Private equity’s tax tussle needs pragmatism, not intellectual purity

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The UK government and private equity bosses are engaged in a familiar tussle. Amid talk of a “black hole” in public finances, the Treasury has taken aim at their compensation, which is partly structured as lower-taxed capital gains rather than income. Predictably, the industry is making noises about relocating to more favourable jurisdictions. Neither side has a killer argument here. Best set aside ideology in favour of a pragmatic solution.

The context helps. Both parties have less at stake than meets the eye. The Treasury is targeting £565mn from a squeeze on the industry — a drop in a leaky bucket. Meanwhile, many countries have favourable regimes for private equity compensation. While a tax rise might cause a few well-heeled barons to relocate, it is hard to see businesses emigrating wholesale. 

Conceptually, too, the line between income and capital gains is fuzzy. UK Chancellor Rachel Reeves does have a point, of course. It is hard to distinguish so-called carried interest, the structure used by private equity, from, say, a performance-related bonus. Yet the former incurs capital gains tax at a bespoke rate of 28 per cent while the latter attracts a 45 per cent marginal rate income tax. 

Imagine that a £1bn private equity fund made a 15 per cent annual return for five years before selling its assets. Carried interest, under which managers typically take home 20 per cent of profits after investors get their money plus an 8 per cent return, would be £200mn. Taxed at capital gains, that’s a net £144mn. A similar-sized bonus would have yielded a net £110mn.

This looks unfair. But intellectual purity is a scarce resource in fiscal policy. It is perfectly possible to dub something income and then tax it at advantageous rates, as Germany and Spain do.

That is one possible fudge here. Of course, one can attach conditions to securing those rates — for example, requiring bosses to “buy” their carry rights by investing more of their own money into the fund. But at the levels required in other countries — 1 per cent in Italy, for example — it is disingenuous to pretend this would align them with the capital gains of other investors. It would simply be a ticket to share in a big bonus pool.

In truth, both politicians and private equity titans might welcome shelving the ponderous debate about whether carry is truly income or capital gains. Instead, the question is at what level should it be taxed and what conditions are required to earn that benefit. There is room to raise more revenue without risking a mass stampede.

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