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UK MPs Hold Fire On Private Equity Tax

by Robert Lee,, London

01 August 2007

An influential committee of MPs has called for a deeper investigation into certain aspects of the UK tax regime as it applies to private equity firms, although they have stopped short of recommending a change in tax legislation or an increase in tax on buy-out funds.

In a report released on Monday, the Treasury Select Committee recommended that the Treasury and HM Revenue and Customs examine the issue of the tax treatment of carried interest as part of their review of the taxation of employment-related securities, and urged the government to publish the results. The report also called for an additional review into whether the tax system unduly favours debt as opposed to equity, thereby creating economic distortions.

The report follows a lengthy examination by the Committee of the risks to the economy posed by leveraged buy-out funds as they begin targeting some of the UK's largest companies. This has led to new proposals for a voluntary code of conduct to increase transparency in the industry. However, it is the issue of taxation which has proved most contentious.

"The tax regime for private equity is one of the most controversial aspects of the industry," the report stated. "The distinctive financial arrangements within the sector mean that the same tax regime can affect private equity differently from other forms of economic activity. Our concern here is to ensure that the tax system treats different sorts of business activities equitably, rather than conferring unfair advantages and creating distortions in the market."

However, in calling for the reviews, the report recognised that any changes could have effects beyond the private equity market, and that care would be needed to ensure that such changes did not damage the UK's financial sector.

There are two parts to the tax debate which could eventually lead to legislative change. The first is the issue of taper relief for 'carried interest.' Business assets taper relief was introduced in 1998 as part of the reforms to Capital Gains Tax (CGT). In its original form, it reduced the CGT payable on business assets that were held for at least 10 years from 40% to 10%. In 2000, the period after which the maximum taper relief applied was reduced to five years, and it was reduced again in 2002 to two years. The original intention was to reward long-term investment, with a view to promoting enterprise and the venture capital industry. This was before the increase in the size of the largest private equity transactions. The questions now are whether taper relief is having the intended effect and whether it is distorting the tax treatment of company revenue.

In a typical private equity fund, the partners in the private equity firm invest their own money in the fund (usually 1 to 3% of the value of the fund) alongside the limited partners. However, the report noted that some partners in private equity finds borrow their share of the equity, and are therefore not investing their own capital. When the fund matures, provided it has achieved its hurdle rate, the private equity partners who have invested in the fund are generally entitled to 20% of the profit which is taxed at CGT rates rather than income tax rates of up to 40%.

"The question is, therefore, whether the reward is disproportionate to the risk, and whether the carried interest should be regarded as a capital gain or a reward for services, reflecting in the latter case the fact that it is not directly a return on the capital invested," the report said.

The Committee has called on HMRC to explain the rationale behind a revision to the 1987 Memorandum of Understanding between the then Inland Revenue and the private equity industry in 2003 which ensured that capital gains treatment would continue to apply to profit shares earned by general partners provided private equity funds operated within certain parameters.

The second aspect to the tax debate is the tax treatment of equity and debt. The report noted that the tax regime relating to debt is the same for all companies, but affects private equity differently from other sectors because of private equity's greater use of debt. Private equity firms have tended to use large amounts of debt to finance their take-overs instead of equity since the deductibility of interest creates substantial tax advantages. It is also believed that the removal of dividend tax credits in 1997 has motivated private equity firms to use equity rather than debt to finance their activities. The Committee is concerned however, about the impact of highly-leveraged buy-ins on UK tax revenues, and the potential for economic distortion if the tax system significantly favours debt over equity as a form of company funding.

The Treasury is already reviewing one specific aspect of the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals and the outcome of this review will be reported in the 2007 Pre-Budget Report.

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