UK Budget: no surprises for PE

Private equity investors were hoping for clarification on the many tax issues facing the private equity industry, but unfortunately UK Chancellor of the Exchequer Gordon Brown included little comment on the subject in his Budget presentation March 22.

Some professionals were hoping in particular clarification on the tax treatment of profits made by private equity executives. So for the time being this means that the taxation of the management teams, the carried interest holders and the taxation of profits and in particular the deductibility of interest on finance costs remain uncertain. It was unlikely anything would emerge on this front, however, given that the government has only recently entered into a consultation period on the matter.

(Interesting, the fate of the UK’s high earners, those earning £100,000 and more from financial services activities, is likely to be of heightened interest to the UK Treasury, after the small print of this latest Budget noted that the total tax paid by this group has tripled from £10.5bn to £34.2bn in the time the current Labour administration has been in power. In 1997/98 there were just 200,000 individuals working in financial services earning £100,000 or more and in the tax year 2005/06 this figure had more than doubled to 500,000 and in the 2005/06 tax year these £100,000+ pay 25% of all income tax revenue in the UK, compared to a 13% reliance on their earnings and revenue generation back in 1997/98. The rise in the size of this grouping of £100,000+ earners is masking a downturn in income tax revenue elsewhere in the UK.)

The changes announced in last year’s Budget marked a fundamental shift in attitude of the Treasury to the private equity sector and created an uncertain tax environment. One of the main uncertainties worrying investors is the amount of interest deductible in leveraged buyouts due to the extension of the transfer pricing legislation. Once the transitional period comes to an end on April 1 2007, the retrospective limitation on historic debt will kick in and reduce the returns on many current investments.

In addition, the industry is aware HM Revenue & Customs (HMRC) is back tracking on the agreement not to attack private equity deals post 1998 in relation to claims for interest deduction. According to Stephen Quest, tax partner at Grant Thornton, it is understood the HMRC is limiting the availability of the safe harbour for management teams who have received sweet equity in buyout transactions. The agreement with the British Venture Capital Association provided comfort that buyout teams would be liable to a capital gains tax at 10% in most cases. However, the spirit of that agreement is now being broken since the HMRC has indicated it will now use income tax rates where the sweet equity holders have not provided loan note funding.

The private equity tax regime is long established and was reinforced in 2003 in a safe harbour provided by a further agreement with the BVCA. It is now feared the HMRC is seeking to undo the effect of this agreement and impose a tax treatment more likely to result in income tax rates being applied to profits realised on carried interests.

Quest voices concern for the industry: “The combination of these uncertainties and the continuing trend to a more aggressive approach to perceived tax avoidance will lead to reduced deal flow in the UK and may eventually lead to private equity businesses relocating offshore.”

The BVCA continues to lobby for a favourable clarification of the situation. BVCA chief executive Peter Linthwaite, said: “We look forward to working closely with the Chancellor over the period of the tax review that has been announced prior to today to ensure that no alteration is made to the environment that helps to ensure we have the largest and most vibrant private equity and venture capital industry in Europe and second only in size globally to the United States.”