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Private equity bosses pay less tax than cleaners

Private equity is back in the public spotlight. City veteran Nicholas Ferguson (left) has revealed the industry's 'sweetest little secret': a loophole that allows executives to pay just 10% tax on earnings.

Private equity is back in the public spotlight. City veteran Nicholas Ferguson, chairman of investment group SVG, "has let us in on the industry's sweetest little secret", said Alex Brummer in the Daily Mail. He noted that UK tax rules allow buyout fund executives to pay just 10% on the bulk of their earnings, and that he had not heard a clear explanation of how paying "less tax than a cleaning lady" is justified. Gordon Brown has signalled a clampdown on the loophole.

Why the tax loophole arose

The anomaly is due to rules that Brown himself introduced to encourage entrepreneurship. Those starting their own business or investing in start-ups would be charged capital-gains tax of just 10%, rather than 40%, when they sold their stakes on, provided they held their stakes for two years. Private-equity reward structures have exploited this taper relief'. Partners typically receive a 20% share of the profit from selling firms in the portfolio after a certain threshold has been reached. This so-called "carried interest" is effectively a performance fee, but is treated as a capital gain.

Thanks to the accelerating buy-out binge, the biggest funds are now worth $10bn-$20bn, so the top partners can expect carried interest of "hundreds of millions, if not billions of dollars" over the ten-year life of a fund, said Martin Arnold in the FT. And the bonanza is contributing to an ever-greater loss of revenue from taper relief, which cost £4.5bn in the last financial year, up from £550m in 1998.

Private equity tax loophole: what next?

The industry insists the tax rules are the same for everyone, but this doesn't bear scrutiny, said Simon Nixon on Breakingviews. In 2003, the Government introduced new rules to clamp down on share-based pay schemes designed to disguise income as capital gains. But the private-equity industry negotiated an exemption, so carried interest remained eligible for taper relief.

Might the private-equity industry, which now accounts for 7% of annual turnover in the UK financial services industry, up sticks if the loophole is closed? It's highly unlikely. As Nixon pointed out, private equity was well established in London before 2003, when the "really juicy tax benefits kicked in", and the tax affairs of buyout group employees "have no bearing on the economics of deals".

Ferguson deems an exodus of executives unlikely: "anyone who wants to live in Guernsey can do so already".  Besides, private equity's long-term future, and its ability to pull off "innovative, value-enhancing deals", depends on its public image, said James Harding in The Times; note that suspicion of buyout firms is partly to blame for CVC's failed Sainsbury bid. The "unjustifiable" tax perk "undermines the credibility of the industry".

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