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Britain’s private equity sector has welcomed as “encouraging” a proposal by shadow chancellor Rachel Reeves that managers who invest in their funds will continue to enjoy favorable tax treatment.
Labor has pledged to raise £565m a year by closing a “loophole” in the taxing of private equity managers’ profits from successful deals, known as carried interest.
But Reeves signaled this week that carried interest should continue to be taxed as capital gains, levied at a lower rate than income, if fund managers put their own capital at risk alongside that of their investors.
“The shadow chancellor’s explanation is an encouraging sign that Labor is willing to support its pro-business sentiment by engaging with this substance,” said Michael Moore, chief executive of the British Private Equity & Venture Capital Association.
Sandy Bhogal, a tax partner at Gibson Dunn, said Reeves’ comments showed “Labour recognizes the issue is nuanced and is prepared to listen before deciding how to amend the law”.
What did Labor promise?
Private equity managers are paid in part by receiving a portion of the investment profits generated by their funds if they achieve returns above a certain level.
This carried interest is taxed as a capital gain at 28 per cent rather than income, which attracts the top rate of 45 per cent plus National Insurance.
Labour’s manifesto said private equity “is the only sector where performance-related pay is treated as capital gains” and pledged to “close this loophole”. Her manifesto did not detail how she would do this.
Reeves told the Financial Times this week that it was wrong that “what is essentially a bonus is taxed at a lower rate than employment income unless you are putting your own capital at risk”.
She also said that if Labor wins the UK general election on July 4, she expects most of the carried interest to be taxed as income under the party’s plans.
But Reeves added: “If you are putting your own capital at risk, it is appropriate that you pay capital gains tax.”
How did the industry respond?
Casey Dalton, a partner at Herbert Smith Freehills, said Reeves’ announcement that most carried interest would be taxed as income would disappoint some private equity professionals.
But Reeves’ comments were well received by others in the industry who believe she has opened the door to less harsh options, such as the “co-investment” regime, where carried interest is taxed as capital gains if executives invest alongside clients.
Some in the industry have privately advocated just such a regime in the UK as a way to avoid a tougher crackdown, according to people familiar with the matter.
What is the co-investment regime?
In Italy and France, fund managers can pay a lower rate of tax on carried interest if they meet a number of conditions, including typically investing 1 percent of the fund’s value.
The amount invested by private equity managers in the UK varies across firms and fund types, but public industry-wide data is not available. Some invest about 1 percent.
Reeves said the amounts currently being co-invested are “small”. When asked, Labor did not provide figures to support this claim.
“The idea of ​​a co-investment clause is a good one and would bring the UK into line with other European regimes,” said one lawyer who advises private equity funds.
How would the co-investment regime work?
If Labor opted for a co-investment approach, it would face several decisions about how the scheme would work.
These include the level of investment required for executives to qualify for the lower tax rate, and whether they have to fund it out of pocket or be able to count contributions from their employer or colleagues.
Workers would also have to decide whether investments financed by “gratuitous loans” would qualify for a lower tax rate. These loans pose a lower risk to borrowers because their personal assets are protected from the lender.
The industry would likely push for lower investment thresholds for large international funds, which can be worth tens of billions of pounds, and co-investments of even 1 per cent would be out of reach for many fund managers.
Do Labour’s numbers add up?
Reeves said Labour’s projection that it could raise £565m a year by 2028-29 was based on a Resolution Foundation paper in 2020.
The think-tank found that closing the carried interest gap would raise £420m. This was based on an average annual interest of £2.2 billion earned in 2016-2018. It did not consider the risk that private equity executives would respond by leaving the UK.
The £565m value of the work was calculated by adjusting the £420m estimate for inflation from 2018, according to a person familiar with the calculation.
Figures recently showed that 3,000 dealers shared £5bn in carried interest in 2021-22.
Using the Resolution Foundation’s methodology, this could lead to almost £1 billion in tax revenue from the interest crackdown.
The large gap between this figure and labor costs gives the party fiscal room to account for fund managers leaving the UK or for some carried interest to continue to be taxed at a lower rate.