Don’t get carried away: private equity funds are investing not trading

13 March 2023

There has recently been a suggestion, featured in the national press, that private equity funds are typically trading rather than investing for UK tax purposes.

In this note we explain the issue, why we strongly disagree with the suggestion and how this all fits into the broader debate around carried interest taxation.

How are private equity funds taxed in the UK?

As private equity funds are usually structured as limited partnerships, their investors are treated for UK tax purposes as undertaking the activities of the fund and directly receiving a share of the fund’s profits. The position that private equity funds are investing rather than trading is well-established in the market and has been accepted by HMRC since limited partnerships were first used for private equity funds in the UK in the 1980s.

Why is this being discussed?

The thrust of the suggestion being made is that private equity funds are typically trading for UK tax purposes with one result being that carried interest proceeds arising to individuals from such funds should automatically be taxed as trading income at 47%.
The consequences of trading status for a private equity fund would not be limited to the tax treatment of carried interest. If a private equity fund was trading then:

  • UK pension funds and charities would be subject to tax on their profits from their private equity investments (as their UK tax exemptions only cover investment activities); and
  • non-resident investors could be liable to UK tax on their profits from UK centric funds in certain circumstances.

What do we think of the technical analysis?

We strongly disagree with the suggestion that private equity funds are trading for UK tax purposes.

The suggestion follows the carrying out of a “checklist” type assessment of the trading status of private equity funds by reference to the “badges of trade”. These badges are a list of indicators that have historically been used by the courts to distinguish between trading and non-trading activity in the absence of a detailed statutory definition of a trade. However, the courts have consistently held that simply applying the badges of trade on a “checklist” basis is not the correct approach and have emphasised the limitations of the badges, which can at times be inappropriate and unhelpful, especially in the context of financial assets.

Before we set out what we believe to be the correct approach, it is important to note that trading versus investing determinations are rarely black or white and most cases are in the grey zone: a tax no-man’s land if you like. It is therefore almost always possible to reach a trading determination by applying the badges of trade in a particular way. That such a determination is reached does not mean it is correct, however1.

The correct approach should be to examine the question of whether an activity is trading or investing in the round to form an overall impression, having regard to the commercial context in which the relevant transactions are carried out. The badges are merely one tool that may be relevant to that exercise.

In decided cases the courts have held that there is a rebuttable presumption that dealing in financial assets such as shares is not trading. A common theme in the cases in which that presumption has been successfully rebutted is that the taxpayers were dealing on a short-term, speculative basis with a view to profiting from market fluctuations. The assets in question were not acquired with a view to income yield or long-term appreciation in value driven by the investee companies’ fundamentals; they were acquired to be sold in the immediate future.

In our view this is the key consideration when considering whether a person is trading in financial assets. The investment approach of private equity and other private asset funds can be clearly distinguished from the types of short-term dealing strategy employed by the taxpayers in the cases mentioned above.

A more general point we would make is that trading versus investing determinations cannot be undertaken in a manner divorced from their commercial context and how the commercial world regards the transactions. This point was made in a leading judgment on this question given by Sir Nicolas Browne-Wilkinson V.-C. in Marson vs Morton [1986] 59 TC 381. He stated at page 393:

“The legal principle of course cannot change with the passage of time: but life does. Since the arrival of inflation and high rates of tax on income new approaches to investment have emerged putting the emphasis in investment on the making of capital profit at the expense of income yield. For example, the purchase of short-dated stocks giving a capital yield to redemption but no income has become commonplace. Similarly, split-level investment trusts have been invented which produce capital profits on one type of share and income on another. Again, institutions now purchase works of art by way of investment. In my judgment those are plainly not trading deals; yet no income is produced from them.”

In today’s commercial world, investing into private assets on a medium to long term basis is seen as investing and not an adventure in the nature of trade. For that reason and the other reasons set out above, we wholeheartedly reject the suggestion that private equity funds are trading.

What policy issues are being raised?

There is a policy debate ongoing about whether investment managers’ carried interest should be taxed as income or capital gains, and at what rate. That is very much on the political agenda, with the Labour Party having stated that they wish to reform the current rules should they win the next election. However, we do not think it helpful to have that debate via a proxy battle in relation to the investment status of private equity funds. We also think it is dangerous in that it would mean that UK pension schemes and charities have been wrongly claiming a tax exemption for their private equity fund investments for the past 40 years.

As explained above, carried interest is a share of investment return not trading income and in our view should be taxed as such. However, irrespective of the debate about its correct characterisation, the reality is that any material increase in the rate of tax on carried interest would leave the UK uncompetitive in comparison to other European jurisdictions such as France, Germany, Italy and Spain that have competitive (and in most cases recently introduced or improved) carried interest regimes. As a result, the UK treating carried interest as income would result in a significant number of (mainly overseas born) private equity executives leaving the UK and would almost certainly significantly reduce, not increase, tax revenues.

Including for the reasons set out above, we do not expect the recent suggestion that private equity funds are trading will have any impact in practice. However, we do expect to hear more from the Labour Party on their plans for the taxation of carried interest as the general election approaches. On that point, our hope is that when the risk to tax revenues of any material changes to the current rules is understood any focus for change will shift to ensuring the qualifying conditions for the UK regime are similar to the regimes in other European jurisdictions.

Even if it was correct to focus solely on the badges of trade (and it is not), these point towards private equity funds having investing status. For example, a typical private equity holding period of four to seven years is indicative of investment – over that length of time funds are significantly exposed to an investee group’s fundamentals, industry trends and general economic conditions.