The debate over the reforms to the capital gains tax regime is in danger of missing a key point. The real significance is not what they do but what they do not.
There has been uproar over plans to introduce a single 18 per cent CGT rate but remove business taper relief and indexation. The plans are seen as skimming some profit off private equity buccaneers but hurting entrepreneurs.
Actually the private equity industry had feared worse. Firstly, there was talk about a specific higher tax rate for private equity partners.
Secondly, the industry was worried partners’ carried interest – their share in the profit of the business – would be taxed as income rather than capital. This would have turned a 10 per cent tax rate into 40 per cent. Neither came to pass and there is little talk of further moves – for now.
The debate over the tax treatment of private equity is still a live issue in the United States. This month the Ways and Means Committee of the House of Representatives approved a bill that would make carried interest liable to income tax, effectively raising the rate from 15 per cent to 35 per cent.
It is part of a wider effort by Democrats to find a way to pay for cutting a politically-sensitive income tax. Congressional rules state tax changes must pay for themselves, thus the need to find new revenue sources.
However it is important to understand that that part of the bill, which would raise $25.5bn (£12.5bn) over ten years, is not just a knee-jerk response.
The bill has been careful drafted, implying that Charles Rangel, the Democrat committee chairman, knows what he is talking about.
It would treat carried interest as income received in exchange for the performance of services “to the extent that carried interest does not reflect a reasonable return on invested capital”. In other words if it is clear partners are not taking a real risk their gains are taxed as income.
Lawyers in the UK warn if the full House passes the bill, it will make it easier for the UK government to come back for more from private equity, saying it is simply following global trends.
While that is no more than speculation, finance and tax directors should think about their own suggestions for reform should the debate be reopened.
On private equity firstly, it is clear the industry failed to get its message across. As few as a quarter of partners deliver the rates of return necessary to qualify for a payment.While those who did reaped large rewards, it might be as few as 100 individuals. As one venture capitalist puts it, the chancellor went “hunting rabbits with a Howitzer and missed”.
What he hit were entrepreneurs and venture capital funds. Sweeping away taper relief did get rid of an excessively complicated regime.
But it did throw the baby – incentivising long-term investment – out with the bathwater. PwC suggests a streamlined system with a single taper applicable to all assets, which reduces from 40 per cent to 10 per cent after 10 years i.e. a 3 per cent reduction in rate each year.
An alternative would be to shift relief from selling a business, which is an odd way to encourage wealth creation, towards relief on capital investment or employment.
Thirdly the government has already indicated it will consider the reintroduction of retirement relief. Ministers should be urged to link this to the debate about pensions by exempting the proceeds of sale if they are put into a retirement fund.
Lastly PwC also suggests a transitional relief. It argues some people will sell out before April to avoid a higher tax bill due to the loss of indexation relief, which protects people from being taxed on purely inflation-linked rises in value.
A notional sale and reacquisition at 5 April 2008 would allow them to crystallise a gain figure and a tax bill that would be “banked”.
It is not fanciful to think the government will come back to the CGT issue. Its 10 years are replete with u-turns and counter u-turns.
The US moves shows there is a serious debate over philosophical attitudes towards taxing gains. Financiers ignore it as their peril.