As the upcoming budget nears, the private equity industry has much to fear as the potential rise in capital gains tax threatens to further stifle investment activity and drive investors out of the UK. Deborah Sterescu investigates…

The debate around a rise in capital gains tax has been ongoing for years now, as many believe it is a mistake for private equity and hedge fund managers to be taxed at such a comparatively low rate - now 18% - and once as low as 10%. As the forthcoming general election nears, the British Venture Capital Association (BVCA) has made its opinion on the matter clear, having just delivered a submission to the Treasury in which the trade body demands the rate of capital gains tax (CGT) be frozen in order to protect against further damage to "fundraising and investment activity".

"From an investor's point of view, the rise in the capital gains tax rate has the potential for a double whammy in that it will have an adverse impact on the number of deals done in the UK and on returns ultimately received. It will push investors to look elsewhere for deals," agrees Adam Levin of international law firm Dechert.

But this is not the end to the abundance of problems that could arise from an increase in CGT to 25%. "A rise in CGT will also affect private equity professionals for the worse, which the BVCA has not mentioned in its submission. Carried interest is not typically taxed except on a CGT type basis, and a rise to 25% could be another reason to drive the mobile private equity community out of the UK to places like Switzerland where there is 0% CGT. This has the potential to lead to a greater exodus than the AIFM Directive or anything else," he continues.

Measures to increase tax have been initiated around the globe as governments have hardened their fists in order to avoid a repeat of the financial turmoil witnessed in the last 18 months. In the US, Congress is looking to pass a bill that would force carried interest to be taxed as regular income as opposed to the more lightly taxed capital gains. Currently, the rate in the US for CGT is 15%, and a rise to 35% (the top income tax bracket in the US) is estimated to raise $24.6bn over 10 years.

Raising capital gains, however, could backfire, as in the UK it has been proven that more capital was raised in years when the CGT was at a lower rate. The move could also restrain risk-taking by dramatically lessening the potential rewards private equity professionals could reap, thereby unquestionably slowing the amount of capital sent out to struggling companies.

Levin explains that these tax measures can be seen as "headline grabbing potential" for the Government to clobber certain groups targeted during the downturn, while simultaneously reducing debt. "The upcoming budget will be used as a means to strike against the Conservative party and prove that the government is now acting prudently. It is a race between the two parties to raise as much tax as possible. We are walking a tight rope, and all this has the potential to lead to the double dip in the economy that everyone has feared," says Levin.