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It is a politically smart bit of heartstring-tugging. Labour’s manifesto pledged that it would pay for 8,500 new mental health workers and other good causes by tightening the tax rules for wealthy private equity executives.
Uncontroversial for most voters. But within this vast industry, huge efforts are being made to persuade the UK’s new chancellor Rachel Reeves to water down her plans to generate an extra £565mn from closing the “carried interest tax loophole”.
Reeves has two arguments in favour of her plan: first, that she needs to raise the revenue to pay for worthier causes; second, that the status quo is demonstrably unfair, because it essentially allows a privileged minority of professional investors to pay tax on a key element of their earnings at the carried interest rate of 28 per cent instead of 45 per cent like other highly paid executives.
The private equity groups, equally, have two arguments against Reeves’s policy.
First, they make a principled point — that carried interest is not really income as reformers argue, but a genuine reward for executives, dubbed general partners in the industry, taking investment risk. If GPs invest alongside third-party investors — so-called limited partners (or LPs) — in a deal, any gain (or “carried interest”) they make should be treated as a capital gain because that is what it is.
Second, the sector insists that implementing the policy as outlined would drive wealth creators and growth generators — key to Labour’s agenda of economic revival — out of the country.
Unpublished research from one private equity firm suggests that more than 60 per cent of those who work in the sector in the UK are foreign nationals, with the implication that many of them could leave the country if they felt overtaxed. Labour’s plan to abolish non-domiciled tax status for wealthy foreigners would compound the incentive to leave. Milan and Paris have both made big plays for financiers, with generous tax breaks.
And so a protracted game of chicken is under way. Who will win?
There are clear flaws in the industry’s arguments. Tax changes and differentials in this sector have not led to an exodus in the past. In 2017, Italy introduced a new regime, taxing carried interest at 26 per cent, instead of the 43 per cent of higher-rate income tax. Ireland taxes carried interest at barely half the UK rate. So far neither country has made huge inroads in attracting private equity executives. London remains the unrivalled European base for the sector.
The more substantive point of principle is also moot. In many cases a private equity manager is not actually investing any of their own money, but is being gifted the “right to carry” by their employer, in much the same way as a banker might be gifted shares as part of a bonus (which is liable to income tax). There is no requirement to actually invest your own money in order to benefit from the carried interest tax break.
Reform is clearly needed, but with a spirit of pragmatic compromise. First, Reeves should follow through on her instinct that individuals must actually invest, say at a level equivalent to 1 per cent of the fund, as similar regimes in France and Italy already dictate. This would tighten the alignment between GPs and LPs, which is in everyone’s interest.
Second, in order to qualify for carried interest taxation, the investment should genuinely be putting capital at risk. At present, CVC is one of very few firms where executives on a bad deal can actually forfeit money, even if the fund overall succeeds.
Third, tax rates should be calibrated smartly. For cases where the threshold for real investment is met, a rate of, say, 33 per cent could be levied; if the threshold is not met, the rate would be 45 per cent. This would still be within the range of competitor jurisdictions, albeit towards the upper end. (France charges up to 34 per cent.)
The snag is that these measures may not raise the £565mn Reeves is counting on. That, though, was always a spurious number, calculated on the basis of an outdated Resolution Foundation report. More recent data suggests raising the 28 per cent rate to 45 per cent could actually raise close to £1bn on a “static” basis that assumes no one would seek to dodge the higher taxes. If Reeves plumped for a 33 per cent rate instead — and factoring in arbitrage on one side, but tighter parameters on the other — that might just get her close to the original target. If private equity can pay a fairer share of tax, while also helping to drive Reeves’s economic growth agenda, the country will be a net winner.