.
This resulted in UK resident members with a less than 10% holding in the LLC being taxed at US ordinary income rates and then being taxed at UK dividend rates on their post-US tax distributions, with no credit for the US tax, resulting in an effective tax rate of more than 60%.
The question in point in the case was whether the UK tax was “computed by reference to the same profit or income” as was the US tax. The First Tier Tribunal (FTT) had found that it was, the Upper Tier Tribunal (UTT) had reversed that decision and the Court of Appeal upheld the decision of the UTT. The Supreme Court was reasonably scathing of the UTT and the Court of Appeal, saying that they had applied their minds to the wrong question by asking whether the LLC member had a proprietary interest in the assets, including the income, of the LLC. Instead the Supreme Court approached the question from the perspective of applying the “ordinary meaning” of the UK/US double tax treaty “in the light of its object and purpose”, as required by international law. Applying this approach and the expert US advice given to the FTT on the nature of an interest in a LLC and the terms of the particular LLC Agreement applicable in this case, the Supreme Court agreed with the FTT that the profits arising to the LLC were the profits of the member as a matter of US law and were the “income arising” to the member from his interest in the LLC as a matter of UK law. Accordingly, the US tax and UK tax were “computed by reference to the same profit or income” and the UK taxpayer was entitled to claim credit against his UK tax liability for the US tax paid on the profits distributed to him.
This judgement is, therefore, very helpful for UK residents who are members of active, operating US LLCs treated as transparent entities for US tax purposes since it means that they should be subject to tax only at the highest effective rate in the US or UK as applicable at the time.
While deciding in favour of the taxpayer, the case is not authority that all US LLCs are tax transparent entities for UK tax purposes and HMRC have not yet provided a response as to whether they will change their current practice in treating LLCs as tax opaque vehicles as a result of the decision.
Another interesting, and as yet uncommented on, point from the case is reference in it to the fact that an LLC member’s interest was not akin to share capital in a company. HMRC states in its Revenue & Customs Brief 87/09 that the members’ interests in a Delaware LLC will be treated as “issued share capital” if they are evidenced by the issue of a member’s interest certificate and other factors relating to the LLC indicate that it has share capital. It is important that entities have issued share capital for a number of UK tax provisions relating to grouping and, particularly, exemptions from tax requiring group relationships. We will have to see, therefore, whether HMRC changes its position in respect of US LLCs having issued share capital in the light of this decision.