What is carried interest? Investing Explained

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s carried interest. 

What is this?

A lucrative tax break, enjoyed by private equity bosses in the US and UK, which is under scrutiny amid the heightened focus on the tax burden on ordinary workers.

Private equity funds take stakes in unlisted businesses with growth potential, and buy public companies, and have acquired businesses worth £80billion this way in recent years. The takeovers, which include Debenhams and Morrisons, can be controversial for their impact on shareholder value, staff and the High Street.

How does carried interest work?

Under the ‘two and 20’ system, the managers of private equity funds charge their investors an annual 2 per cent, plus an extra 20 per cent performance fee on any returns above a certain level (typically 8 per cent).

The managers’ share of the 20 per cent 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 per cent of the profits.

Lucrative: The term dates back to the 16th century when captains of merchant ships were entitled to 20 per cent of the profits

What rate of tax do managers pay on this money?

A manager’s individual slice of the 20 per cent is taxed not as income tax, but as capital gains on the basis that it is a gain from an investment. This means the rate payable is 28 per cent, rather than 40 per cent higher rate of income tax or 45 per cent, the additional rate on earnings above £125,140.

The arrangement has been in place since it was introduced in 1987, following lobbying from the sector, apparently.

Does the taxman lose out?

THE loss to the Exchequer is estimated to be about £600m a year because the payouts are much larger than managers’ basic salaries. According to Macfarlanes, the legal firm that represents the private equity industry, the top 255 managers took home £2.7billion in the 2020-21 tax year.

But there may be unintended consequences. These managers are highly mobile and could leave for locations with more welcoming regimes, depriving the Exchequer of the money they pay in other taxes.

In Spain, the effective tax rate on carried interest is 22.5 per cent. Some managers are ‘non-doms’ whose permanent home is outside the UK. This could make them more inclined to leave.

Is there pressure for reform?

Yes. Dan Neidle, the former head of tax at legal firm Clifford Chance, now head of the Tax Policy Associates body, says it should be abolished, although it could continue to be available to managers who staked their own money in funds, rather than the small amounts that most are said to commit.

What would a Labour government do?

Labour is engaged in a City charm offensive. But the party’s leader Sir Keir Starmer and Shadow Chancellor Rachel Reeves say they would withdraw the concession.

Is carried interest under threat in the United states?

In the US, carried interest profits are also taxed as capital gains, although the government would like to find a way to end the tax break while staying on good terms with powerful Wall Street figures. Supporters of reform include top financier Bill Ackman, of Pershing Square Management, who calls the concession ‘a stain on the tax code’.