Carried interest, a share in the profits of a private equity fund's investment, is currently taxed at 18% or 28%. The Government plans to change this, viewing the current regime as too generous. From 6 April 2025, the capital gains tax rate on carried interest will rise to 32%. From 6 April 2026, all carried interest will be treated as trading profits and subject to income tax as well as national insurance, with a 72.5% multiplier reducing the effective tax rate for ‘qualifying’ receipts. The new regime will build on existing rules and will apply to both employed and self-employed fund managers.
Summary
Carried interest is a share in the profits of an investment made by a private equity fund, granted to fund managers, and is contingent on the performance of that investment. Due to its unique nature, carried interest has its own tax regime, which currently sees these distributions taxed at a rate of 18% or 28%. The Government considered this regime too generous and promised to bring in a new tax regime to close a perceived 'loophole'.
What is changing?
Changes will be introduced in two phases:
- From 6 April 2025, the existing regime will remain but the rate of capital gains tax that applies will increase to 32%
- From 6 April 2026, all carried interest will be treated as trading profit and subject to income tax and national insurance contributions. A 72.5% multiplier will apply to reduce the rate of tax for ‘qualifying’ carried interest receipts
The new regime will build on top of existing rules and definitions for carried interest. It will not displace the existing disguised investment management fee (DIMF) and income based carried interest (IBCI) rules.
The existing regime will continue to apply until 5 April 2026 to allow time for consultation on the new regime, enabling the definition of qualifying carried interest to be refined.
New regime
IBCI rules already apply to subject specific carried interest receipts to income tax and national insurance. This is the case where the average holding period of the investments, to which the carried interest relates, is less than 36 months, with a blended approach for holdings of 36-40 months.
The new regime will build on this regime and treat any carried interest that is subject to IBCI rules as trading income.
For ‘qualifying investments’, those not caught by the IBCI rules will then see the effective tax rate paid on carried interest reduced by a ‘multiplier’ mechanism.
It is intended that this will reduce the amount of carried interest subject to taxation by 72.5%. For an additional rate taxpayer, this would effectively reduce the rate of tax and national insurance to 34%.
Modification to IBCI rules
The Government plans to modify the IBCI rules, to remove an exemption for carried interest received in connection with employment and subject to employment-related securities (ERS) rules. This will broaden the scope of the rules to catch both employed and self-employed fund managers in future.
A consultation document has also been issued to seek views on further modification to these rules to broaden their application to two suggested areas:
- Requiring a minimum threshold for capital invested by fund managers and;
- Requiring a minimum period of time between the award of carried interest and its receipt
The consultation period will run until 31 January 2025 and it is not expected that further detail will be available before early Spring 2025.
Territorial scope of carried interest
It will continue to be possible for individuals to limit the amount of carried interest that is subject to UK taxation where the investment management services leading to the carried interest were performed outside the UK. This will only apply for individuals qualifying for the new four-year foreign income and gains regime.
However, the reclassification of carried interest as trading income will create a new liability to taxation for non-UK resident individuals who receive carried interest arising in respect of duties performed within the UK.
Our comment
Private equity is a significant part of the UK economy, serving both as a source of investment for UK businesses and as a key industry within the UK’s financial services sector. Currently, London ranks second only to New York as the world’s leading private equity hub.
Senior executives are now more mobile and flexible than ever. There was concern that any overreach by the Chancellor could prompt these executives, who pay large amounts of tax at the highest tax rates, to relocate to more favourable jurisdictions. This could diminish the sector and reduce long-term capital funding for UK businesses.
Our pre-Budget wishes were for the Chancellor to balance the need for increased tax rates with maintaining the UK’s competitiveness relative to other major economies, as well as to ensure simplicity and consistency in the application of the rules.
While overall tax rates are increasing, it is at least a small consolation that they have not risen significantly relative to the main rate of capital gains tax, now at 24%. It is also helpful that the new regime will build on existing definitions and rules, with a period of consultation on modifications to the definition of qualifying carried interest. However, it is disappointing that there will be no transitional provision for existing carried interest entitlements that are yet to be received.
It also remains to be seen whether these changes, coupled with stricter tax rules and more onerous reporting requirements for individuals moving to the UK, will severely limit the UK’s attractiveness as a hub for private equity.