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The UK private equity sector has welcomed as “encouraging” shadow chancellor Rachel Reeves’ suggestion that buyout managers investing in their funds would continue to enjoy favorable tax treatment.
The Labor Party has promised to raise £565m a year by closing a ‘loophole’ in the taxation of private equity managers’ profits from successful deals, known as carried interest.
But Reeves indicated this week that carried interest should continue to be taxed as capital gains, at a lower rate than income, if fund managers have put their own capital at risk in addition to their investors.
“The shadow chancellor’s clarifications are an encouraging signal that Labor is willing to back its pro-business music with a commitment to substance,” said Michael Moore, chief executive of the British Private Equity & Venture Capital Association.
Sandy Bhogal, tax partner at Gibson Dunn, said Reeves’ comments show that “Labour recognizes the issue is nuanced and is willing to listen before deciding how to change the law.”
What has Labor promised?
Private equity managers are paid in part by receiving a share of their funds’ investment profits if they achieve returns above a certain level.
This carried interest is taxed as capital gains at 28 percent rather than as income, which has a top rate of 45 percent plus national insurance.
Labour’s manifesto states that private equity is “the only sector where performance-related pay is treated as capital gains” and has pledged to “close this loophole”. The manifesto did not detail how it 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 labor income if you don’t put your own capital at risk”.
She also said that if Labor won the UK general election on July 4, she expected most accrued interest would 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 has the sector responded?
Casey Dalton, partner at Herbert Smith Freehills, said Reeves’ statement that most carried interest would be taxed because 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 a “co-investment” regime, where carried interest is taxed as capital gains when executives invest alongside clients.
According to people familiar with the matter, some in the industry in the United Kingdom have privately advocated such a regime as a way to avoid a crackdown.
What is a co-investment regime?
In Italy and France, fund managers can pay a lower tax rate on carried interest if they meet a number of conditions, including investing typically 1 percent of a fund’s value.
The amount invested by UK private equity managers varies by company and fund type, but no public sector-wide data is available. Some invest about 1 percent.
Reeves said the amounts currently co-invested were “small”. When asked, Labor provided no figures to support this claim.
“The idea of a co-investment condition is sound and would bring Britain in line with other European regimes,” says a lawyer who advises private equity funds.
How would a co-investment regime work?
If Labor were to adopt a co-investment approach, it would have to make several decisions about how the regime would operate.
These include the level of investment managers need to qualify for a lower tax rate and whether they should fund this out of their own pocket or count contributions from their employer or colleagues.
Labor would also have to decide whether investments financed by ‘non-recourse loans’ qualify for a lower tax rate. These loans pose lower risk to borrowers because their personal wealth is shielded from the lender.
The industry would likely push for lower investment thresholds for large international funds, which could amount to tens of billions of pounds and make co-investment of even 1 percent unaffordable for many fund managers.
Are Labour’s figures correct?
Reeves said Labour’s forecast that it could raise £565 million annually between 2028 and 2029 was based on a 2020 Resolution Foundation document.
The think tank concluded that closing the loophole would save £420 million. This was based on the average annual interest of £2.2 billion earned in 2016-2018. The risk that private equity executives would respond by leaving the UK was not taken into account.
Labour’s £565m figure was calculated by adjusting the £420m estimate for inflation since 2018, according to a person familiar with the costs.
More recently, data showed that 3,000 dealmakers shared £5 billion in carried interest in the 2021-2022 period.
Using the Resolution Foundation’s methodology, this could lead to almost £1 billion in tax revenue from a crackdown on carried interest.
The large gap between that number and Labour’s cost calculation gives the party fiscal space to take into account fund managers leaving the UK, or the fact that some carried interest remains taxed at a lower rate.