What is carried interest? Investing Explained
INVESTING EXPLAINED: What you need to know about carry interest – a lucrative tax break enjoyed by private equity bosses in the US and UK
In this series, we break down the jargon and explain a popular investment term or theme. Here it is carried interest.
What is this?
A lucrative tax break, enjoyed by private equity bosses in the US and UK, is coming under scrutiny amid the heightened focus on the tax burden on ordinary workers.
Private equity funds take stakes in unlisted companies with growth potential and buy listed companies, acquiring companies worth £80 billion in recent years. The acquisitions, including Debenhams and Morrisons, could be controversial due to their impact on shareholder value, staff and the High Street.
How does carry interest work?
Under the “two and 20” system, private equity fund managers charge their investors 2 percent annually, plus an additional 20 percent performance fee on any return above a certain level (typically 8 percent).
The managers’ share of the 20 percent is called ‘carried interest’. The term dates back to the 16th century, when captains of merchant ships sailing from Genoa, Venice and other ports were entitled to 20 percent of profits.
Lucrative: The term dates back to the 16th century when captains of merchant ships were entitled to 20 percent of profits
What tax rate do managers pay on this money?
The individual portion of a manager’s 20 percent is not taxed as income tax, but as capital gains on the basis that it is profit from an investment. This means the rate to be paid is 28 per cent, rather than the 40 per cent higher income tax rate or 45 per cent the additional rate on income over £125,140.
The scheme has been in place since its introduction in 1987, apparently after lobbying from the sector.
Does the taxman fall victim?
THE loss to the Treasury is estimated at around £600 million a year because payouts far exceed managers’ base salaries. According to Macfarlanes, the law firm representing the private equity industry, the top 255 executives took home £2.7 billion in the 2020-2021 tax year.
But there can be unintended consequences. These managers are highly mobile and could leave for locations with more hospitable regimes, depriving the Treasury of the money they pay on other taxes.
In Spain, the effective tax rate on interest carried forward is 22.5 percent. Some managers are ‘non-doms’ whose permanent residence is outside the UK. This could make them more inclined to leave.
Is there pressure to reform?
Yes. Dan Neidle, former chief of tax at law firm Clifford Chance, now head of the Tax Policy Associates division, says it should be done away with, although it could remain available to managers who put their own money into funds, rather than the small amounts the most would commit.
What would a Labor government do?
Labor is on a charm offensive for the city. But party leader Sir Keir Starmer and shadow chancellor Rachel Reeves say they will withdraw the concession.
Is ‘carry interest’ under threat in the United States?
In the US, interest income carried forward is also taxed as capital gains, although the government would like to find a way to end the tax break while remaining on good terms with powerful Wall Street numbers. Proponents of the reforms include top financier Bill Ackman of Pershing Square Management, who calls the concession “a blemish on the tax code.”