Will Labour follow through on its commitment to reform carried interest?

It is no secret that Labour remains in a hugely advantageous position in the build-up to the next General Election, expected in Autumn 2024. YouGov’s latest polling has the voting intention figure at 47% compared to the Conservative’s 24%, and the Party looks likely to form the next government.

While Labour Leader Keir Starmer has broadly aligned himself with the Conservative Government’s economic agenda to date, one area where Labour has sought to create some distinction is with its proposals for private equity tax reform. While this is unlikely to gain a significant amount of national media attention, it will have huge implications for private equity firms operating in the UK and the UK’s attractiveness as a destination for this type of investment.

The proposals centre on the tax arrangements utilised by private equity firms, in particular carried interest. Carried interest refers to a share of profits earned by general partners of private equity firms. General partners typically receive 20% of a fund’s returns (usually above a pre-defined minimum return known as the hurdle rate) as a performance fee for managing the fund.

While this appears relatively uncontroversial, what has attracted particular attention is the tax treatment carried interest receives. Rather than being taxed as income, which would incur a tax rate of up to a 45%, carried interest qualifies for capital gains tax and is taxed at a rate up to 28%.

The private equity industry argues its payments are not bonuses but investment returns, as investors are required to invest their own money in deals to be entitled to them. Opponents of the current approach believe that the everyday reality of most private equity firms means they should be considered trading, not investment, businesses.

Shadow Chancellor Rachel Reeves has placed private equity tax arrangements firmly in her sights ahead of the upcoming General Election. Reeves has described the existing arrangements as “absurd” and said a Labour government would close the “carried interest loophole”. The Party estimates the change would raise £440 million a year for the Exchequer.

Reeves’ argument is also gaining some traction in the legal profession. In March 2023, a leading tax lawyer argued that most private equity funds should be treated as “trading” for tax purposes. Changing the classification would mean payouts would be levied as income with a top rate of 45%, rather than at a capital gains tax rate of 28%. The same author suggests that to facilitate the change, the Government would need to introduce legislation to avoid an uncomfortable judicial review of HMRC.

This stems from a statement agreed in 1987 between the British Venture Capital Association (BVCA) and Inland Revenue, which recent analysis suggests could be unlawful, saying that typical private equity funds were not “trading” for tax purposes, with the consequences being that carried interest was taxed as capital. Since then, the Inland Revenue and HMRC has followed the BVCA statement, and private equity funds rely on it as a matter of course.

If legislation to change the existing system were to be introduced, it is currently unclear the extent to which it would be prioritised by an incoming Labour administration. Other long-touted reforms, namely amending VAT arrangements on private school fees, for example, will form part of the Party’s first year in government Shadow Ministers have confirmed. With Labour positioning economic growth as a central plank of its election pitch, the wisdom of alienating potential investors will also likely be called into question. At the recent Party Conference in Liverpool, Labour confirmed it would seek to unlock private sector investment across a variety of industries including infrastructure for digital connectivity, laboratories and energy.

While Labour has previously made bold commitments in relation to the private equity industry, wider pledges and the prioritisation of other reforms could push changes to carried interest tax arrangements down the pecking order. However, given that Labour has clearly presented its views on ending what it refers to as a “loophole”, the viability of dropping the proposals altogether is unlikely.

A possible route forward would be to reform the current capital gains tax treatment utilised by the private equity industry so that returns on investments in sectors outside Labour’s industrial strategy are taxed as income, while investments in those sectors continue to benefit from the reduced rate. While Labour has confirmed it has no plans to introduce a wealth tax, increase capital gains tax or put up the top rate of income tax, this does leave the door open to a two-tiered approach. This would allow Labour to present itself as going after private equity bosses, an argument popular with its traditional voter base, while also encouraging investment in areas tied to its economic agenda.

GK Strategy is an expert advisory firm that supports investors with political and regulatory due diligence, and political advice and insight, across a range of different sectors including energy efficiency, adult social care and education. Please do get in touch with our insights team at insights@gkstrategy.com if you would like to discuss Labour’s approach to private equity tax reform or any other potential investment areas.