Episode 2: Tackling tax issues and investment funds - Inside UK Labour’s tax manifesto

Patricia:

Welcome to the second instalment in our podcast series, Tax Lyrical. I'm joined this morning by Sophie Lloyd. Hello Sophie.

Sophie:

Hello Patricia.

Patricia:

And Alastair Ladkin.

Alastair:

Hi Patricia. I'm looking forward to the discussion.

Patricia:

So it has been an interesting few days here in the UK with the general election, and in case you missed it, Labour won. We thought it would be interesting to just run through what the key tax measures are in the Labour manifesto and when those changes might actually come in. It's safe to say that with its majority, it should be relatively easy for Labour to pass new laws and so changes that have been set out in the manifesto are indeed likely to happen. Today, we are going to focus on a couple of tax changes that we think are particularly interesting, the changes to the non-dom regime and the proposed changes to the taxation of carried interest. But before looking at those specific issues, it is important to note that Labour were elected with a promise not to raise taxes on working people. Sophie, do we have any idea what that actually means?

Sophie:

I don't think so specifically Patricia, but what is clear is that Labour will have to raise additional tax revenue. Their manifesto contained plans to raise around £8.5 billion in additional tax revenue as well as £3.5 billion in borrowing to fund its policies. The biggest fund of the additional tax revenue was said to be from non-dom rules and reducing tax avoidance. And that heading was said to raise over 5.2 billion of that 8.5 billion. In relation to those non-dom rules, Labour's manifesto provided that it would abolish non-dom status and replace it with what it called a modern scheme for people genuinely in the country for a short period and end the use of offshore trusts to avoid inheritance tax.

Now, Labour have effectively lifted the non-dom changes announced by the Conservative Party, which had been due to take effect from the 6th of April 2025. But both the associated costings and some of the detail revealed so far have indicated that the Labour version of these changes will be less generous than those that the previous government had announced.

By way of reminder then, the proposals are to replace non-dom status with a new residence-based regime offering a 4-year exemption for offshore income and gains for individuals who have been non-resident for the previous 10 years. Labour have indicated that they would make the transitional reliefs announced by the Conservative government less generous, disregarding the 50% exemption for foreign income in 2025 to '26, and not offering that 50% exemption is said to raise 600 million.

In addition to that, there's the loss of inheritance tax protection for trusts and this is going to be the case regardless of whether the trusts are set up now or whether they already exist. But what is not clear from Labour's proposals is whether this would also apply to trusts which already exist and existed before the set law became resident in the UK. Now, inheritance tax as we know is a sensitive topic in the UK and it is possible that these measures in particular, could encourage some wealthy people to leave the UK rather than face 40% inheritance tax on assets which may have been acquired long before becoming UK residents.

Alastair:

So that's some news that could be bad for non-domicilaries, but it's not all bad news. There are some good aspects to the revised regime too, and there are two angles there. There's good news for non-doms who are not currently living in the UK but would come to the UK in the future. And there's also good news for existing non-doms. So dealing with new arrivals first, the detail of the proposals is a bit unclear, but where it looks like it's headed is that for the first four years of being in the UK, a non-dom will not be taxed on their foreign income gains. They will be tax-exempt. And that would also be the case if those foreign income and gains are brought into the UK. Labour have also said that they're considering an additional incentive to get non-doms moving to the UK and that's that UK income may be tax-exempt if it's invested in a certain way. So that would go beyond the current regime and be an additional incentive, but we don't know what the details are yet.

The second bit of good news is for existing non-doms, the Conservative government said that it would introduce a 2-year temporary repatriation facility which would allow non-doms to bring their foreign income and gains to the UK between April 2025 and April 2027 for a flat rate charge of 12%. And the reason that that's good is that under the current regime, non-doms would pay tax at full rates if they were to bring their foreign income and gains to the UK. So the 12% rate is a clear advantage there. That was proposed by the Conservative government. Labour have said that they will keep that relief and they've also said that they would consider extending that relief beyond the 2027 window that's currently proposed. Again, it's not clear what the details are there, but that's a potentially useful development from Labour.

