Biden’s Democrats threaten to change the tax treatment of Carried Interest Plans in the US

February 25, 2021

It perhaps comes as no surprise that the beneficial tax treatment of carried interest is under attack again in the United States.

A group of Democrat Representatives has put forward a bill to change the tax treatment of carried interest to that of ordinary income, which can be as high as 37% in the US.  Currently, carried interest gains are taxed at the capital gains tax rate of 20%.

One of the group commented “the carried interest loophole has allowed private equity tycoons to pay lower tax rates than their secretaries….. This loophole has survived too long and we are going to push hard to see that it is finally closed.”

This comes following the US Treasury releasing tax regulations in January this year clarifying the provisions enacted as part of the Tax Cuts and Jobs Act of 2017, which placed limits on the tax benefits associated with carried interests. These rules impose a three-year holding period requirement, rather than the standard one-year holding period requirement, in order to receive long-term capital gain treatment on carried interest gains.

Democrats have often in recent years put forward legislation that would end the carried interest tax break in the United States.  These efforts have, up to now, fallen by the wayside because there has for so long been a Republican majority in the Senate.  But now a repeal in this carried interest tax treatment looks more likely, as the Democrats now have a majority in Congress, albeit by a narrow margin.

President Joe Biden himself has not specifically proposed repealing the carried-interest tax break, but he has suggested a more comprehensive tax-code change. He has said he wants to end preferential long-term capital gains rates for people earning $1 million or more, and instead tax such gains at the top income rate, which he has proposed to increase to 39.6%. If Congress were to approve that plan, high-income private equity and hedge-fund managers would largely lose the ability to use the carried-interest provision to lower their tax bills.

It is difficult to believe that Biden’s proposal will stand much chance of going through as this would seem to punish genuine long-term investment gains by ordinary (albeit income rich) citizens.

But given that the taxation of carry has frequently been in the sights of Democrats and given also that this would just punish a relatively small group of PE and hedge fund managers, who may not be universally liked in the US anyway, it seems quite possible that some sort of change will happen to this “taxation loophole”.  It is a question of watch this space.

For those based in the UK, carried interest gains are currently taxed at a special capital gains tax rate of 28% if the carried interest is either held by an employee (an employment-related security) or, for self-employed individuals if the carried interest is not an income-based carried interest.

For a carried interest gains not to be taxed as income in the hands of a self-employed individual carried interest holder under the income-based carried interest rules, there is an investment holding period requirement (similar to the one in the US).  Whether carried interest in the UK is taxed to income tax or CGT is now determined by looking at the average holding period of all of a fund’s investments, weighted to the value of those investments.

For carried interest in the UK to be subject entirely to CGT, this weighted average holding period must be at least 40 months. A holding period of between 36 and 40 months leads to an apportionment between income tax and CGT, and for any average holding periods of less than 36 months the charge is entirely to income tax.

Whilst there have been some recent concerns in the UK that the taxation
of carried interest may be coming under scrutiny again (it has before) it seems for now that the Chancellor is not minded to attack this particular area, specifically.

Back in July last year, the Chancellor launched a review of capital gains tax.  The Chancellor asked the OTS, in particular, to ‘identify opportunities relating to administrative and technical issues, as well as areas where the present rules can distort behaviour or do not meet their policy intent.’  What followed was the publication by the Office of Tax Simplification (OTS) of its report titled: “Capital Gains Tax review –first report: Simplifying by design”.

This did set some alarm bells ringing although the evidence from the political reaction in the immediate aftermath suggested that the Chancellor was unlikely to make any drastic or dramatic changes to the current capital gains tax regime in this country.

In our November newsletter, we wrote “It should be noted that the OTS does not formally represent Government policy. It is difficult to predict at this stage which of its recommendations might be acceptable to the Government.

Following the economic downturn because of the pandemic, the Government will probably be looking at increasing tax revenue. While on the one hand, increasing the CGT rate is likely to bring in some revenue, it could also slow down transactions, which, in turn, could hinder growth and recovery. Perhaps the Government will balance these two factors and consider a modest increase in the rates of CGT.”

Undoubtedly more will be revealed in the Budget on Wednesday 3rd March.  It would not be right to say we are looking forward to it, but it is fair to say we will be keeping a close eye on what the Chancellor has to say.

For further information contact Nigel Mills

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