Carried Interest - the dilemma

On the 23rd of February in Leeds the Shadow Chancellor, Rachel Reeves?spoke with buyout bosses and venture capitalists. It was reported that the discussions were rich and revolved around her perspectives on the economy, business initiatives, and the pivotal role that private equity and venture capital play in driving growth and innovation across the UK.

Investors around the table laid out their pitch for private capital and its role in the economy and the Rachel Reeves responded that, “The private equity and venture capital sector is incredibly important for fulfilling our mission to grow the economy.”

However, top private equity bosses around the country are concerned about a potentially punitive tax measure from Labour that threatens to eat into their earnings and jeopardise?Labour’s pitch to the City. The policy established in 2021 is a commitment to increase the tax rate on carried interest ?to as high as 45%, in line with the additional rate of income tax.

Carried interest or ‘carry,’ is one of the primary ways that private equity bosses make money. It allows private capital managers to benefit from a share of the profits of asset sales while currently paying a capital gains tax(CGT) rate of 28%.

A top London private equity lawyer has warned that Labour’s plan to raise the tax rate on buyout executives could be more damaging for the UK capital’s status as a deal making centre than Brexit. It is alleged that the ramifications from possible departures of fund managers would have a ripple effect on the banks, law firms and consultants advising and working for them. One commentator mentioned that,?“It could be worse than Brexit for financial and advisory services in London.”

Private equity is a significant business generator for London and any move by private equity firms to relocate out of the UK will have a damaging effect on the UK economy including for law firms in London. Some firms are making contingency plans to shift staff out of London if the tax changes come into play, according to industry insiders. However, advisers and private equity executives are hopeful that Labour will compromise and only increase the tax on carry by a few points, ensuring the UK remains in line with other European countries.

France, Italy and Germany tax carried interest at between 26% and 34 %. It is reported that Reeves has come under pressure from colleagues to scale down the planned tax increase over concerns that it would make the UK less attractive to international investors and prompt an exodus that could outweigh the ￡400mn Labour estimates could be raised by ending the tax break. Labour MPs have warned that the party, needs to find new ways to fund its spending plans after the? government? copied its policy to end the current resident non domiciled ?“non-dom” regime. The current non domiciled remittance regime allows wealthy foreigners to avoid paying tax on offshore income and gains provided that they pay a remittance base charge. The government also extended a windfall levy on oil and gas companies, a move that had been part of Labour’s revenue-raising plans.

A public affairs adviser to global private equity firms said the Government’s announcements in the Spring Budget would make it more difficult for buyout fund managers to negotiate a compromise on carried interest with Labour because the opposition party now had less headroom to fund its public spending pledges. Labour has said previously that, if elected, it would “make the tax system fairer” by “closing unfair and inefficient tax loopholes” including those enjoyed by private equity fund managers. One adviser said some professionals were relocating in anticipation of the tax increase. “

While the private equity industry is small in terms of the number of people it employs — the carried interest regime is? a valuable source of fees for law firms, banks and consulting firms.

The concern is that if the higher tax rate is imposed the industry will relocate and jobs in support industries such as banks and professional services would follow. Previous tax rises have not dulled London’s attraction, such as when former Conservative chancellor George Osborne raised tax on CGT from 18% to 28 % in 2010.

Brexit has since changed the calculus for the capital, though, prompting some investors to relocate to places including Paris and Milan. It is reported that there has been a Brexit toll on London as a financial centre, and the concern is ?same could happen with carried interest. Central to the warning from dealmakers and advisers is that increasing the tax rate dramatically ?would put the UK out of sync with international peers and encourage ?dealmakers overseas. France, Italy and Germany for instance tax carry between 26% and 34% ?and in the US, the rate is currently 20%.

However, debates over the appropriate rate of tax have occurred in those countries too. As part of his re-election platform, President Biden has pledged to scrap the 20% lower CGT rate on carry and increase it to 37% in line with the upper band of income tax. In 2012 in France, Francois Hollande also proposed imposing ?a 75% tax rate on carry, prompting warnings of an exodus of dealmakers.

However, none have so far acted.

The prospect of a substantial increase in the rate is already prompting action in some quarters. The BVCA, which convened the meeting in Leeds earlier this month, has been discussing the plans with Rachel Reeves.

?Michael Moore, the chief of the BVCA and former Lib Dem MP, said the group “will work to maintain the internationally competitive arrangements which attract capital and investment professionals to the UK”. Labour have set out their taxation position. And we have shown the party how much the industry contributes to the UK,” Moore added.

For Labour, the debate is proving difficult as it mounts an effort to win round the financial services sector. As one industry source describes it, back in 2021 the party may have been framing it as the “asset strippers and their Mayfair tax loophole” but that “rhetoric just isn’t there anymore.”

“There has definitely been a shift in the perspective of the industry in that respect,” the person added.

However, the political situation is also stacked against Reeves and Starmer. Labour has just had one of its key revenue raisers copied by the Conservatives in the scrapping of non-dom tax status in the budget and it is now looking for tax measures to fund its manifesto plans.

Suggestions Labour might consider watering down its proposals did emerge in recent months – but it seems a broadly fair assumption they might be less likely to do so now.

The dilemma for Labour is that it is also juggling “wider economic fairness issues” and many would view increasing the tax rate on carried interest as addressing unfairness. A Labour spokesperson said: “Labour has worked hand-in-glove with the financial services sector and is proud to have recently published our Financial Services Review this year after consulting extensively with the sector. The financial services industry is one of Britain’s greatest assets and Labour’s plan promises to build on this success, unlock investment and drive growth.

Summary

The carried interest deduction is primarily available to investment managers of investment partnerships, such as private equity or hedge funds. To qualify for this deduction, one must earn a share of the profits generated by these partnerships, known as “carried interest,” as a result of their management activities.

Individuals and small businesses may not directly claim this deduction, but they may be able to benefit from it indirectly if they have an ownership interest in a qualifying investment partnership. To take advantage of this deduction, one must make significant investments in certain types of partnerships, which may not be practical for the average person.

A hurdle rate exists ?to align the interests of the investment manager with those of the investors and ensure that profits are generated before the manager receives a carried interest payment.

The current UK tax treatment of carried interest relies on a 1987 agreement with the BVCA. HMRC ?agreed a statement with the BVCA stating that typical private equity funds were not “trading” for tax purposes, with the consequence being that carried interest was taxed as capital. Since then HMRC has? followed the BVCA statement, and private equity funds rely on it as a matter of course.

However, some distinguished tax critics maintain that ?on a proper analysis, the way most private equity funds work means that they are probably “trading” for tax purposes, and so carried interest cannot be “capital.”

It is interesting that the current discussion does not appear to challenge the trading: investment distinction but instead focuses on the rate of tax applied irrespective. It is possible that if Labour are elected? their need for tax revenue on the one hand but their desire to not upset the venture capital industry on the other will result in a compromised tax rate somewhat in excess of 28% but below the 45% mentioned in 2021.

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