Photo credit: Bill Noble/Reuters
Rachel Reeves gives unprecedented new tax discount to a few thousand fund managers worth nearly £500m a year by 2028-29
One of the few concrete tax proposals within the Labour Party’s successful General Election manifesto was the promise to remove the loophole for ‘carried interest’ received by Private Equity fund managers. Carried interest refers to the share of profits fund managers earn when investments perform well. While this is effectively a bonus, it has traditionally been taxed at the lower capital gains rate (currently 28%) rather than as regular income which is taxed at higher marginal rates, subject to minimum holding periods. The distinction allows private equity fund managers to pay significantly less tax compared to employees, or the self-employed, in other sectors who are taxed on their full earnings at income tax rates, leading to the often repeated quote about private equity executives being taxed at lower rates than their cleaners[1].
In recent years Labour has highlighted this inequity and promised to treat these earnings more similarly for tax purposes. In her response to the Autumn Budget 2022, Rachel Reeves criticised then Chancellor Jeremy Hunt for not closing the loophole, and the Labour manifesto decisively committed to remove the tax perk, stating “Private equity is the only industry where performance-related pay is treated as capital gains. Labour will close this loophole.”
However, now that they are in power, they seem to have cooled on the idea. Rather than closing the loophole, the Government has simply moved it, citing the ‘unique characteristics of carried interest’ as the reason for not fulfilling a manifesto pledge. In failing to do so it has created a new risk of future lobbying pressure further eroding tax revenues.
The new rules: marginal changes, same advantage
The Autumn Budget set out two key changes to be introduced in the coming years:
– Capital Gains Tax (CGT) adjustment: For the 2025-26 tax year the rate of capital gains tax (CGT) on carried interest will increase to 32%, up from the current rate of 28%. This 4 percentage point increase mirrors the hike in rates for higher rate taxpayers on other gains (20% moving to 24%), so is neutral in comparative terms.
– Taxed within the income tax framework: From 2026-27, carried interest will be treated as trading income from self-employment and therefore taxed entirely ‘within the Income Tax framework’. In principle it will therefore be liable to a marginal tax rate of 47% (45% income tax and 2% NIC). However, a 72.5% “multiplier” will apply, effectively discounting 27.5% of carried interest earnings as if they were business expenses. Carried interest will therefore be taxed at a marginal rate of just over 34%, significantly below the combined 47% marginal rate (income tax and National Insurance Contributions) applied to other forms of self-employment income.
Neither of these changes actually close the loophole, which is just shifting from one tax to another, and create further risk for future tax policy. The 72.5% ‘adjustment’ is unprecedented and its impact is clear. It allows private equity fund managers to retain the beneficial treatment that Labour promised to end.
An Illustrative Example
Consider an individual earning a £1 million bonus from carried interest versus another earning £1 million in standard self-employment income:
- Private equity fund manager: Taxable income is reduced to £725,000 due to the 72.5% multiplier. At 45% income tax and 2% NIC, the total tax liability is £340,750, leaving post-tax earnings of £659,250.
- Regular self-employed individual: The full £1 million is taxed, resulting in a liability of £470,000 (income tax and NIC combined), and post-tax earnings of £530,000.
This discrepancy saves the fund manager nearly £130,000, underscoring the scale of the tax advantage. HMRC say only 3,100 individuals use the current arrangements, so the beneficiaries of the change are very concentrated, and the above example is slightly lower than the average per claimant.
Undermining tax equity and reducing tax revenues
The government justifies this concession by citing the “unique characteristics” of carried interest but offers no evidence to explain why any concession is needed or how the figure has been arrived at. This shift sets a dangerous precedent – it means a small group of high earners are not taxed on the full value of the income they are paid, and the Government has blessed such an arrangement! If carried interest receives special treatment within the income tax framework, other industries could demand similar adjustments, further compromising how much tax can be collected to fund public services.
The scale of the climb down is best illustrated by the changes in forecasts for additional tax revenues resulting from the changes. Originally projected to generate an additional £565 million in tax revenues in 2028-29, the revised estimate is much lower at £80 million in 2028-29, putting a figure on the cost of the Government’s concession.
A political deception
This retreat reflects the strength of lobbying from the private equity sector. While the government portrays the reforms as closing the loophole, the reality is a fudge. By embedding the sleight of hand within the income tax regime, it becomes harder to address and opens the door to future erosion of tax revenue under pressure from other sectors.
The Government’s approach signals not reform, but capitulation, offering private equity a new and enduring tax break at the expense of broader fairness. The principle of equal treatment under the tax system has been significantly undermined.
[1] British Buyout Chief Questions Industry Tax Break – The New York Times
