How Rachel Reeves’s private equity tax compromise supports UK’s global competitiveness

Rachel Reeves, the UK Chancellor, did not follow through on Labour’s election pledge to impose the top 45% tax rate on private equity bosses in the Budget. Instead, she offered a compromise—increasing capital gains tax on carried interest from 28% to 32%—aimed at raising revenue without risking the country’s competitive edge.

Carried interest allows private equity (PE) managers to be taxed on a portion of their investment profits as capital gains at 28%, rather than as income, taxed at 45%. Most senior-level private equity managers already invest their own capital into their deals. For years, they’ve had “skin in the game,” with significant portions of their personal income at stake.

Labour’s election manifesto had specifically targeted this, calling it a loophole unique to private equity, and proposing to close it to raise £565 million annually. But after consultation with the industry, this tougher stance seems to have softened.

This is a pragmatic move with an outcome that is irritating but not as bad as it could have been. Private equity fund managers had voiced concerns that such a tax hike could drive wealthy investors out of the UK, especially when combined with Labour’s plans to scale back tax breaks for non-domiciled individuals. Losing this capital could negatively affect the economy.

Probably worse for most PE funds is the wider increase in taxes on their operating businesses, the higher inflation for longer, higher expected interest rates and lower projected growth numbers. In combination this probably hits the ‘net net’ position more than tax on carry.

The fascinating analysis on the topic comes from the Treasury’s own assessment of the benefit of this policy in the Budget scorecard: Between now and the end of 2027 the expected tax take from this policy is a mighty minus £5m. The expectation is as the policy matures by 2030 there is about £80m of tax revenue from this policy.

Given a) the lack of fiscal headroom to raise government funds for capital investment and b) the pitch during the election and in the manifesto that this government would ‘crowd in’ investment with the private sector, the policy seems entirely at odds with the objective of growth. Labour’s original £565 million estimate from closing the loophole doesn’t match the detail of the Treasury forecasts.

Many private equity funds in the UK are structured as LLPs, which are already subject to strict rules around disguised salary, capital contributions, and tax avoidance. HMRC’s oversight is stringent, and if an LLP partner’s sole motive for investment is tax avoidance, they face a tough battle defending against an investigation. Well-run funds with commercial objectives don’t face this issue, as partner capital is used strategically.

It’s often overlooked that many funds are already compliant with these existing rules. Even if these rules were more strictly enforced or enhanced, the additional tax revenue would likely be far less than expected.

The UK remains a global leader in private equity, particularly in London, which accounts for nearly half of all private equity investments in the country. In fact, five of Europe’s top 10 private equity firms are based in London, and the sector generated an estimated £286 billion in GDP in 2023, supporting 4.4 million jobs.

While it’s sensible to tighten up regulations and close loopholes, the potential gains from doing so are limited, given that many funds are already playing by the rules.