24 March 2016

Important announcements relating to the UK tax treatment of carried interest and limited partnership law reform

Today (Thursday 24 March) has seen the publication of the UK's Finance Bill following last week's budget, and the Government's response to its consultation on changes to UK limited partnership law. Both publications will be broadly welcomed by the private equity and venture capital community. 

Tax treatment of carried interest in the UK 

Today's Finance Bill (which can still be amended as it completes its passage through Parliament) included the all-important and much-anticipated revised law describing the types of carried interest that will become subject to tax as income (rather than capital gain) under the new "income based carried interest" rules. The revisions to the draft legislation are, by and large, helpful: they attempt to broaden the range of fund activities which merit a simplified average holding period calculation treatment, and confirm that funds which have an average holding period of 40 months or more will fall outside of the income tax regime. The changes to the rules should reduce compliance and make it less likely that any carry will be taxed as income, but tests contained in the new rules are both complicated and detailed, so the new regime could hardly be described as user-friendly.

The type of funds now able to use the "simplified" average holding period calculation include funds with controlling interests in trading companies, venture capital funds, significant equity stake funds (not quite a VC fund, but with board rights), controlling equity stake funds (broadly more than 50% of investments in controlling stakes in trading companies), real estate funds, fund of funds, secondary funds and direct lending funds.

This is indeed a significant step forward and our initial analysis is that most mainstream private equity and venture capital funds should remain within the capital gains tax regime. For some funds with longer-term investment horizons, however, there are still concerns: funds using an NAV based system of carried interest may well find themselves unable to rely on the regime for 'conditional exemption' from income tax other than in the first 4 years of the life of the fund, and deal by deal carried interests might also have issues in qualifying on deals which realise within 40 months of investment.

We are hosting a private seminar for clients to discuss the implications of these changes on 22 April. Attendance is by invitation only, but please contact us if you are interested in attending. Further details are available here.

Changes to UK limited partnership law 

Last summer, the UK Treasury issued a consultation paper on long-awaited changes to limited partnership law. Although these changes are not dramatic, and quite technical, they are helpful and the industry has been working with the government for many years to deliver them. Although the draft legislation is not yet available, and will need to be analysed carefully in the coming weeks, today's announcement was very positive and demonstrates that the government has listened carefully to the responses to the consultation and has modified its proposals to accommodate them. 

Generally, the proposals issued last summer were positive and dealt effectively with some of the key issues with the existing law – although they will only apply to certain limited partnerships (those which qualify as "private funds"), and do not allow English partnerships to elect to have legal personality (which is a change that would require primary legislation). 

Our summary of the original proposals is available here

However, the industry had some continuing concerns which have been discussed with the government, and all of these concerns now appear to have been accepted and dealt with appropriately. The detail of the legislation will need to analysed before a definitive verdict can be given, but the following issues appear to have been rectified:

  • Proposals to facilitate striking limited partnerships off the register have been dropped. This is welcome, because the government proposals had given rise to a concern that limited partners might lose their limited liability if a partnership was inadvertently struck off. This proposal may return in more general form, but is off the table for this round of amendments.
  • The industry was concerned by the requirement for a solicitors' certificate that the limited partnership complied with the qualifying conditions for application of the new regime (broadly, that the limited partnership was a collective investment scheme). That requirement has been dropped and replaced with a certificate given by the general partner.
  • The government has also confirmed that the exceptions to the definition of "collective investment scheme" will not apply in determining whether the fund is a collective investment scheme, and therefore qualifies for the new regime. That will simplify the process for deciding whether a limited partnership qualifies (and should ensure that almost all fund partnerships will do so).
  • The limitations on the ability of an existing limited partnership, or one formed as an ordinary limited partnership after implementation of the new rules, to opt into the new regime seemed unnecessarily restrictive. These have been liberalised considerably.
  • There have been a few helpful clarifications to the "whitelist" of matters which are not deemed to be participation in management if undertaken by a limited partner.
  • Capital contributed to a limited partnership established before the new regime becomes effective cannot be withdrawn, on the basis that a third party might be relying on that capital, unless the capital was contributed after the partnership has opted in to the new regime. But capital contributed to partnerships established after the new regime becomes effective will be able to be withdrawn, even if contributed to an ordinary limited partnership before it opted in to the new regime.  That seems to be a sensible and helpful outcome.

These and other comments in the consultation response are very welcome, and it is now anticipated that this new regime will become effective "within a year".  The requirement to make changes to procedures at Companies House necessitates some delay, but the government seems committed to implementing these changes as quickly as it can.

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