What should be done about carried interest?

Carried interest is the reward that executives of a private equity (PE) firm earn when the underlying PE fund successfully sells one of its investments. That reward is currently usually taxed as a capital gain, at a rate of 28%, rather than as income at up to 45%.

The recent debate almost two years ago, the Labour Party announced that it would close the ‘carried interest loophole’ if it is elected (‘Labour plans to raise £500m by closing fund managers’ tax loophole’, The Guardian, 19 September 2021). At the time, Labour calculated that this would raise about £440m, which is a relatively small amount in the overall Budget arithmetic (total UK tax receipts were £786bn in 2022/23), but the measure would, it said, reduce unfairness. As the Shadow Chancellor Rachel Reeves put it:

‘Instead of hitting working people and businesses with tax rises, we should be spreading the burden and creating a fairer system. It’s absurd that the current regime around carried interest means tax breaks for fund managers averaging £170,000 per person.’

Dan Neidle of Tax Policy Associates argues that the treatment of carried interest as a capital gains item is wrong on first principles for a large number of existing funds (‘Carried interest: the £600m loophole that doesn’t actually exist’, (as reported in Tax Journal, 14 March); see also ‘Carried too far?’ (2023) British Tax Review, No. 1). This treatment is now being challenged by judicial review proceedings being brought by the Good Law Project (as reported in Tax Journal on 17 June). The JR proceedings will certainly highlight the issue but given that the question of whether a particular fund is trading or not is a purely factual question, I am unconvinced that the proceedings will succeed. And I note that Judith Freedman, Oxford Emeritus Professor of Tax Law, commented on Twitter that, while she strongly believes we need to look at the way we tax profits from private equity, ‘I do not think litigation (almost certainly doomed to fail) is the way to have a serious discussion about tax policy issues.’

A separate question is whether the high gearing, which is a common feature of private equity structures, leads to excessive risk of failure. The current furore around Thames Water (bought out by a private equity consortium led by Macquarie in 2007, and subsequently sold to a group of institutional investors) has highlighted the dangers of high debt levels, particularly at a time of rising interest rates. Whilst this is not itself a tax question (although there is a separate debate to be had about the tax treatment of debt and equity), it adds pressure to the policy debate. Indeed, The Guardian article about Labour Party policy noted that:

‘The party also believes that closing this tax loophole will also reduce the incentive for private equity to engage in asset stripping. It says nearly 60% of big retailers that went into administration between 2010 and 2019 were linked to a private equity takeover.’

Where are we heading?

It seems likely that, one way or another, carried interest rewards will become taxable as income. Indeed, an article in last week’s Tax Journal (‘Incentivising fund managers: carried interest v growth shares’ (Kitty Swanson and Kirsten Hunt), 7 July 2023) shows that advisers are already thinking about how the capital nature of rewards could be maintained, by switching to a new mechanism such as growth shares – although there will be a risk that any change to the taxation of carried interest could also affect other planning ideas.

So, what is the likely law change? There are, in my view, three basic options:

• bring in legislation which specifically targets carried interest, and deems it to be taxable as income;
• expand the definition of employment-related securities (ERS) to include carried interest; or
• align the tax treatment of income and capital gains more generally.

All of these options have potential attractions and drawbacks.

It is superficially attractive to bring in specific legislation to target carried interest. In theory, this could be carefully targeted and focus on the issue which has been identified, without having wider implications for other structures. However, this involves drawing a new boundary, and that will bring risks that tax planning will evolve to get round the boundary – which in turn will lead to more legislation, and so on. The example of growth share planning shows just how quickly new techniques will be devised.

Expanding ERS would probably be a solution which most closely targets the nature of carried interest. Intuitively, the PE executives earn these rewards through their work, and so categorising the equity share as an employment-related security appears apt. However, PE executives are typically members of an LLP rather than employees (for historical reasons, but not least because there is a lower NIC cost) and so this would require either an expansion of the definition of ‘salaried members’ of an LLP, or widening ERS significantly to apply to all LLP members.

The broadest, and most radical solution, would be to tax capital gains at the same rate as income. This has been done before, by Nigel Lawson in 1988 (and was reversed by Gordon Brown in 2008). However, almost as soon as it was introduced, reliefs and exemptions were created so that ‘genuine’ long term gains benefited from a lower rate – retirement relief, taper relief, indexation, entrepreneur’s relief (now business asset disposal relief) and so on. It is unlikely that aligning the rates of tax for income and capital would be as simple as some lobbyists seem to think.

Whatever solution is adopted, there will be a balance to be struck between complexity and ‘fairness’. But most would probably agree that the current rate of tax on carried interest is too low, and so some change is likely in the near future. Watch this space.

Would you like to know more?

If you have any questions or would like to discuss your specific circumstances, please get in touch with your usual Blick Rothenberg contact or Heather Self using the form below.

This article was originally published in the Tax Journal and is reproduced with kind permission.