It is one of the Labour party’s signature tax policies if they win the coming election; Rachel Reeves is risking the ire of the private equity industry, worth around £5.1bn in 2023, by changing the way in which individual investment fund managers are taxed.
The issue has polarised debate, so it is helpful to understand the background on the way so-called carried interest is taxed and some of the implications of the proposals, which are projected to raise £400mn to £500mn for the exchequer.
Carried interest is a share of the overall profits of a private equity fund paid out to the fund’s investment managers.
Typically, individuals working for the fund manager receive these profits directly from the fund in a personal capacity. Profits realised this way have been subjected to a lower rate of taxation than income tax paid on a salary. And changing that really is the nub of what is being proposed by Labour.
So, let’s take this back a step. Carried interest payments are triggered when a fund hits a particular level of profitability and once an agreed amount of the profits has been paid to the investors.
Enabling the managers to share in the overall profits of a fund in this way helps to align the objectives of the key executives with the investors in the funds; in other words, both investors and fund managers are focused on long-term growth.
These tax arrangements can be traced back to the origins of the private equity industry in this country in the 1980s.
The UK is not alone in offering beneficial tax treatment for carried interest. Such treatment has long been available in the US and there are also carried interest regimes in France, Germany, Italy and Spain – typically providing for individuals to be taxed at rates at a similar or lower level than the current UK regime.
So, what tax do fund managers pay on profits reached in this way?
For now at least, it is possible for individual fund managers to treat their carried interest returns as capital gains arising from a long-term investment in the businesses owned by the fund. This means profits are taxed at 28 per cent – provided, of course, the carried interest is properly structured and satisfies a number of conditions.
Above all, the carried interest must reflect a return on long-term holdings of shares: the 28 per cent tax rate is only available to managers of funds to the extent that the underlying returns have been generated through capital gains rather than income.
That generally means private equity, real estate and infrastructure funds that typically acquire and hold stakes in relevant businesses for periods of around five years or more.
It is not available to managers of hedge funds or other vehicles that pursue dealing or trading strategies involving more frequent buying and selling of shares and securities.
