Taxing carried interest as income, and why it isn’t a good idea

The UK’s Labour Party confirmed that they would close what they call the PE tax loophole if they win the next general election. It means that fund managers who earn performance fees (called carried interest) need to tax them as income (at the full marginal rate of 47%) instead of as capital gains (at 28%) as it is currently. The Labour Party announced that this measure would increase the state’s tax income by £440m a year. This, however, is only the direct impact of the policy. The indirect impact – which is much harder to measure – could result in a much lower, mid-term or even negative impact on the country’s finances.

Fund managers are the facilitators of redistributing money from investors to where no regulated currency from banks ever would go. Private funds finance most successful young businesses as well the not so successful ones; they invest in large infrastructure projects and finance real estate projects; they allow companies to react to changing market conditions by providing the necessary cash to restructure themselves. All these transactions are high risk, as they are determined on whether a start-up is successful, or the restructuring of a company pays off. The investments are normally long-term as the necessary success does not usually turn around in months or even a few years. The investor therefore puts their money in high-risk and long-term investments and needs a great deal of trust, that the fund manager’s interest can produce a profit, so it is worthwhile to waive the ability to spend that money somewhere else.

The carried interest or performance fee is the primary incentive payment structure in private markets and for fund managers. It incentivizes fund managers to increase the return on investment as there will only be carried interest if they exceed the minimum performance promised to the investor. So, every fund manager’s executive hopes, as much as the investors, that the fund exceeds the promised performance.  

It’s precisely this structure that explains why this is not income in the sense of payment for effort and knowledge. The investor shares with the fund manager some of their gains to align the fund manager’s interest. The gains would be taxed as capital gains, going to the investor – why would that exact same money now be taxed as income if going to the fund manager?

But aside of this technicality, taxing carried interest at a higher rate will reduce the effect of alignment between investor and fund manager as it is less attractive for the fund manager.  

Potential impact on a post-Brexit UK

There are three potentially negative effects which reinforce why this is a bad idea for a struggling post-Brexit UK.  

1. It could incentivise fund manager’s executives to move to a location where carried interest is not taxed as income, which would cost the state not only the 28% tax in carried interest, but also the tax on income of these executives and the know-how and expertise will wander with them.  
2. Even worse; whole fund managers might switch their location potentially reducing their investments in the UK’s economy, which will result in less jobs and therefore less taxes.  
3. Trust from investors in the UK’s fund managers is reduced, and less money is made available in the currently strong UK’s private markets sector.

Ideas for change

If anything, what the government should ensure is that the carried interest structure is not misused, and actual income is declared as carried interest. Ideas for change could be: have a minimum investment holding period for which carried interest can be paid and taxed as capital gains. Or carried interest is only taxed as gains if the overall performance of the fund management company is higher than the expected performance. And if political pressure is high, the maximum share of gain to the fund manager could be defined, and everything above that could be taxed as income.

In the UK’s current (and future) economic situation, the government should ensure that business is thriving, and money is flowing as freely and unregulated as possible to the companies, where jobs and prosperity are created. The immediate effect of this tax legislation would only concern a few thousand individuals in the UK and there would be an immediate increase in available money to the state, but the longer-term effects are much broader with potentially severe impacts, which is much harder to estimate. In my opinion the £440m is just not worth the risk.

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Gregor is an expert in waterfall calculations and distributions in the Private Markets sector. He has worked in various roles in the financial services sector, predominantly as product manager and IT leader. Gregor holds a Masters in Physics from the ETH in Zurich, an MBA from Rochester-Bern and a certification in Financial Modelling, Valuation and M&A from HHL Leipzig Graduate School of Management.

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