Carried interest is pure fiscal ‘cakeism’


It is a fiscal perk that has helped mint a good many private equity billionaires. 

Instead of paying income tax on bonuses such as ordinary corporate executives, buyout groups’ executives pay a lower capital gains tax rate on the sometimes massive gains they pocket.

Here is a quick example that illustrates the benefit. Take an ordinary bonus of, say, £1m. A toiling executive must hand £450,000 of it to HM Revenue & Customs in income taxes, assuming it all falls into the highest rate band. But if he or she can term that payout “carried interest” on a private equity transaction, the executive has to cough up just £280,000 and avoids national insurance, another payroll tax.

No wonder private equity bosses defend the treatment so fiercely. A decade ago, the founder of Blackstone, Steve Schwarzman, offered an insight into how highly it is prized when he compared then-president Barack Obama’s attempt to abolish it to “a war”.

But there is a problem with this arrangement: it is almost impossible to justify. Which is why politicians in Britain are right to review “the interactions of how [capital] gains are taxed compared to other types of income”. A government review this week concluded that income and capital gains taxes should be brought into “greater alignment”. 

It is not that increasing taxes on “carried interest” would transform public finances devastated by coronavirus. Taxing it as income would only raise an extra £440m a year in the UK, according to a report by the University of Warwick and the London School of Economics. What is at issue is fairness. If taxes have to go up generally, surely the first thing for the scrapheap should be a loophole that benefits only those at the very top of the income scale?

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In my view there is little doubt that taxing “carry” as capital confers an undeserved advantage. Basically, it is the fiscal equivalent of having your cake and eating it.

Transactions on which capital gains are made should by definition be ones in which that same capital is at risk. Take a simple example: when a company’s chief executive buys some of its stock, a chunk of his or her wealth is placed in the balance. The CEO may gain or could lose the lot.

That is why the tax treatment is different when that same boss obtains a similar equity interest through a grant of share options. These offer the same possible upside, but put none of the chief executive’s capital at risk. If the share price falls, the options expire unexercised. It is an asymmetrical structure. If the shares go up and the executive duly exercises the options, the difference between the strike price and the market value is not a capital gain. It is subject to income tax.

Which of these two does a buyout group’s remuneration more closely resemble? It is the latter. The private equity firm does have a bit of “skin in the game” in the form of a sliver of cash invested directly in the buyout fund (generally about 1-3 per cent). But almost all of its gain comes from the carry — the 20 per cent slice it receives out of 100 per cent of the fund’s profits under a typical fund management contract.

Buyout groups argue that the carry is akin to a profit share, as if they themselves were bearing the same risks as the external investors in the buyout fund. But they are not. Their participation is basically through an option where the strike price is, in effect, the purchase price of the acquired companies plus any accumulated financing costs.

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So if we follow the logic, gains on exercise should be taxed as receipts of income not capital.

None of this, of course, is welcome news to the private equity top brass. Remember Mr Schwarzman’s dark talk of conflict if their privileges were ripped away? 

The irony is that there is an easy way for PE executives to keep their favoured tax treatment. All they have to do is to stop trying to have their cake and eat it too. A recent paper by the Oxford academic Ludovic Phalippou suggests that they should put more of their own capital on the line.

This isn’t just an issue for the taxman. The pension funds backing private equity should be keen on more symmetrical contracts; ones where the buyout firm takes a real loss on its own capital if deals don’t pay off. 

That would not only make buyout groups discriminate more carefully which transactions they got involved in; it would also make them less likely simply to pile up ever more assets to extract bigger management fees. And that is a change that would benefit everyone.

Jonathon.Ford@ft.com



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