Executive Summary The private equity sector was a net loser from last week’s Budget, with the proposed restrictions on interest deductibility and a lifetime limit on employee shareholder schemes. The extension of entrepreneurs’ relief is welcome, however, and the Government seems to have accepted that CGT treatment will be available under the new rules on carried interest if the investments are held for more than 3 years.
The 2016 Budget had more tax implications for the private equity sector than we anticipated. The most important measures announced were as follows:
- Restrictions on tax deductibility of corporate interest expense: as expected, the UK is changing its interest deductibility rules to be more in line with countries such as Germany. From 1 April 2017, the starting point is that corporation tax relief for interest will be limited to net interest expenses up to 30 per cent of a group’s UK EBITDA, with the disallowed tax relief being available for use in future years (subject to this restriction). However, the following exceptions will apply:
- Tax relief on the first £2 million of the whole group’s net UK interest expense will not be restricted.
- An entity with net UK interest expense above the 30 per cent ratio will be able to receive tax relief on interest up to the level of the net interest/EBITDA ratio of its worldwide group, in recognition that some groups may have high external gearing for genuine commercial purposes. We will need to await the proposed drafting before the extent to which the private equity sector can benefit from this exception in practice becomes clear.
- Tax relief for interest on the provision of private finance for certain UK public infrastructure will be unrestricted.
There will be further consultation on the detailed design of the rules and on a specific regime for the banking and insurance sectors.
- Employee shareholder scheme (ESS): the CGT exemption for ESS shares will be restricted to a lifetime limit of £100,000 of gains. This limit applies to ESS shares issued pursuant to any employee shareholder agreement that is entered into after 16 March 2016, and it significantly restricts the benefit of ESS relief for affected employees. Although we are not surprised by a change to the ESS regime to counter its perceived abuse, we doubt whether a lifetime limit will be effective in achieving this.
- Extension of entrepreneurs’ relief to long-term investors: the scope of the entrepreneurs’ relief regime (giving rise to a 10 per cent CGT rate on gains) is being extended to shares issued in unlisted trading companies (or unlisted holding companies of a trading group) on or after 17 March 2016 and held by individuals for at least three years (beginning at the earliest from 6 April 2016). The individual does not need to be employed by the company, own at least 5 per cent of the shares or even be entrepreneurial…. This is a welcome extension.
- Capital gains tax rates (except for carried interest): for gains accruing from 6 April 2016, the higher CGT rate for individuals will be reduced to 20 per cent (from 28 per cent). However, an 8 per cent surcharge will apply to carried interest, so that there is effectively no change to its tax treatment.
- Tax treatment of carried interest: back in December, it was announced that (from 6 April 2016) carried interest will generally be subject to CGT (rather than income tax) treatment only when the fund undertakes “long-term investment activity”. It was originally mooted that investment horizons of at least four years would be needed to constitute long-term investment activity, but it now seems that longer than three years will suffice. This is a welcome development, on which we are expecting greater clarity soon.
- Reduction in corporation tax rate: the rate of corporation tax from 1 April 2020 will be 17 per cent (rather than the 18 per cent previously announced). The reduction to 19 per cent from 1 April 2017 will still be going ahead.
- Use of carried-forward tax losses: from 1 April 2017, only 50 per cent of a company’s profits above £5 million can be sheltered by carried-forward tax losses, but companies will be able to use carried-forward tax losses more widely than at present – i.e. against all income streams and against profits of other group companies.
Client Alert 2016-081