ri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Ye UA DEMYSTIFIEDri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Interest - Why Critics and Proponents Are Both Wrong n February 27, 2021 John Gilligan articles Director & Non Executive Director Summary This is a lengthy note that leads to simple conclusions. The taxation of carried interest is widely misunderstood. It is not as material an issue as either proponents or critics present it to be. Changes to the tax could have unintended knock-on effects to the structure of individual deals and the broader Private Equity fund industry that may not be socially optimal. As ever, a calm head is needed when considering politically contentious issues that may have unintended consequences. Introduction — Carried Interest Taxation “Under the current rules, carried interest—an individual fund manager's enhanced share of profits realized from investments— is taxed as capital gains at 28%” This is a quote from Pitchbook, a business that is targeted almost exclusively at professionals working within the private equity industry. It is wrong, materially wrong. At a time that there is a clamour about CGT and carried interest it is important to get the details right. So hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! aneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln What is Carried Interest? For those not familiar with what Carried Interest is here’s a quick summary: For simplicity I’ll assume an old standard fund structure with a 2.0% management fee and 20% carried interest over a hurdle rate of 8% (with no liquidity or 3rd party leverage) Breaking that apart: 2.0% Management fee: the fee is paid in advance by investors to the manager based on the committed fund size during the investment period. once the investment period expires the fee reduces to the same %ge of the cost of the investments (not the value). This fee may be structured as an advance of carried interest, or be in addition to carried interest. 8% Hurdle: The hurdle rate is an IRR, which places IRR firmly at the centre of the PE world. If you are paid based on an IRR, you will manage IRRs. This is unfortunate because maximising IRR does not maximise profit or value, but, for this discussion, we are where we are. 20% Carried Interest: Once the fund exceeds the hurdle rate, the manager receives 20% of all the profits of the fund. This involves some arithmetic called the catch up, that excites those who like these things. but we will focus on the big picture for now. Base Cost Shift: The mechanics of this also used to include a mysterious process called “Based Cost Shifting” that people still get overly excited about. In the UK this was abolished, but you’ll hear people talk about it so let’s pause a while and explain it, Carry is 20% hitpshwuudinkein.comipuleetaxaton-cariaginerestuty-cites-proponents-bathjonr-aligan! aneri3r2021 fa sone (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Jobs transferred the appropriate amount of the cost from the investor to the manager. It was successfully argued that this gave the manager a base cost that they had not paid for which reduced their tax charge. For our purposes all we need to know is that it was abolished. Defining Terms Carefully I'll start by carefully defining terms, because that is where the errors start. Let’s be very precise and use “realised” profits to mean capital gains received and “earned profits” to mean other profits (fees, interest, dividends). In fact, the total return to a fund has three elements: Revenue profits/losses, realised capital gains/write offs and unrealised capital appreciation/depreciation. So, Total Return = Revenue return + Realised Capital return + Unrealised Change in Valuation I'll use a real example to put some numbers on it: These are actual data from a mid-1980s Private equity portfolio in the UK that I analysed in minute detail as a graduate analyst. The analysis was completed 5 years after the initial investments were made and is the aggregate over the 5- year period. hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! aneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln fa Interest Received Dividends Fees Total Income Realised Profit net of losses Cash Distributions Cost of outstanding Inv Valuation of outstanding Inv Excess Valuation Total Profit Cash paid: DPI Total Return: TVPI Fund IRR. Cash flow Gross Investment Return flow - At Cost Cash Distributions Net Cash flow ‘Total return Income Capital gain Revaluation Total return Total Returns Earned £m £m £m £m £m £m £m £m £m £m Pere. Pere eae £m £m £m £m £m £m £m £m Home My Network 23.0 25.0 20 50.0 23.0 73.0 768 88.0 112 90.2 1.01 1.81 20.50% = 1740 97.2 73.0 22 50.0 29.0 112 There was £174m of gross investment in the portfolio. Revenues of £50m had been earned at this point and realised profits of £29m, giving realised cash distributions of £79m. The unrealised portfolio had an estimated value of £88m, an increase of £11.2m over the cost. The total return was therefore the sum of