Patricia:

It is just really interesting isn't it in that some of the changes such as for the newer arrivals in the UK or that temporary repatriation facility are just quite ... Could potentially be really useful for people?

But again, obviously then there's the IHT issues with trust. So it's quite complicated. And I mean do you think the answer is that basically, non-domiciled individuals, whether in the UK or thinking about coming to the UK, will really need to think about their own personal circumstances and making any decisions and get some good advice? Do you think that's right Alastair?

Alastair:

Absolutely. These issues are all very fact-specific and non-doms should be considering all of their options including maybe leaving the UK but also staying in the UK under the new regime. As I say, it's all very fact-specific and something that non-doms should be considering with their usual personal advisors.

Patricia:

Sophie, what do you think we can expect from Labour's announcement to invest approximately 855 million in HMRC to reduce tax avoidance? What do you think we're going to see the consequences of that being?

Sophie:

Well, we've already seen an increasingly assertive HMRC over the last 10 years in particular. There've been a greater number of inquiries being opened by HMRC for taxpayers to respond to. And what I think we can expect as a result of this announcement is for this trend to continue. And the amount of tax revenues that Labour are expecting to collect as a result, as we know, is large. And so it must be the case that HMRC's compliance activities are going to increase. Labour has said they're going to recruit an additional 5,000 members of HMRC staff and then also invest in technology to assist the HMRC staff in the collection of tax. In the Labour manifesto, there was also a reference to making legal changes to ensure that there are genuine deterrents to tax evasion. So it's not clear what those are at the moment, but there may be an announcement of some additional Draconian measures in order to further deter taxpayers from behaviours that the Labour government consider to be evasion or avoidance.

Now the 5,000 additional staff may allow HMRC to be more effective during the inquiry process where currently under-resourcing appears to cause problems or mistakes. HMRC have certain statutory powers once they've opened an inquiry, but those powers are then also subject to certain taxpayer protections including in the form of time limitations and information collection limitations amongst others. But we still regularly see cases in the tax tribunals where HMRC lose cases due to missing statutory deadlines or making other procedural mistakes. And whilst the taxpayer in question in the tribunal as the respondent in these cases, might be relieved that they've won the case on the basis of process, in general, this is not really a satisfactory outcome for the general UK taxpayer who wants to see their tax collection agency operating effectively and collecting tax as it's due.

Patricia:

It's fascinating, isn't it? It'll be really, really interesting to see the changes in the approach of HMRC and whether actually as you say, those glitches on missing deadlines and things like that [inaudible 00:11:17] as a result of this investment. So I suppose we will just wait and see what happens over the next few years, but fascinating.

The next topic I thought would be interesting to just discuss is carried interest. Now as we all know, Labour have announced plans to raise almost 500 million by taxing carried interest as income. Alastair, what do we really know about that at the moment? What are the details that we know at the moment?

Alastair:

So Labour has said in its manifesto that private equity is only industry where performance-related pay is treated as capital gains and that Labour will close that loophole. Now it's worth saying here that perhaps Labour's being a little bit mischievous and you can see the political need for it, but really the current rules are not a loophole because they result from extensive discussions between HMRC and the BBCA and represent the agreed settled position since 2015. But of course a new government is well entitled to change the rules and that's what they have said and that's what Labour has said that it will do. The current regime is that carry is taxed at a minimum rate of 28% and the reason that that's a minimum rate is that the overall tax rate on carry depends on how that carry is made up. So at one extreme there is a private equity fund that say only ever returns gains and in that situation, the 28% tax rate would apply because ... Or carry would be satisfied by paying gains to the executives.

In contrast, a fund might invest in debt so that a large proportion of its returns are made up of interest. And in that situation the tax rate for carry would be an overall rate of more than 28% and the extent to which it's more would depend upon how much of that carry is paid as interest. So that's the current position. What Labour have said is that they will close the loophole and they have said that the way to tax carry in the right way for them, is to tax it as income. Now what does that mean in practise? Because income could mean a bonus or income could mean income tax rates. Well, there's no suggestion that carry will be taxed as a bonus and that's good because it means that there's no expectation and no suggestion at all that carry will be subject to employers National Insurance contributions as is the case with bonus.

