Critics argue that treating carried interest as a return on an investment made by these individuals does not reflect the economic reality. Indeed, Reeves has described this tax break as “absurd”.
The view seems to be that carried interest should be seen simply as a performance-related bonus that should be taxed as employment income. Were this to happen, it would result in effective tax rates as high as 53 per cent (including the cost of national insurance).
It is of course the prerogative of an incoming government to introduce changes to the tax regime, especially if the proposals constitute a manifesto commitment. However, treating any such changes as 'closing a loophole' does seem to mischaracterise the position.
After all, the current arrangements are a product of basic and long-standing tax principles that distinguish between income and capital gains. They are certainly not any kind of tax avoidance scheme.
Because, after all, there are already extensive anti-tax avoidance rules that apply in the investment management sector. Carried interest typically only comes under the beneficial capital gains tax treatment if it matches at least the spirit, even if not the exact letter, of a typical arrangement mapped out in a 2003 memorandum of understanding between HMRC and the BVCA, the private equity trade body.
Such arrangements will involve the executives receiving an entitlement to carry at the beginning of the life of the fund, often at only a nominal cost. The payment of the carry will not be linked to the performance of the individual manager themselves, although any entitlement would typically be forfeited if the individual left the firm.
The managers must also be paid a full market salary for their work on the fund, which will be fully taxable as employment income.
The carry will only pay out once the investors in the fund have had their invested capital returned in full, together with an agreed rate of return up to a hurdle threshold, which is commonly around 8 per cent (usually calculated using an annualised returns metric known as IRR).
Returns above the hurdle will be shared between investors and holders of carried interest, typically on an 80:20 basis, with some of the carried interest going to the fund manager and the other amounts going to individuals directly.
The way that carried interest is calculated means that it will often only pay out after most of the fund’s investments have been sold, as that will be the point at which the hurdle is exceeded.
As such it can be towards the very end of the life of a fund, perhaps after seven years on a typical arrangement, before any payment.