these, £90.2m. hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! Jobs oneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln great performance if the valuation could be realised, DPI (cash paid back/cash invested) was 1.01 and TVPI (Cash paid back + Value/Cash Invested) was 1.81 with 0.8 of that in unrealised value (RPI). The portfolio had matured and was on the upslope of the J Curve in the jargon. Cash is King In most fund managers the performance fee is a share of the total return. In private equity it is different. Private equity is a cash business. so the changes in valuation are not relevant to our problem. If we were talking about hedge funds or quoted fund managers, the situation would be different. In these funds the performance fee usually includes marked to market increases in the total value of the assets of the fund. The manager ears a fee and in addition shares a percentage of the increase in (usually) the quarterly total return (but not any losses). In PE it is just cash that counts, although valuation can in some funds change the timing of payments, but that’s for another day. So carried interest is a share of both earned revenue and realised capital returns, but not a share of total return and not just a share of realised profits. Taxation of Carried Interest Now we can look at the taxation of carried interest in a real example and be confident that we are not just waving random numbers about indignantly, How much tax is the investor and a manager going to pay, and how much will the exchequer earn? hitpsiwuudinkedn.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! aneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Home My Network at Feb 2020, but it’s the arithmetic that is wrong, not the rate. I have done the calculation both based on cash (which is correct) and including valuation to give a sense of the amount that would be earned if the valuations were realised. Total carried Interest ‘Assumed Tax Rate Incorrectly Calculated Tax Charge Post Tax Payment to Managers 58 18.0 28%, 23% 42 - 5.05, 1138 12.99 What’s wrong with this? Well, the fact is that carried interest is taxed as income when it is income and capital when it is capital. Now let's do it Right Total Income 10.0 10.0 ‘Assumed income Tax Rate 45% 45% Income Tax 4.50 - 450 After Tax Income 5.50 550 Realised Profit net of losses 5.80 8.08 Capital Gains Tax Rate 28% 28% car Paid 1.62 2.25 After Tax Capital gain 4.18 5.79 Total Income & Capital Gain 15.80 18.04 Total tax Paid 6.12 675 After Tax Earnings 9.68 11.29 Tax Rate Paid 39% 37% hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! Jobs m9ri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln fa sone Jobs surplus were realised in cash, So why do we hear the argument that carried interest is taxed at 28%? Here we find the importance of being a nerd. A Nerdy Explanation is a Good Explanation. I will describe the UK situation, but the same kind of intricate nerdiness is needed in all countries. In the Limited Partner Agreement there will be a schedule defining the way carried interest is calculated in that particular fund. If we look at the ILPA (Institutional Limited Partners association) template we can see an investor friendly example. ILPA use “distributable proceeds” to cover both income and capital. Here is the detailed legalise: Le Distributions; Allocations Ll Distributions of Distributable Proceeds. Subject to 6.5 (Use of Distributable Proceeds to Fund Drawdowns), Distributable Proceeds (other than Temporary Investment Income) from any Portfolio Investment shall be initially apportioned among the Partners in proportion to their Sharing Percentages with respect to the applicable Portfolio hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! aneri3r2021 fa sone (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Jobs provided in this Article 14 (Distributions; Allocations) and Section 6.6 (Defaulting Partners), the amount so apportioned to each other Partner shall be distributed between the General Partner and such Partner as follows: 1.1.1 First, 100% to such Partner until such Partner has received cumulative distributions pursuant to this Section 14.3.1 equal to such Partner’s aggregate Capital Contributions; 1.1.2 Second, 100% to such Partner until the cumulative amount distributed to such Partner pursuant to this Section 14.3.2 is equal to the Preferred Return for such Partner; 1.1.3 Third, [80]% to the General Partner and [20]% to such Partner until the General Partner has received cumulative distributions with respect to such Partner pursuant to this Section 14.3.3 equal to [20]% of the cumulative amount of distributions made or being made to (i) such Partner pursuant to Section 14.3.2 and this Section 14.3.3 and (ii) the General Partner with respect to such Partner pursuant to this Section 14.3.3; and 1.1.4 Fourth, thereafter, (() [20]% to the General Partner and (ii) [80]% to such Partner.” So here we can see the mechanism for the catch up when a fund goes into carried interest that we mentioned