UK loses £600mn a year by under-taxing private equity executives, says lawyer

The UK tax authority is missing out on about £600mn a year as a result of a longstanding perk applied to private equity executive payouts, according to an analysis by a leading tax lawyer.

Most private equity funds should be treated as “trading” for tax purposes, argued Dan Neidle, former head of tax at law firm Clifford Chance, in a paper published in the British Tax Review journal on Thursday.

Changing the classification would mean payouts would be levied as income with a top rate of 45 per cent, rather than at a capital gains tax rate of 28 per cent.

The tax perk, which has helped mint a number of private equity billionaires, has been a source of controversy for decades. The opposition Labour party has pledged to close the so-called “carried interest loophole” by taxing manager payouts as income should it win the next election.

The loophole dates back to a deal struck by an industry lobby group in 1987. But critics argue that HM Revenue & Customs should be collecting much more tax from executives who run buyout funds.

“It can’t be right that some of the richest people in the country pay tax on their income at 28 per cent whilst the income of a nurse or teacher or train driver bears rates of 40 per cent, including national insurance,” said Jolyon Maugham KC and director of campaign group the Good Law Project.

Maugham added that he was “working with leading counsel to formulate and, if advised, bring a legal challenge to this practice”.

About £3.4bn of capital gains from carried interest was reported in personal tax returns in the 2020-21 tax year, a 26 per cent rise on the previous year. Had this been taxed as income and not capital gains, HMRC would probably have raised about £600mn more in revenue, Neidle said.

“HMRC should be investigating each private equity buyout fund on a case-by-case basis before accepting that carried interest is taxed as capital,” he noted.

The analysis comes ahead of chancellor Jeremy Hunt’s Budget next Wednesday when he will be seeking to find extra fiscal headroom in the public finances.

The private equity industry argued that managers’ payments were not bonuses but “investment returns” because executives were required to invest their own money in order to be entitled to them. Therefore, these payments were eligible for lower capital gains tax rates.

However, some experts have noted the sums that executives invest were small and often funded through non-recourse loans, meaning they were not putting money at risk.

John Cullinane, director of public policy at the Chartered Institute of Taxation, a professional body, said Neidle’s analysis was “powerful” and “obviously would be very unwelcome to those directly affected”.

But Sir Edward Troup, a leading tax consultant and former executive chair of HMRC, said it would be better for parliament to revisit the rules on carried interest rather than the tax authority pursuing its own action “with unpredictable wider consequences”.

HMRC said that whether a fund was trading or investing depended on the facts of each case. “If we have reason to question a declaration of carried interest to us, we will query it to ensure the right tax is paid.”