Business
Hypocrisy at the highest level
Published 30 August 2007
Untrammelled capitalism has been allowed to set its own rules for far too long - and by a Labour Chancellor, who promised to put "stability" first
The earth tremor on financial markets this summer diverted attention from one of the trickiest problems inherited by Alistair Darling from his predecessor - the taxation of private equity.
The storm over the takeover of corporate Britain by the private equity princelings was at its height when Darling arrived at the Treasury in late June. Alliance Boots, the chemist chain, had just been swallowed by the original barbarians at the gate, Kohlberg Kravis Roberts (KKR), in a £10bn-plus deal that rocked not just the City, but the sensibilities of the nation. The private equity bosses found themselves in the midst of excoriating hearings before the Commons Treasury select committee at which the cavalier approach to jobs and pensions and generous tax advantages was on full display. But Gordon Brown and the government were convinced that private equity was too key a part of the Square Mile's success to be driven overseas.
The founder of the industry in Britain, Sir Ronald Cohen, was among Labour's biggest donors and the cerebral Cohen has the ear of the PM. Indeed, Brown included Damon Buffini - among the most controversial of private equity bosses for his role in displacing jobs and services at the AA - in his high-level Business Council. Asked in an interview with the Financial Times whether he was ready to tax private equity excess, Darling replied he would not be forced into a "knee-jerk" response to the public disquiet.
Now all the indications from the Treasury are that the government is plotting a retreat from the industry it so warmly embraced. The tax privileges seem sure to be curtailed dramatically in this autumn's pre-Budget report.
Paradoxically, the market already is punishing private equity and the nexus of hedge funds that have made so much money backing overseas and private bids for chunks of British industry. Most private equity deals and overseas takeovers have been financed by our leading high-street banks. Until this summer, the banks were able to lay off the risk inherent in such highly borrowed or leveraged deals by refinancing them. Some of the debt was parcelled up into neat packages, known as "collateralised loan obligations" (CLOs), and sold on to investment funds around the globe. But with the emergence of the crunch in the credit markets, the appetite for debt and funny money like CLOs has totally dried up. This has left the banks holding the loans and the big buyout houses like KKR, which bought Boots, nursing far higher interest-rate bills than they calculated.
Indeed, so tight has financing become that many private equity deals have had to be shelved altogether. Plans by Cadbury Schweppes to organise an auction for its American soft-drinks arm have had to be called off. Instead, Cadbury is considering issuing new shares in its US offshoot to existing shareholders. The mighty KKR itself has been forced to put off its own plans to offer some of its shares to the stock market.
At present, private equity in Britain enjoys two separate tax breaks. The first, known as "equity borrowing", allows the principals in a private equity deal to finance part of the initial capital they put into the deal by borrowing it from friendly banks. This allows them to treat the "equity" as loans in their personal and corporate balance sheets and deduct the interest charges against taxes. It is as if consumers were able to borrow the deposit for a house purchase from the bank, treat it as a business expense and deduct the interest from PAYE.
The second privilege is what is known in the trade as the "carried interest". This ruse allows the private equity titans to claim that their earnings are in fact profits, which are then taxed as capital gains rather than income. Under tax changes made by Gordon Brown, designed to encourage entrepreneurship, the capital gains tax rate falls to just 10 per cent - if an asset is held for just two years - against the 40 per cent tax rate that more wealthy earners pay on income. As a result, some of the most wealthy people in the country have been paying the least tax. The government fears that changing this tax incentive will drive the private equity industry offshore to Ireland or Switzerland.
It now looks as if Darling is ready to double the capital gains tax rate on "carried interest" to 20 per cent, in an effort to recapture some of the income being made by private equity. The difficulty for the Chancellor and HM Revenue & Customs will be devising a system that hits the private equity bosses, but leaves Britain's real entrepreneurs unscathed.
The tax clampdown, however, will be too little too late. The excess of the past five years demonstrates the dire consequences of allowing untrammelled capitalism to set its own rules and to enjoy unique tax privileges. That this should happen under Labour, which promised to put "stability" first, points to hypocrisy at the highest level.
Alex Brummer is City editor of the Daily Mail
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