In last autumn's Budget, the Government announced its intention to overhaul the taxation of carried interest, increasing the applicable rate of capital gains tax (CGT) from 28% to 32% from 6 April 2025, bringing the new taxation regime into force from 6 April 2026. We wrote about the announcements in July last year.
The Government consulted on the proposed changes last summer and the response was published on 5 June. It confirmed that draft legislation will be published for technical consultation before the summer recess with the intention of bringing the changes into effect with the Finance Bill 2025/26 and confirmed some policy updates.
Current tax treatment of carried interest
Broadly speaking, a stand-alone CGT regime has applied to carried interest since July 2015 provided certain conditions are met. It should be noted that an income tax liability might also arise, i.e. where the carried interest is paid out of dividend or interest income with relief from double taxation being available where this occurs.
What's changed, and what effect do we think this will have on the PE industry?
The Government's response to the consultation
While the response to the consultation does not include a U-turn on the proposed change to bring carried interest within the income tax framework, the Government has confirmed that it will implement a number of the recommendations submitted.
The Government has confirmed it will not introduce a minimum co-investment requirement, nor will it introduce a minimum time period requirement on the basis that the existing asset-level average holding period (AHP) condition together with the tax rules which apply to carried interest, are sufficient to limit qualifying carried interest treatment to long-term rewards. The net effect means that carry, subject to internal "house" rules, can potentially continue to be allocated to a relatively wide universe of PE investment professionals within a PE house (i.e. not just the senior executives who can meaningfully co-invest out of their own pockets, as would have been the case if the proposal had not been dropped).
Several legislative changes will also be made to the AHP, including (but not limited to) the introduction of a bespoke provision for all types of credit fund, which will deem debt investments to be made and disposed of at a specific time to make the application of the rules more straightforward and better reflect commercial reality.
Further, the Government intends to introduce three statutory limitations on the territorial scope of the revised regime. These limitations will apply where qualifying carried interest arises to a non-UK tax resident so that the territorial scope of the new regime applies proportionately. It is hoped this will ensure the fair taxation of rewards for UK work whilst maintaining the UK’s attractiveness as a global centre of asset management activity. The statutory limitations will work in conjunction with any relief available under an applicable double taxation agreement (DTA).
The statutory limitations are as follows:
- any services performed in the UK prior to the Autumn Budget will be treated as if they were non-UK services;
- any UK services performed in a tax year in which the individual is neither UK tax resident nor meets a new UK workday threshold (i.e. where a non-UK tax resident spends at least 60 workdays in the UK in the relevant tax year) will be treated as non-UK services; and
- any UK services performed in a tax year will also be treated as non-UK services if three full tax years (in addition to the then current tax year) have passed during which time the individual was neither UK tax resident nor met the UK workday threshold (as set out above).
As such, qualifying carried interest which arises to a non-UK tax resident will only be subject to UK tax where it relates to services performed in the UK (determined by reference to the number of UK workdays) and all the following apply:
- the UK services were performed within the previous three tax years;
- the UK services were performed in a tax year in which the individual was UK tax resident or met the UK workday threshold; and
- where there is an applicable DTA, the UK services are attributable to a UK permanent establishment of the relevant individual.
As announced in the Autumn Budget, the legislation will remove the current exclusion which limits the application of the income-based carried interest (IBCI) rules to self-employed fund managers so that these apply to all fund managers regardless of their employment status.
Our view
The Government has shown a willingness to listen to industry due to the importance of private equity as a source of investment, employment and economic activity in the UK. Failing to listen would perhaps go against the "agenda for growth" and work against the interests of UK PLC.
From a practical perspective, not including the co-investment requirement, means that PE sponsors can sensibly continue to incentivise their investment professionals through the allocation of carry points and across appropriate levels within their teams. To effectively restrict carry to only individuals wealthy enough to co-invest would have limited the industry's attractiveness to up and coming talent.
Another key point to note is that direct lending funds (which many large PE sponsors are now running as strategies alongside traditional buyout) now automatically fall within the average holding period rules in the AHP condition. The certainty this provides can only be a good thing, given the huge growth in private credit as an asset class following the financial crisis. With a record-breaking Q1 for global private credit fund-raising in 2025, aligning the UK's carried interest regime to incentivise UK managers to raise and deploy direct lending and credit funds domestically is crucial. Capturing this investment is essential, as these funds significantly contribute to the growth of UK middle market companies, a key driver of the economy.
It will be interesting to see the draft legislation when it is published before the Government's summer recess to see if it remains as positively balanced as the consultation response.