And that's important because those contributions are quite expensive at 13.8%. So if Labour doesn't intend to tax carry as bonus, what are the possibilities? Well, if they would like to tax carry as income, they may simply increase the 28% rate to the 45% rate, which is currently the highest tax rate for income. No doubt that will come out in the detail of the proposal and there are various ways that that could be achieved. For example, there could be a straight change to the Gains tax rate, so the 28% rate or there could be some more nuanced changes to the way that the other rules, so the [inaudible 00:16:03] rules work maybe, and that all remains to be seen, but what's at stake is tax rates going up from the 28% to 45%.

Sophie:

And Rachel Reeves made some comments to the Financial Times a few weeks ago, which suggested that it may be that private equity managers are going to be required to invest a certain amount or percentage in the funds in order to access the beneficial carried interest rate of taxation. Now maybe that's an inference that some tax professionals have made, but just to repeat exactly what Rachel Reeves said, she said, "If you are putting your own capital at risk, it is appropriate that you pay capital gains tax." Now, Labour have also said that most carried interest will be taxed as income. So it's very unclear from those statements together what that really means and whether that statement about most carried interest being taxed as income is most in terms of the amount of carried interest returns, or most in terms of the individual fund managers receiving it, i.e. most of the 3000 people who receive carried interest returns each year.

Assuming that our inference is right and that Labour are going to require a personal capital contribution to access the beneficial carried interest taxed regime, that may cause more junior members at a fund manager to struggle to make the required capital contribution personally. And so they may be the people who then have to pay income tax rates on their carried interest returns. And perhaps from a policy perspective, those are the individuals for whom carry looks most like a bonus in any event. But I'm not sure, and I don't think any of us are sure, if that's the direction this is heading in. And what do you think about that Alastair?

Alastair:

Absolutely, it's a really interesting point, and as you say, we're all speculating here, but it's possible that what Labour don't like about carry is the potential for it to be a one-way bet. Because under the current rules, carry can be acquired very cheaply based on the valuation basis that's been agreed with HMRC. And if an executive isn't required to make a co-investment alongside acquiring carry, then arguably that's a one-way bet in the sense that there's no cost really to the executive of acquiring the carry and it could be hugely valuable. In contrast, if the executive is required to make a significant co-investment, then they're putting their own money at risk. And so maybe from Labour's perspective they would see that as not closer to the circumstances where they would see carry as having to be taxed as income, but more like the sort of investment that would normally be taxed at Gains Tax rates.

And maybe here there's a really interesting point to draw out in comparisons with other European jurisdictions because in some European jurisdictions like France and Spain, their carry regimes give favourable tax rates on carry provided certain conditions are satisfied, and those conditions include executives making significant co-investment to the fund alongside their carry. So that's playing into this idea that carry may be subject to favourable tax rates, but the price of that is executives putting their own money at risk by making a co-investment.

One further point that's worth mentioning is bearing in mind all this uncertainty, what is the sensible way for funds to allocate carry now, bearing in mind that there's uncertainty in the future? And I think what we are seeing is that maximum flexibility is the best approach. So that could mean having the flexibility to take carry in any form, so that if in the future the Labour Party introduce a regime that has particular conditions, then carry can be restructured to comply with those conditions. And that could be as simple as making provision for the co-investment that we were just talking about.

So being in a position where for a fund being raised now, as things develop with the Labour proposals, it would be an easy and simple job to arrange matters so that executives could make any co-investment that was required under the new rules. Because of course it will be very unfortunate to be in a situation where perhaps that was the commercial intention of everybody, because of course co-investment is very common, yet because of some peculiarity in the new rules, it wasn't quite possible to get and satisfy all of those conditions. So flexibility for the future is really important.

Patricia:

That's really good advice Alistair, in thinking about if you're putting in place documentation now, flexibility has to be key. Because as you say, you don't want to be in the position that because you've drafted your documents in such a way, you don't have the ability to actually satisfy conditions such as co-invest etc. So I think that's a really good takeaway from this actually, just to keep flexibility in your documents.

One other thing you mentioned there was other European jurisdictions. Do you think that the combination of these non-dom changes and the potential change in the taxation of carried interest, might cause some fund managers to start to consider other jurisdictions? I mean is that something you're actually seeing in practise? And if so, what jurisdictions do you think people are looking at?

