Taxing matters: gains today, gone tomorrow
It is a truth universally acknowledged, that any person in possession of good fortune, must be in want of a tax accountant. No one wants to pay tax and we all make use of the allowances that the government gives us to reduce our tax bill. Some allowances are easy to understand, like your income tax personal allowance, others are a bit more complex, but are usually there to encourage good behaviour, for example, providing for your pension.
Other allowances can lead to distortions, as taxpayers seek to use them for purposes beyond their creator’s intentions. This can give rise to unfairness in the tax system. In the eyes of the government, this is exactly what has resulted from the low rates of tax on capital gains and carried interest in recent times. This notion of unfairness sits at the heart of the government’s consultation on carried interest and possible moves to change capital gains tax.
There are recent examples of the government closing off loopholes because they believe the tax code has distorted behaviour and created unfairness. Many companies encouraged workers to work as contractors rather than employees. This allowed companies to save on employers’ national insurance, and it allowed the workers to set themselves up in personal service companies and pay themselves dividends, which are taxed at lower rate regular PAYE tax.
The government was happy with personal service companies paying dividends rather than PAYE to encourage self-employment and a more flexible workforce, but they were unhappy with companies pushing regular employees to be contractors purely to reduce tax. After a few court cases involving “disguised employees”, the tax man closed off the loophole and seeking to clawback billions of unpaid taxes.
The tax man feels that the low tax rate on CGT and carried interest is having a distorting effect. There is evidence that the very top tier of taxpayers is converting their income into capital gains to pay lower tax. For instance, the top 0.01% by income (around 5,000 people) pay an effective tax rate of 35%, which is in the fairness ballpark. However, the top 0.01% by total remuneration (including realised capital gains) pay an effective tax rate of only 15%,[1] which seems unfair as the broadest shoulders should carry the largest tax burden.
One of the ways the wealthiest are converting their income into capital gains is carried interest. The government believes that private equity partners should not pay capital gains tax for putting other people’s capital at risk. They see carried interest as akin to a bonus payment, which should be taxed as income. If private equity partners’ own capital is at risk, then only gains on this capital should be taxed as a gain.
Rachel Reeves has been clear that the present tax breaks around carried interest are “absurd”[2] and that Labour are consulting on changing the tax rules to “reflect its economic characteristics”[3]. Similarly, the treatment of capital gains could also come under the microscope. The government will want to encourage investment but somehow stop income being turned into capital for tax purposes.
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This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
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[1] wp465.2020.pdf (warwick.ac.uk)
[2] The FT 13 June 2024
[3] The tax treatment of carried interest – A call for evidence – GOV.UK (www.gov.uk)