Getting friendly with the system

Loopholes in the tax system are giving many financial services professionals preferential tax treament

WHO PAYS A higher rate of tax – a UK-based private equity manager or an office cleaner? How about a US commodities broker or a mechanic? Or an Irish-based venture capital fund manager and a plumber? While the financial services professionals may undoubtedly be contributing more in tax to their respective exchequers each year, they nonetheless pay tax at a lower rate than their blue collar counterparts, thanks to the existence of loopholes which offer them preferential tax treatment.

With income tax rates on the rise all over – in Ireland it has already passed 50 per cent with the levies; in the UK the top rate of tax is set to rise to 50 per cent; while in the US there are plans to increase the top tax rate to 39.6 per cent – it may be galling to discover that certain professionals working in the embattled financial services industry are being exempted from such hikes.

One of the biggest beneficiaries of such preferential treatment are US-based hedge fund and private equity managers, as a loophole in tax law means that they are entitled to pay income tax at lower rates than their fellow workers.

This is because money managers at privately held partnerships, such as hedge and private-equity funds, can pay capital gains tax (15 per cent) on a large part of their income, rather than the more prohibitive income tax rate.

The loophole arises in part because of the way hedge funds are structured on the “2 and 20” model. According to this, managers are paid 2 per cent of assets as an annual management fee, and income tax must be paid on this. For the “20” portion however, which is the percentage of gains that the manager collects from his clients, the manager only has to pay capital gains tax, as this profit is known as “carried interest”.

It has been estimated that hedge fund and private equity managers would save $30 billion in taxes over the next 10 years if the rules were left standing, but given increased desire from US authorities to crack down on tax avoidance, this may not be the case.

US president Barack Obama has already proposed the abolition of the loophole, and last December the House of Representatives passed a bill closing it. However, whether anything comes of this remains to be seen as it is the third time in three years that the House of Representatives has passed this bill, but the Senate has not yet taken it up.

And it’s not just US-based hedge fund managers who are benefiting from preferential tax treatment. Their options and commodities broker counterparts are also availing of a 28-year old tax benefit to reduce their tax burden. At present, brokers can pay a blend of capital gains and ordinary tax rates on their income, rather than paying the full 35 per cent income tax rate.

This means that for every dollar earned by a dealer, 60 cents is taxed at the lower capital gains rate, while the remaining 40 cents is taxed as income on a rate of up to 35 per cent. Overall, this gives an effective tax rate of just 23 per cent.

Less attractive perhaps than a straight 15 per cent rate, but much better than what the average US citizen must pay. However, Obama has also pin-pointed his desire to abolish this loophole.

Many consider the existence of such schemes as being distinctly unfair. Investment guru Warren Buffet has opposed such preferential treatment on the grounds that why should he pay a lower rate of tax than his secretary, who earns $60,000 a year. After all, it means that for professionals working in specific sectors such as hedge funds and commodities, the US government is effectively subsiding their jobs, because they pay a lower rate of tax on a large part of their income.

Moreover, the practice is not just confined to the US, as private equity managers on this side of the Atlantic also enjoy preferential tax treatment.

In the UK, buy-out chiefs are entitled to pay capital gains tax (CGT) at 18 per cent on profits from the sale of companies in which they have invested. Although the rate is not as attractive as it once was, it is nonetheless considerably better than income tax rates.

From 2003 until 2007, executives only had to pay CGT at a rate of 10 per cent, following the introduction of a lower CGT rate aimed at encouraging entrepreneurship. Under the rules, those starting their own business or investing in start-ups in the UK were only charged CGT at a rate of 10 per cent, rather than 40 per cent, when they sold on their stakes, provided that they had held it for two years. In 2007, however, a flat rate of 18 per cent was introduced.

Now, like many of the other incentives, it appears that this may also be shortly on the way out. Although it was feared that the British Government would raise the CGT rate to 25 per cent in last month's budget, heavy lobbying from associations such as the British Private Equity and Venture Capital Association, combined with an apparent reluctance from the Government to antagonise the business community ahead of the forthcoming general election, meant that the rate was left unchanged. However, given the gulf between CGT and the top rate of tax in the UK, it is expected that this gap will be closed at some stage. If it does, it may mean that private equity chiefs will re-locate to countries like Switzerland.

Although Switzerland does not formally offer tax benefits for financial services professionals, it has been pressing hard to attract firms who are thinking of re-locating out of London, and in effect is agreeing individual tax rulings, which appear to be capping the amount of tax individuals pay there. Moreover, the CGT rate in Switzerland is 0 per cent.

Here in Ireland, such preferential schemes also exist. In 1995, as part of the promotion of the IFSC, the Seed Capital Scheme, which enabled qualifying individuals to claim back their individual income tax for the previous five years on the amount invested in the company, was extended to traders on Finex, the futures and options division of the New York Board of Trade (Nybot).

The scheme attracted numerous investors who were looking to avail of the tax breaks on offer, such as Conor Foley, who would later establish spread betting firm WorldSpreads. The trading floor was closed in 2008, following a merger between NYBOT and Intercontinental Exchange (ICE).

More recently, an incentive for venture capital fund managers was introduced in Ireland which enables fund managers investing in carrying on research, development or innovation activities, to pay reduced rates of tax on profits arising on certain investments at a 15 per cent rate for partnerships.

To qualify for the reduced rate, the investment must be in a private trading company whose business is set up and commenced on or after January 1st 2009, and the investment must remain in place for at least six years. Elsewhere, financial services professionals from a wider skills base have long flocked to tax havens such as the Cayman Islands, where they pay no tax.

However, where once opportunities abounded in these sun-drenched islands, now finding a job is a much more difficult prospect given efforts from the US authorities to stop US companies operating in such havens. And, while Dubai remains a tax-free alternative, its future as a financial centre also looks a little shaky given its recent debt problems.

But there are still incentives for those looking to relocate. In Gibraltar, for example, financial services professionals who "possess skills not available locally and which are of particular economic value to Gibraltar", can become a High Executive Possessing Specialist Skills (Hepps), which means that they will only pay tax on the first £100,000 of annual income. So, for a trader earning £500,000, their total income tax bill will come to just £26,750.

So if you're looking to reduce how much you lose in tax in your pay-check every month, it may be time to consider changing careers.