earlier. hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! oneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Jobs an [80:20] sharing of profits. Second there is no distinction made between capital gains or income, it is all about sharing total profits, however they were earned. Next let us look at the legislation on the taxation of carried interest in the UK for tax purposes (emphasis added): “Definition of carried interest ITA07/S809EZC(1) “Carried interest” for the purposes of these carried interest rules is the sums arising to an individual fund manager as set out in ITA07/S809EZC (IFM36520) or as described in ITA07/S809EZD (IFM36540). Sometimes amounts of income or gains may be referred to as carried interest and these amounts may not meet this statutory definition. It is a question of fact if a sum meets the definition of carried interest set out in ITA07/S809EZC or ITA07/S809EZD. Amounts that are determined to be carried interest are subject to the higher rates of capital gains tax in accordance with TCGAg92/S1H(9)(a) and (b).” The tax legislation does define “carried interest”, but what it says is that carried interest is only the gain that is taxable as capital gains. So, the hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! son8ri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Jobs all along. This is where the confusion arises. The UK tax authorities do not classify income received from the fund as carried interest, but literally everybody else does include the income when they are talking about carried interest. What this means is that when you read comments like: “Under the current rules, carried interest—an individual fund manager's enhanced share of profits realized from investments—is taxed as capital gains at 28%” you need to ask yourself a question: Whose definition of carried interest are we using here? The tax definition, or the one that we all use in our daily discourse on the matter (if that isn’t making too comical an assumption about the subject matter of our daily discourse!), The Headlines: 1. Carried Interest is not all capital gain. 2. Carried interest is not taxed as capital gain. 3. Income is taxed at 45%, Capital at 28% 4. The rate of tax paid rises as the income element of carried interest increases. In our real example the actual rate that would have been paid today was 39%, hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! neri3r2021 fa sone (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln letwork Jobs Anyone who has ploughed through to this point is probably thinking that I am arguing in favour of the current status quo and therefore I’m some kind of proponent of the Private Equity industry lobby, That would be a misread of the analysis. All I am saying is that the “debate”, as it usually unfolds in public, is based on a fundamental misunderstanding of how the taxation of carried interest actually works. Both the critics, who argue that 28% is a low rate of tax, and the proponents who say that increasing the rate is a material disincentive to investment are grossly exaggerating the issue. If we look at the impact of equalising CGT and the higher rate income tax band (the 40% upper rate, not the extended 45% rate in the example) we can see that the impact is far from as significant as either side presents it. We can simply calculate the real tax charge in our example based on CGT at 40% and see how much the tax rate rises for the manager. hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! ra8ri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Tatal Income 10.0 10.0 ‘Assumed Income Tax Rate 45% 45% Income Tax - 450-450 After Tax Income 550 5.50 Realised Profit net of losses 580 5.80 Capital Gains Tax Rate 40% 28% CGT Paid = 232 - 162 0.70 After Tax Capital gain 3.48 418 0.70 Total Income & Capital Gain 15.20 15.80 = Total tax Paid - 682 612 0.70 After Tax Earnings 898 9.68 0.70 Tax Rate Paid 43% 39% 4% The tax charge would increase from 39% today, to 43% if CGT were at 40%, an increase in the overall tax rate of just 4%. Now we need to think about what this means to each party. Investors Will Leave Britain? Are all the investors going to leave the UK if the tax rate on carried interest increases by about 4%? I doubt it. they didn’t leave when the income tax rate went up from 40% to 45%, it seems unlikely that they'll up sticks for this change. I know it is cumulative, but I am inviting you to form your own view based on some real data. Will the Critics be Silenced? Probably not. This is just one of many detailed, intricate analyses you need to go through to get the right picture of Private Equity. We haven’t even started on the nonsense that is talked about interest deductibility in leveraged businesses (Hint: not all interest is deductible and never was), short-term flipping hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! raneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln in reputable commentaries. Will the Exchequer get More Income? Yes, but will it materially higher? Probably