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November 10, 2024
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Private Equity

Private equity investments, divorce and the Budget….


In its 2024 election manifesto, the Labour Party said: “Private equity is the only industry where performance-related pay is treated as capital gains.  Labour will close this loophole.”  

The newly elected Labour government proved to be as good as its word and on 29 July the Chancellor launched a call for evidence, committing to taking action in relation to carried interest.  Written representations were to be submitted by the end of August and it was plainly stated that stakeholders should “…expect a further announcement at the Budget on 30 October.”

So, whilst speculation has been rife in the weeks leading up to the Budget about what tax changes could be expected, it was always clear that the treatment of carried interest was in firm focus. (See further “This is going to hurt” – potential implications of the forthcoming Budget on financial arrangements on divorce (charlesrussellspeechlys.com) where these and other potential tax changes were outlined.)

What was the loophole?

Until now, private equity investments could be structured so that much of the rewards could be taxed at capital gains tax rates.  Whilst profits on any “co-investment” made in a private equity fund was less contentious (attracting CGT at 20% on the gain), the real mischief was perceived to be the way in which carried interest was taxed.

Once a private equity fund has made sufficient profits to repay the original investment, there will then be a defined hurdle after which any excess profits are divided up between the fund managers, the “carried interest” share. Provided certain conditions were met, this carried interest was then taxed at a special rate of 28% capital gains tax.  

The “loophole” therefore arose because, whilst carried interest links the success of the fund’s returns to the compensation received by the fund managers, which sounds and looks very much like a performance fee, it only attracted tax rates of 28% rather than income tax rates of up to 45%.

What has happened in the Budget and how might this impact financial remedy cases?

As anticipated, today’s Budget has made changes to the tax treatment of carried interest.  Whereas it was previously attracted CGT at 28%, the rate has now been increased to 32% with effect from April 2025. The Chancellor also made clear that there would be further reforms from April 2026 to make carried interest rules “simpler, fairer and better targeted” so, whilst today’s changes were less significant than many had anticipated, it is clear this is not the end of the story.

There is a careful line to tread; as with the change in the taxation of non-domiciliaries (many of whom are also private equity investors and therefore doubly impacted by today’s changes), it is important that the changes do result in a net benefit to the economy in practice.  To the extent that investors react negatively and move money elsewhere, the gains made by the marginal increase in rates will be offset by overall losses in tax receipts, with the added risk of slowing economic and investment wheels in the process. 

As to how this will impact financial remedy cases, where there are tax increases, the net assets available for division between the parties will be reduced.  This is explained further in the article linked to above (“This is going to hurt”).

How do the courts approach carried interest entitlements upon divorce?

The leading case of relevance is A v M [2021] EWFC 89. In that case the court was required to address the treatment of carried interest and how it should be approached in the financial settlement upon divorce.

Notwithstanding the tax treatment referred to above – and echoing the government’s argument about the nature of carry – the husband’s case was that carried interest was the same as a bonus, representing future income rather than capital and therefore should not form part of the matrimonial property available for sharing between the parties.

The wife’s case was that this should be treated as another capital asset in the case, so that the carried interest, once received, should be divided fairly between the parties; the husband had effectively been trading with her share of the marital assets and it was therefore fair for her to receive her share when realised.

In resolving the conundrum of whether carried interest should qualify as capital or income, Mostyn J’s decision in A v M offered little assistance. He said: “For what it is worth, it is my view that carried interest …is neither exclusively a return on a capital investment… nor an earned bonus…but rather a hybrid resource with the characteristics of both.

He went on to formulate a method to calculate the “marital portion” of the carried interest entitlement by considering what proportion of the lifetime of the fund fell during the marriage (from establishment of the fund to the date of trial).  The wife was then entitled to share in the portion considered to relate to the marital acquest.

Summary

The family courts rather sat on the fence when giving a view on whether carried interest amounts to capital or income and in fact today’s Budget applies a similar approach, adopting a special tax rate somewhere between CGT and income tax rates and with further changes signalled for the future. This area (both in legal and taxation terms) remains an interesting and developing one to watch in the future.



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