Why UK private equity is ‘encouraged’ by Labour’s signals on promised tax crackdown

The UK’s private equity industry has welcomed as “encouraging” shadow chancellor Rachel Reeves’s suggestion that buyout executives who invest in their funds would continue to enjoy favourable tax treatment.

The Labour party has pledged to raise £565mn a year by closing a “loophole” on the taxation of private equity managers’ profits on successful deals, known as carried interest.

But Reeves signalled this week that carried interest should continue to be taxed as capital gains, levied at a lower rate than income, if fund managers have put their own capital at risk alongside their investors’.

“The shadow chancellor’s clarifications are an encouraging signal that Labour is willing to back up its pro-business mood music with engagement on the substance,” said Michael Moore, chief executive of the British Private Equity & Venture Capital Association.

Sandy Bhogal, tax partner at Gibson Dunn, said Reeves’s comments showed that “Labour recognise the issue is nuanced, and are prepared to listen before deciding on how to amend the law”.

What has Labour promised?

Private equity managers are paid partly by receiving a portion of the investment profits made by their funds if they achieve returns above a certain level.

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

Labour’s manifesto said private equity “is the only industry where performance-related pay is treated as capital gains” and has pledged to “close this loophole”. Its manifesto did not detail how it would do this.

Reeves told the Financial Times this week it was wrong that “what is essentially a bonus is taxed at a lower rate than employment income, when you’re not putting your own capital at risk”.

She also said if Labour won the UK general election on July 4 she expected most carried 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 industry reacted?

Casey Dalton, partner at Herbert Smith Freehills, said Reeves’s statement that most carried interest would be taxed as income would disappoint some private equity professionals.

But Reeves’s comments were received well 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 if executives invest alongside clients.

Some in the industry have been advocating privately for just such a regime in the UK as a way of avoiding a harsher crackdown, according to people familiar with the matter.

What is a co-investment regime?

In Italy and France, fund managers can pay a lower rate of tax on carried interest if they meet a number of conditions, including investing typically 1 per cent of the value of a fund.

The amount invested by UK private equity managers varies across firms and fund types but public, industry-wide data is not available. Some invest about 1 per cent.

Reeves said the amounts currently co-invested were “tiny”. When asked, Labour did not provide figures to support this assertion.

“The idea of a co-investment condition is sound and would align the UK with other European regimes,” said one lawyer who advises private equity funds.

How would a co-investment regime work?

If Labour were to opt for a co-investment approach, it would face several decisions about how the regime would operate.

These include the level of investment required for executives to qualify for a lower rate of tax and whether they must fund this from their own pocket or be allowed to count contributions from their employer or colleagues.

Labour would also need to decide whether investments funded by “non-recourse loans” would qualify for a lower tax rate. These loans are lower risk for borrowers because their personal wealth is shielded from the lender.

The industry would be likely to push for lower investment thresholds for large international funds, which can run to tens of billions of pounds and make a co-investment of even 1 per cent prohibitive for many fund managers.

Do Labour’s numbers add up?

Reeves said Labour’s projection that it could raise £565mn annually by 2028-29 was based on a paper by the Resolution Foundation in 2020.

The think-tank found that closing the carried interest loophole would raise £420mn. This was on the basis of £2.2bn annual average carried interest earned in 2016-2018. It did not factor in the risk of private equity executives responding by leaving the UK.

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

More recently, data has shown 3,000 dealmakers shared £5bn in carried interest in 2021-22.

Using the Resolution Foundation’s methodology, this could lead to almost £1bn in tax revenue from a carried interest crackdown.

The wide gap between that number and Labour’s costing gives the party fiscal room to account for fund managers leaving the UK or for some carried interest to continue to be taxed at a lower rate.