Why UK private equity firms are ‘encouraged by Labour’s signal on tax crackdown

The UK private equity industry hailed Rachel Reeves, shadow chancellor’s suggestion to continue to offer favourable tax treatment for buyout executives investing in their funds as “encouraging”.

Labour has promised to raise £565mn per year by closing the “loophole”, known as carried interests, in taxing private equity manager’s profits on successful deals.

Reeves said this week that carried interests should be taxed at a rate lower than income if the fund managers put their capital at risk along with their investors.

Michael Moore, Chief Executive of the British Private Equity & Venture Capital Association said: “The shadow chancellor’s clarifications are encouraging signals that Labour is willing and able to support its pro-business sentiment music by engaging on the substance.”

Sandy Bhogal is a tax associate at Gibson Dunn. She said Reeves’s comments show that “Labour understands the issue as nuanced and are willing to listen before making a decision on how to amend law”.

If they are able to achieve returns that exceed a certain threshold, private equity managers receive a part of the profits generated by their funds.

The carried interest is taxed at 28 percent as a capital gain, rather than income which attracts the top rate of 45 percent plus national insurance.

Labour’s manifesto stated that private equity is “the only industry in which performance-related compensation is treated as capital gain” and pledged to “close the loophole”. The Labour manifesto didn’t specify how they would achieve this.

Reeves said this week that was incorrect and “what is basically a bonus” is taxed lower than employment income when one is not risking their own capital.

She said that if Labour wins the UK general elections on 4 July, she expects most carried interest to be taxed under the plans of the party.

Reeves said: “If your capital is at risk, it’s appropriate to pay capital gains tax.”

Casey Dalton of Herbert Smith Freehills said that Reeves’ statement that carried interest will be taxed at the same rate as other income may disappoint private equity professionals.

Reeves’s comments have been well received by other industry professionals who feel that she has opened up the possibility of less harsh options, such as “co-investment”, where carried interest would be taxed in capital gains when executives invest with clients.

People familiar with the issue say that some in the industry advocated for a similar regime in the UK to avoid a more severe crackdown.

Fund managers in Italy and France can lower their tax rate on carried interest by meeting certain conditions. These include investing 1 percent of the fund’s value.

There is no data available on the amount invested in private equity funds and firms by UK managers. Some managers invest around 1 per cent.

Reeves stated that the current co-investment amounts are “tiny”. Labour refused to provide any figures in support of this claim when asked.

One lawyer who advises funds of private equity said that the idea is good and would align Britain with other European regimes.

Labour would have to make several decisions regarding the operation of its regime if it chose a coinvestment strategy.

This includes the amount of investment that executives must make to qualify for lower tax rates and whether or not they can count contributions made by their employers or colleagues.

Labour would have to decide if investments funded with “nonrecourse loans” qualify for a reduced tax rate. The risk is lower for the borrower because their wealth is protected from lenders.

It is likely that the industry will push for lower thresholds on investment for large international funds. These can be worth tens or even hundreds of billions and make co-investments of just 1 percent prohibitive to many fund managers.

Reeves stated that Labour’s projection of raising £565mn per year by 2028/29 was based upon a Resolution Foundation paper in 2020.

According to the think-tank, closing this loophole could raise £420mn. The average annual carried interest for 2016-2018 was £2.2bn. The risk that private equity executives would leave the UK was not taken into account.

According to a source familiar with Labour’s costing, the £565mn figure for Labour was calculated by adjusting £420mn estimates for inflation since 2018.

In 2021-22, data shows that 3,000 dealmakers have shared £5bn of carried interest.

A crackdown on carried interest could generate almost £1bn of tax revenue using the Resolution Foundation’s methodology.

The large gap between this number and Labour’s costs gives the party the fiscal room it needs to take into account fund managers who leave the UK, or carried interest that continues to be taxed lower.