no. Will the change have any other unintended implications? If you equalised CGT and Income tax at the same extended rate of 45%, you would eliminate the incentive to realise a gain as capital. That might push funds in two directions: First, they would take a higher preferred yield from the investment. This disadvantages the management and employee shareholders by putting a dividend strip ahead of their equity claim. We called this the “Equity Ilusion” in our book on the matter. Second, they may choose to switch away from the buy-to-sell model and move towards the buy-to-own model. Given the competitive nature of the deal process, which pretty much guarantees that you bear the “Winner’s Curse” in any auction, and the difficulty in finding new primary deals, this would be a further step away from the old model of Private Equity, Have we missed anything? Well inevitably yes, otherwise why would all those tax advisers and inspectors exist? There have, for example, been intricacies in funds to channel income preferentially to some LPs and capital to others so that managers got more low tax capital (this has been stopped in the UK), and there is now leverage in some funds and secondary transactions at multiple levels that can turn income into hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! saneri3r2021 fa (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Jobs preferred yields to increase the chances of actually earning carried interest in the first place. However, the purpose of this was dispel one myth, not demystify them all, to coin a phrase! Conclusions This is a lengthy note that leads to simple conclusions. The taxation of carried interest is widely misunderstood. It is not as material an issue as either proponents or critics present it to be. Changes could have unintended knock-on effects to the structure of individual deals and the broader Private Equity fund industry that may not be socially optimal. As ever, a calm head is needed when considering politically contentious issues that may have unintended consequences. Further Reading If you want to know more the late, great Prof Mike Wright and I tried to cover the ground more fully in the fourth Edition of our book "Private Equity Demystified", All author royalties are gifted to The Big Issue Trust, a UK Charity that aids the homeless. hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! s919ri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Ma Sone peo Jos Private Equity Demystified: An Explanatory Guide amazon.co.uk Private Equity Demystified: An Explanatory Guide now more Report this Published by &B John Gilligan Narticles (+ Follow rector & Non Executive Director On the topical issue of the taxation of Carried Interest Hprivateequity GS Like © comment > Share & GOL ee 26 Comments Most relevant Add a comment. © ww hitpshwuudinkein.comipuleetaxaton-cariaginerestury-cies-proponents-bothjonn-aligan! 1619rnsr021 (84) The Taxaton of Cad intrest Why Cites and Proponents Are Both Wrong | LinkedIn Ma fone yeh Am not sure | followed. let's keep it simple, A fund invested 100 including mngt fees. And 150 were due to be distributed. Carry is 10. 140 given to LPs. Tax paid or the 10 is 28%, is it not? You seem to imply itis 39%. Like - 2) Reply + 17 Replies Load previous replies ® John Gilligan « 3rd+ Amo ve Director & Non Executive Director ANNA MARIA SERAFIMA RAEVSKAYA-REPNINA Thank you for you comments. | think we are done Like | Reply Enrico Corazza LLM + 3rd Amos Private Clients & Corporate Tax Consultant If a sum paid to a fund manager meets the definition of carried interest as per $809EZC(1) ITA2007 the amount is considered carried interest and taxed at 28% So when people say that carried interest is taxed at 28% they are correct. The fact that the fund manager receives a remuneration package that includes also income not chargeable to CGT does not mean that carried interest is not taxed at 28% Like 1) Reply + 2Replies Load previous replies e John Gilligan « 3rd Ame v4 Director & Non Executive Director the point is that the definition in the legislation is different to the common usage of the term. When people calculate their carried interest they do not calculate the defined term, Like | Reply Load more comments A John Gilligan Director & Non Executive Director hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! wieri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln Home MyNetwork Jobs The Oxford Finance Lab - What Happens Next? John Gilligan on Linkedin The Paradox of Private Equity John Gilligan on Linkedin Private Equity Demystified: If not tax avoidance, then what are all those tax havens for? John Gilligan on Linkedin Private Equity Demystified - Again John Gilligan on Linkedin hitpshwuudinkein.comipulsetaxaton-cariaginerestuny-cites-proponents-bothjonn-ailigan! saneri3r2021 (84) The Taxaton of Carried Interest Why Cites ang Proponents Are Bath Wrong | Linkedln dee all tr articies hitpshwuudinkein.comipulsetaxaton-cariaginerestuty-cites-proponents-bothjonn-aligan! s9n9