Friday Letter A taxing issue

Don’t think for a minute UK politicians have lost interest in how the taxman should treat private equity.  

It would be convenient if the current lull in the mega buyout market let the private equity industry off the political hook, it found itself on in the summer.

In the UK, UK politicians have been exercised by the low tax rate said to be paid by many buyout deal doers, in particular after Nick Ferguson, one of the industry’s own, blew the whistle earlier this year.

However, the credit crunch has pushed private equity off the front pages of the mainstream media. Has it pushed it off the political agenda too? Now that LBO party has ended so abruptly, surely politicians must now appreciate that investing in a private equity fund is actually not a one-way bet to riches beyond imagination?

This seems a risky assumption to make. And if any in the industry really believe the turmoil in the debt markets is enough to bury the taxing of carried interest, then at least the British Venture Capital Association is leaving nothing to chance.

Philip Shuttleworth, a partner at ECI Partners in London and head of the BVCA’s tax committee, is leading the charge against complacency, ahead of the new UK Chancellor Alistair Darling’s first budget statement some time in October.

In the tax debate, the focus is on carried interest. Private equity’s critics want carried interest on a fund taxed as income – which it currently isn’t – because only a small portion of carry is actually derived from the executives’ own investment in the fund. The majority of carry is earned on the investors’ capital and should therefore be treated as a performance fee and taxed accordingly.

The industry, unsurprisingly, doesn’t see it quite like that. Shuttleworth told PEO earlier this week there were a number of reasons why the existing capital gain tax treatment of carry should persist. He argued carried interest is intrinsically linked to co-investment. If a general partner does not invest alongside its limited partners, it will not qualify for carry. Shuttleworth said no executive would co-invest by choice on a stand-alone basis, because it is a highly concentrated, undiversified, long-tem illiquid investment, which may amount to as much as a year’s salary and bonus. As such it represents a disproportionate risk for an individual, compared with the institutional investors for which private equity is small part of a mostly liquid portfolio.

Carry is a risk-related reward, Shuttleworth noted, and to meddle with it would potentially distort all forms of collective investment where investors receive disproportionate returns in line with their risk exposure.

Put like that, carried income does look less like income, and the notion that it should be taxed as capital becomes more compelling. Will it be politically viable to leave the current regime alone? After the turmoil of the credit crunch, it is difficult to say. One thing is certain after the recent run on a UK high street bank: Chancellor Darling will be looking for some easy wins. Taxing the industry may just be one.