UK Government Updates Tax Regime for Carried Interest

As part of the Autumn Statement, the UK government on 30 October 2024 announced a reform of its taxation of carried interest. This follows a call for evidence on the reform of the UK taxation treatment of carried interest in July, and considerable speculation on how that reform might take shape.

The tax treatment of carried interest is a subject that has been increasingly scrutinised by various governments around the globe. The UK government has been under considerable pressure from a number of industry bodies and advisors not to make reforms so substantial that they would risk changing taxpayer behaviour (such as private equity principals changing their place of residence). The announcement made acknowledged the vital contribution private equity makes to the UK economy. The reform is to take place in two stages.  

The first is that the rate of tax that applies to carried interest in the UK, to the extent it is treated as a capital gain and not employment or other income, will increase from 28% to 32% for carried interest arising on or after 6 April 2025. The existing complex regime that determines what returns can be treated as carried interest that is taxable as capital gain (rather than as income) will remain in place for now.

The second stage of the reform will be more substantial and is designed to create a “simpler, fairer and better targeted” regime from April 2026. Some high-level details have been disclosed in a second consultation, on which representations can be made until 31 January 2025. The revised regime is designed to safeguard the UK as an asset management hub. The proposal is a new regime that brings carried interest within the income tax regime, rather than capital gains, but with its own classification rules and effective rate of income tax.

The existing rules that deem certain carried interest returns to be income where the underlying assets have not been held by the fund for a sufficiently long period—the income-based carried interest (IBCI) rules—are to be retained, but may be varied. For carried interest that does not fall within the IBCI rules, it appears that the basic rules that determine which individuals qualify for returns to be treated as carried interest will be retained, but those returns will be treated as trading income and taxed accordingly, albeit with special computational rules to reduce the effective rate of income tax. They will also be subject to national insurance contributions (NICs), as a result of which the effective rate of tax (including NICs) is expected to be around 34%.

COMMENT

The appropriate tax treatment of carried interest has been debated and amended over the years, and the current system is already complex. The proposed reform is less aggressive than some of the options that were being discussed—see our August 2024 LawFlash UK Government Calls for Evidence on the Reform of Carried Interest. The consultation document calls for views on various aspects of the proposed reform, including a requirement for carried interest holders to make a minimum capital co-investment, and possible changes to the period of time before which carried interest can fall within the regime.

It is somewhat hard to imagine that the new regime from 2026 will indeed be “simpler” than the existing regime, given that the existing qualification requirements look to be largely retained, and will then be overlaid with special computational provisions to reach the stated effective rate of tax. Consideration is also being given to introducing a minimum holding period by individual carried interest holders, which could have anomalous results, e.g., where preexisting carried interest is reallocated following a departure or where there is a new joiner to an established team.

The implication is that the new regime will apply to returns arising from April 2026, regardless of when the individual first became a carried interest holder. To the extent the capital contribution rules are changed, this could present some challenges, especially with respect to funds launched prior to the new rules being finalised, not to mention the complexity of some fund structures and the ability to measure capital contributions.

Given the importance of the asset management industry to the UK’s economy, we hope that the government will continue to adopt a collaborative approach with stakeholders and to react favourably to the concerns that more radical changes could impact the UK economy.

HOW WE CAN HELP

Our lawyers stand ready to discuss the latest consultation and are interested in hearing the views of clients and contacts with a view toward making a composite submission to the government. If you would like to discuss this or participate in our response, please contact the authors or your usual Morgan Lewis contact.