HMRC closes buyout firms' use of partnership tax loophole

HM Revenue & Customs has moved to close a loophole that allowed buyout firm executives to avoid paying income tax on investor fees by using limited partnerships, in legislation whose details could make greater change possible after May's general election.

However, alterations by the HMRC to the final legislation, which comes into force on April 6, have calmed private equity industry fears that it could also have accidentally overthrown the taxation of carried interest - a bedrock of buyout funds' returns.

The profits that executives share on deals with investors have historically been classed as capital gains and taxed at a lower rate than income, which meant buyout managers could sometimes pay rates of 18 per cent or less.

The final rules may, however, set a precedent by establishing that it is individuals who receive carry payments in law.

In December last year, the government said it would act to stop buyout firms using limited partnership structures to "disguise" management fees as capital gains. It said it would preserve carried interest's tax status.

Firms typically charge these fees as 1-2 per cent of investors' committed funds, including to pay salaries.

"Since the annual fees are clearly a return for services provided, they should be charged to income tax," according to HMRC guidance.

The law's original version was pared back after complaints over whether its draft definitions could have inadvertently taxed some carried interest as income too.

Laura Chardin, tax partner at King & Wood Mallesons, said: "Having an understood tax treatment for carried interest, which is now on more formal terms, being dictated by primary legislation, gives welcome certainty for fund managers."

Carried interest has been threatened over the years by increasingly complicated tax law drawing hostility from politicians on both sides of the Atlantic.

"Every time, like the cat with nine lives, it seems to walk away," said Nick Thornton, partner at Fried Frank.

The law, however, also refers to carried interest as "a sum which arises to the individual".

"The real element of stepping stone in this legislation is that it has identified the link between someone's professional activities and their related investment returns, which is necessary to justify the taxation of those returns, at least partly, as active income rather than capital," said Mr Thornton.

"It's not a big step, in legislative as opposed to policy terms, to extend that" to taxing carried interest as income in future, he added.

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