A legal challenge has been launched to the way HM Revenue and Customs supposedly approaches how carried interest is taxed in the UK. A pre-action letter has been sent to HMRC, but full details of the challenge are not yet public. The claim appears to be that the 1987 memorandum of understanding between the private equity industry and HMRC (the “1987 MOU”) is unlawful insofar as it provides for HMRC not to investigate whether funds are trading rather than investing. The argument is that may improperly allow carried interest holders to be taxed at the lower rate of capital gains tax (28%), rather than paying income tax on their returns (at rates up to 45%).

The challenge is still at a very early stage and, based on the information available, the standing and legal basis for it is unclear and the arguments are questionable. It also is not challenging what we see as the key point of the 1987 MOU: that HMRC accept that the value of carried interest can be taken to be its acquisition cost for employment income tax purposes if certain conditions are met. But even if the challenge does not ultimately succeed in court, this has resulted in renewed media focus on carried interest taxation. It may also make it more likely that a change in government next year would lead to a change in the law to treat some or all of the carried interest as income.

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