Press Room

11 Oct 2021

Carried interest – the big bad wolf of wilfully misunderstood? – James Paull

In light of the news that a Labour government would crack down on the private equity industry by ending a “loophole” that allows executives to pay a reduced rate of tax on their bonuses, Head of the Incentives Group, James Paull, examines the carried interest debate.

James’ article was published in TheWealthNet, 11 October 2021, and can be found here.


As the speculation continues as to the best way to use the tax system to shore up the UK finances following the coronavirus pandemic, the Labour party has weighed into the debate by reviving the periodic attack on the private equity industry, and, on the tax treatment applied to so-called “carried interest”, the ability by private equity managers to share in the returns of very successful funds.

The latest attack accuses the private equity sector of using a “loophole” to pay 28% tax on their “bonuses”, while the rest of the population pays 47% on theirs. At the same time, it berates the industry for its failed investments. So, according to Labour, the industry is very successful and very unsuccessful at the same time.

As is so often the case when politics gets involved, a very one sided and often incomplete picture is painted. Although it is true that carried interest gains are taxed at 28%, this is a special, higher rate than would be paid on other gains on share sales (taxed at a maximum of 20%). In fact, the only other asset which is taxed at 28% is residential property.

So, is carried interest really the big bad wolf that it is made out to be? Or is it being wilfully misunderstood? As is usually the case, the position is somewhat more nuanced than is made out by those with a political agenda.

What is carried interest?

When investors back a private equity fund, they normally want to ensure that the financial interests of the individual managers who are responsible for locating and managing the investments are aligned with theirs. When the managers make money, so do the investors (and vice versa). Managers will often also be required to invest their own money alongside the fund (so-called co-investment). On top of this, managers can be incentivised through “carried interest”.

Carried interest is effectively a highly leveraged form of investment. Managers invest a relatively small amount (although still usually thousands of pounds) of capital in the fund, which will only start to deliver a return once the investors have been returned all their investment together with a return on it (typically 8% per annum over the life of the fund). Carry is typically acquired before the fund has made any investments, so there is no guarantee that the fund will even find suitable investments, let alone that they will be successful. If the fund doesn’t do both things, the initial investment will be lost.

Of course, there are some funds that find extraordinary success and deliver enormous returns to their investors as well as to the managers holding carried interest. However, these funds tend to be less common than is portrayed by detractors. It is very far from true that carried interest is a certainty for any individual manager.

The other point to note is that carried interest is measured over the life of the fund. It can therefore be very long term and is certainly not an annual opportunity as salary and bonuses are.

A (very) brief history of carried interest tax

Historically, carried interest was very tax effective, there were several techniques which could be used by private equity executives to access some very low effective tax rates. These advantages have gradually been whittled away and it is now very difficult, if not impossible, to achieve rates below the headline 28%. It is also worth noting that an individual investing in a successful start-up would (for now at least) be taxed only at 20% so it is wrong to single out carried interest taxable through a “loophole”.

Wider tax debate

There is clearly a need to use the tax system to plug at least some of the funding gap and realistically taxes are going to have to rise. However, tweaking carried interest to tax it at 47% would, even on Labour’s figures, make only a very small dent in this. Incidentally, the same could be said of the potential alignment of capital gains and income tax rates. If lawmakers are serious about raising money, the harsh reality is that they are going to have to look at one of the big 3 (income tax, NIC and VAT) or impose a one-off wealth tax. None of these are popular though, as the Conservative Government has found when recently announcing rises in NIC and income tax on dividends.

This article is not designed to be an apologia for the private equity industry. They have proven more than capable of defending themselves. However, by focusing on their usual whipping boys with view to scoring political points whilst raising relatively small amounts of tax, politicians (both Government and opposition) are in danger of being accused of fiddling whilst Rome burns, undermining their fiscal credibility at the same time.

James Paull

James is Head of the Incentives group at Andersen LLP. He provides advice in respect of the deign, implementation and operation of employee incentive arrangements to companies, partnerships and individuals with a particular focus on tax, legal and technical aspects.

Email: James Paull