21 April 2008
The private equity industry is no stranger to controversy, having recently attracted the attention of the Government and the media alike. The much-publicised changes to the taxation of capital gains and the tax treatment of UK resident, non-domiciled individuals - so-called 'non-doms' - were part of the Government's stated aim of making the private equity sector pay a "fairer share" of tax.
So what impact will these changes have on the industry as a whole? And what key changes in practice can a tax lawyer working in the private equity sector expect to see?Management teams and a flat rate of taxFrom 6 April this year a flat tax rate of 18 per cent on capital gains was introduced and taper relief abolished. The stated reasons for this were first to simplify the tax regime applying to capital gains, and second to ensure that the private equity industry no longer benefited from an effective tax rate of 10 per cent. The resulting backlash from the business community to the October 2007 announcement resulted in the introduction of entrepreneurs' relief, which addressed some of the concerns raised.
Important considerations for management teams and their lawyers involved in typical management buyout deals will be the tax treatment of an exit from the structure and ensuring ;that ;the requisite conditions for entrepreneurs' relief are satisfied. This essentially means a shift of importance from the time that an individual has held shares for to the percentage of interest held.
In practice, however, this will have a limited effect, as it is fairly common for each member of the management team to have a 5 per cent equity stake (together with voting rights) in the acquiring company.
Lawyers may also need to consider the tax treatment of a disposal of any shares in the target. Before 6 April this involved looking at the taper position of each manager. A preference for consideration to be either bank-guaranteed qualifying corporate bonds (QCBs), which defer the payment of the tax due on any capital gain, or non-qualifying corporate bonds (non-QCBs), with which taper continues to accrue, depended on whether the manager had achieved a 10 per cent effective rate of tax.
Has this position now been simplified? In short, no, as the wording of the draft entrepreneurs' relief legislation means that the relief will need to be considered at each stage. For example, where the shares in a target would have qualified for entrepreneurs' relief but the loan notes of the acquiring company might not, the manager may prefer to receive QCBs, as this will ensure that an effective rate of 10 per cent will apply on disposal, rather than the 18 per cent rate that would apply to a non-QCB.
The point is that careful consideration will need to be given not only to the circumstances existing at the time of the deal, but also to future events. Bear in mind, however, that entrepreneurs' tax relief is limited to the first £1m of qualifying gains, so once this threshold has been reached an 18 per cent rate will apply across the board, with different managers inevitably being at differing stages of use. An 80 per cent increase in tax is not a small matter, and it may even be the case that the market moves towards examining alternative methods of structuring private equity deals.
Residence, domicile and carried interestLawyers advising non-dom carried interest holders on the impact of the changes to the rules on domicile and residence will no doubt have breathed a sigh of relief when the Chancellor announced that no further changes were going to be made to the rules for the next two parliamentary terms.
The furore created when the initial draft legislation went much further than was expected resulted in an influx of queries from concerned clients and a buzz of activity as advisers considered the various options available, most of which were not feasible because of the short time remaining until 6 April.
Lawyers were left unable to give any sensible long-term advice. Now, though, amended draft legislation has been published and the position seems to be that UK-resident and domiciled individuals are in most cases subject to tax at 18 per cent on proceeds of carry that are capital gains.
Although carried interest held through an offshore trust is no longer exempt from capital gains tax altogether, non-doms are still better off holding carry in respect of UK situs assets through an offshore trust, as any returns will only be taxed on remittance.
Clearly the changes do not signal the end for offshore trusts in this sector, but it follows that the concept of remittance will become more important, as lawyers will need to ensure that there is no inadvertent remittance to the UK.
One change that has slipped under the radar somewhat is the change to the taxation of share incentives granted to UK tax-resident employees and directors who are not 'ordinarily resident' in the UK. UK-resident employees or directors who are granted employment-related securities in the UK after 5 April have to pay income tax and/or national insurance contributions on those securities - even where they are not ordinarily resident. This will mean that making an election to ensure capital treatment will become a necessity for individuals who do not benefit from capital treatment under the relevant memorandum of understanding (such as 'late joiners'), resulting in a higher upfront tax charge for a larger number of people.
It will be interesting to see whether the predicted exodus of private equity groups does actually materialise - leading to less UK activity and revenue for the Exchequer. Perhaps an alternative would have been to keep the rules on capital gains tax and residence and domicile as they were and instead reduce the rate of income tax that proverbial 'cleaners' pay to zero. nDominic Adams is a partner in the tax department and Sunaina Srai-Chohan a professional support lawyer at SJ Berwin
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