This submission argues that private equity funds enjoy three unwarranted tax breaks. They usually do not pay tax on their capital gains, they receive excessive tax relief on interest paid resulting in little or no current tax being paid on their UK profits and the taxation of income attributable to carried interests as capital gains is economically unjustifiable.
As a result it is suggested that the first two tax breaks provide private equity funds with an unfair competitive advantage by lowering their cost of capital and the last provides it with a further unfair competitive advantage by lowering its cost of employing key staff. Each distorts the UK financial markets in ways that are harmful to those markets themselves, the companies that are quoted on them and their ability to secure the capital and management resources to operate for best benefit for the UK as a whole. This is the principle reason for requiring change in the way in which private equity is taxed in addition to the loss of tax and increased social inequality that also justify that change.
Required tax changes are proposed in this paper. First of all it is suggested that income attributable to carried interests be taxed as such under income tax rules. This would eliminate market distortions, reduce abuse of the domicile rules, open the market for management talent, eliminate an unwarranted subsidy of the employment costs of these funds, end the taxation by concession which currently exists in this sector without statutory support and increase social cohesion.
Next it is proposed that explicit thin capitalisation rules be introduced to prevent the abuse of interest payments from the UK to offshore entities to eliminate the charge to UK tax by companies operating in this sector. In addition, it is suggested that tax relief should not be given on interest paid on loans incurred by a UK company that directly or indirectly arose to assist the acquisition of its shares by a third party. This, it is suggested would end the subsidy currently provided by the UK Exchequer to the owners of capital in this sector, would create a level playing field for all types of fund in the financial markets and would reduce the loss of tax in the UK arising from financial manipulation in the private equity market. This also supports company law that suggests this support can be illegal if supplied directly.
Finally a review of tax residence rules and the rules with regard to controlled companies is suggested to develop strategies that prevent the avoidance of the taxation of capital gains arising on the sale of corporate assets located in the UK. This would, again, prevent the effective subsidy provided at present by the UK tax system to the private equity sector, which reduces its cost of capital and provides it with unfair competitive advantage effectively allowing it to acquire quoted companies at undervalue due to the tax relief the private equity sector enjoys.
It has been suggested that to tackle these issues is to risk the private equity market moving out of the UK. This is not true for the following reasons:
a. These activities are already not here for many purposes: they are paying little or no tax so the economic footprint they have here in terms of a return to society is already very low;
b. The companies they want to buy are here, and this will continue to be the case;
c. The support services they need are here and this will continue to be the case.
As such any change is not likely to be detrimental to the UK, the retention of profits here or on tax paid here.
In contrast the upside of the proposed changes is significant:
a. Some, and maybe significant amounts of, tax will be paid;
b. Taxation by concession will be stopped;
c. The UK will no longer be subsiding an activity that does not require state aid;
d. The effective assignment of significant amounts of UK taxation revenue for the benefit of those who are already amongst the wealthiest people in the world will be reduced;
e. Substantial distortions in the UK market for corporate executives will be eliminated, so cutting their rewards, and reducing a cause of significant friction and inequality in society;
f. The cost of capital of private equity companies will be increased, so reducing their competitive advantage. This will mean that:
i. they compete more fairly with existing corporate finance structures which are proven, are accountable and relatively (when compared to offshore) transparent;
ii. stability will be enhanced, which has not been proven to be the case and is inherently unlikely of private equity,
iii. jobs and markets will be protected as a result.
g. The role of the City will be supported in the face of competition from offshore with the inherent threat that poses to the world financial and taxation regulatory environment.
For these reasons the actions proposed in this report are recommended to the Committee.
The full report is available here.