Alastair:

We are seeing fund managers look at moving to other jurisdictions and in a sense that's been an ongoing discussion since Brexit, where fund managers have been setting up additional regulated entities throughout Europe for marketing purposes. But of course Labour's changes to the non-dom regime and to carry are another reason for fund managers to think very carefully and for executives to think very carefully about whether staying in the UK is good for them. Of course there's a huge number of things to consider if an executive is thinking of moving to another country. And there are a number of tax regimes throughout Europe that have been put in place by particular countries in order to attract executives and business people including fund managers, to that country. An example of that would be Italy, which seems a popular place at the moment and that is somewhere that fund managers and executives have been considering. But I guess the point to emphasise is all of this really depends upon the specific facts of a particular executive and their family and the specific detail of the rules in the country that they're thinking of moving to.

Patricia:

It's fascinating, isn't it? Because I mean on one side we might have people thinking about leaving the UK and going to places like Italy and then on the flip side, if these changes come in for the four-year period, being able to come in and get tax-free returns and money into the UK, people thinking about moving to the UK. So maybe it's just going to be a great European switch around, everybody moving around.

Alastair:

Exactly.

Patricia:

It's all just fascinating, isn't it, to see how it's going to play out? I mean there were a few other points in the manifesto which are probably just worth touching on in connection with this. So I think it was interesting that Labour made no promises on Capital Gains Tax and I think when pushed on CGT, Keir Starmer said "All of our plans are fully funded and fully costed and none of them require tax rises over and above the ones that we've announced." So what do you think Sophie? Do you think that means people should be relaxed about CGT or do you think it means that there could be a possible hike?

Sophie:

Well, it's very difficult to say as usual, isn't it Patricia? And I think over the last few days there has been a bit more chat about possible CGT rises. And I think what's interesting about that is that a CGT rise doesn't always result in more tax payable. And that's been shown over the course of history and that's likely because CGT taxpayers are quite low in number. There's only 370,000 of them, I think, in the last official government statistics released for 2021-22. And those small number of taxpayers tend to have a bit more control over the timing of when they pay tax than other taxpayers. And because if rates rise, they can maybe, they might be able to simply choose not to make a disposal at that point. So it's difficult to predict, firstly, whether a CGT rise would be something that would help Labour in costing any of their measures or funding any of their measures I should say.

But it's also difficult to predict what's going to happen based on Keir Starmer's woolly words, which are admittedly a lot more vague compared, to say, the pledge not to raise income tax, where labour have quite explicitly said that it will keep income tax thresholds frozen until April 2028. And it could be of course that Keir Starmer had to be deliberately careful with his words on CGT because, for example, the carried interest regime will effectively require a rise in CGT rates in relation to a specific type of return. So there might be targeted measures such as that which are effectively causing a raise in CGT rates in relation to specific returns.

Patricia:

I mean, that's interesting, isn't it? As you say, the wording is quite carefully chosen and is, as you say, just not as we're pledging not to do it. So we think we have to watch that space again, don't we? I mean, do we have a sort of feel for when we think these changes are actually going to take effect? Do we have any insights in that at the moment?

Alastair:

Our best guess at the moment is that there'll be a budget in early autumn, and that's because of the constraints that the Office for Budget Responsibility has for doing the analysis that it needs to do as part of the budget process. So bearing in mind an early autumn budget, we'd expect the majority of changes to take place from the start of the 2025-26 tax year or if earlier, the date of Royal Assent for the Finance Act 2025.

Patricia:

Sounds like we may have to redo this in 10 weeks time. We might have a little bit more colour mightn't we about what's happening? But it's all just so interesting. I mean, thank you Sophie and Alastair, that's been just really, really fascinating to give a little bit more colour and what we know at the moment, and we will have to just watch these developments play out over the next few weeks, the next few months.

And thank you for listening to our second podcast in the Tax Lyrical series. We hope you enjoyed it. If you've got any questions, please just send us an email. Delighted to chat it through and we look forward to you joining our next podcast, which will be coming up in the next few weeks.