This year, from 6 April, the capital gains tax rate for this interest will rise to 32 per cent from 28 per cent. From April next year, all carried interest will be taxed as income, although the specific details are open to consultation. These are substantial changes for private equity firms and others in this investment space.

The following article examines changes that the UK government is making to carried interest. Carried interest is a share of profits from a private equity, venture capital, or hedge fund paid as incentive compensation to the fund's general partner – the people running the fund. The tax treatment of this has been criticised by those arguing that it is unduly light, and gives those running such funds an easy ride. Others beg to differ. To discuss the issue is Stephen Kenny (pictured below), partner at PKF Littlejohn. The editors are pleased to share these ideas; the usual editorial disclaimers apply. If you wish to join the conversation, email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com.
 

Stephen Kenny

In the lead up to last autumn’s Budget, there was much speculation about the Chancellor closing the carried interest “loophole” – which, rather than being a loophole, was a deliberate, long-standing treatment of carried interest. 

While changes to the carried interest regime were indeed announced by the government, they were not as radical as some people had expected – but they will still have a significant impact on the private equity industry. In this article, we look at the new rules, their likely consequences and how best to plan for the change. 

What is changing?
The changes to carried interest are being introduced in two stages:

From 6 April 2025, the capital gains tax (CGT) rate for carried interest will rise to 32 per cent from 28 per cent.

The more substantial changes will come into effect the following year. Some of the detail is still subject to consultation, and we are expecting draft legislation later this year. 

At the moment, we know that from April 2026, all carried interest will be taxed as trading income. This means that the carried interest will be subject to both income tax and National Insurance, therefore being taxed at an effective rate of up to 47 per cent (45 per cent income tax for an additional rate taxpayer and 2 per cent National Insurance).

This treatment will apply to all carried interest received irrespective of whether it is capital in nature, interest or a dividend. It is hoped that this simplification of the existing regime will flow through to easier reporting, which at the moment can be overly complicated and, in my experience, is often done incorrectly.  

As trading income, carried interest will be treated as UK source when the investment management services, which give rise to the carried interest, are performed in the UK, and outside the UK when those investment management services were performed outside the UK. This means that non-residents will be subject to income tax on carried interest when it relates to services performed in the UK, subject to the terms of any applicable double taxation agreement. This approach will mirror the current treatment under the Disguised Investment Management Fee Rules (DIMF). 

For “qualifying” carried interest, there will be a multiplier of 72.5 per cent which will reduce the effective tax rate to 34 per cent from up to 47 per cent (based on current income tax and National Insurance rates). Given that this rate will apply to all carried interest, it could potentially lead to a reduction in the rate for people who are receiving carry predominately as interest or dividends. The effect of the changes in rates is shown below:

Whilst carry tends to arise on equity disposals as a capital gain, people who are receiving carry as dividends or interest are likely to be better off under the new regime.

How will carry qualify?
It is worth stressing that further conditions are expected to be added to the carried interest rules. To be considered “qualifying,” we expect that carry will need to meet a modified version of the existing Income Based Carry Rules (the 40-month holding period requirement). In addition, the current exclusion from the Income Based Carry Rules for carry that is within the Employment Related Securities regime will be abolished. This means that the test will apply equally to self-employed and employed managers.  

The test will also include two new additional conditions, which are subject to further consultation:
1) A minimum co-investment commitment
There will be a new requirement for a minimum co-investment by the managers into the fund. It is being suggested that this will be assessed on a collective, rather than individual, basis. 

2)  A minimum holding period between the award of the right to receive carried interest and the receipt of the carried interest
The individual will have a minimum time period between being awarded the right to receive the carried interest and the date the carried interest is paid. This differs from the current Income Based Carry Rules, which are assessed at the fund level. 

This test will apply to all carried interest arising after April 2026; there will be no grandfathering of existing arrangements. 

What can be done to plan for the changes?
There are three recognised routes for planning for these changes:
1) Check that the carry structure will work under the new rules; 
2) Crystallise carry under the current regime at current rates; and
3) Leave the UK and move to a lower tax jurisdiction.

Everyone, without fail, should be reviewing their current carry structures – both to confirm that their carry arrangements will be compatible with the new regime and also to estimate the change in their liability (which will inform whether they want to pursue option 2 or 3). 

Crystallising carry at the current rates is an interesting option. This would most likely involve selling portfolio companies to a follower fund, restructuring or selling companies. However, the commercial considerations must take precedence over any potential tax saving. Before a fund is able to undertake any restructuring, it would have to consider the obligations to the investors.

For example, crystallising by selling to a third party is only realistically going to be an option for a fund approaching maturity – and the manager would still have obligations to the investors to get the best price (which may not be easy if there is a rushed sale). As such, whilst this should be considered, it is not something I have seen being put into practice very often. 

That then leaves us with the option of exiting the UK for a jurisdiction with a lower tax rate for carried interest. This is a big step but, in my experience, has proven to be the most popular response so far (and I am not the only advisor seeing this). 

So where are these people going?
The United Arab Emirates and, to a lesser extent, Saudi Arabia have become popular destinations over the last few years as neither charge tax on carried interest. However, many are choosing to stay closer to home and opting for jurisdictions such as Jersey or European countries that have a lower tax rate (Spain, for example, taxes carried interest at 22.8 per cent). It might also be possible to take advantage of the non-domiciled regime being introduced in countries such as Italy which, for the payment of a charge, would take foreign carry outside the tax regime and is available for up to 15 years.

If you are thinking about leaving the UK, you will need to work out if you can take the necessary steps to become non-resident. This would mean considering the number of days you would need to be in the UK for work and leisure, if you would keep accommodation in the UK and the impact on family members. 

The changes to the carried interest rules will have a significant impact on many in the private equity industry. As the full details of the changes unfold, planning ahead and seeking professional advice will be key in navigating this shifting tax landscape. 

About the author:

Stephen Kenny is a specialist in private client and has over 15 years of industry experience. His expertise covers non domicile and residence, advice on investing in the UK, and family wealth planning, as well as support with taxes such as Capital Gains Tax and Inheritance Tax. Kenny has significant expertise in the private equity and venture capital fund sector, covering fund structuring, EIS/CT tax reliefs for investors, tax support to the wealth management industry, the taxation of crypto assets, and business lifecycle planning, including providing tax advice to management teams on exit.