Labouring Over the Loophole: The Labour Government's Proposed Reform of Carried Interest Taxation

Reform In Motion

The Chancellor’s announcement on Wednesday that the UK’s capital gains tax (CGT) rate for carried interest would be increased by only a few percentage points from 28% to 32%, effective April 2025, was welcome news to many. However, as speculated in the press over recent weeks and months, this preliminary rate hike will pave the way for more substantial changes to the regime.

From April 2026, the UK’s revised carried interest regime will sit wholly within the Income Tax framework with only so-called “qualifying” carried interest enjoying preferential tax treatment whereby a 72.5% multiplier will be applied to determine the amount subject to income tax (at 45%) and Class 4 national insurance contributions (at 2%). This will result in an effective tax rate of circa 34.1% for carried interest which meets the qualifying conditions – though precisely what those conditions are remains subject to further technical consultation.

The two conditions being considered for this special computational rule to apply are (i) an aggregate minimum co-investment amount, and (ii) a minimum holding period. From the consultation document released on Wednesday, it seems that the UK government favours the second of these, given perceived difficulties with a minimum co-investment requirement.

Most notably for carry participants resident outside of the UK, the new regime is also expected to introduce a territorial element to the taxation of carried interest, such that non-UK resident carry participants performing investment management services in the UK could be subject to tax under the new UK carried interest tax regime.

Expectations Versus Reality

While many had hoped for lighter reforms resembling the French or Italian regimes which require a minimum co-investment to benefit from preferential CGT rates, the UK government has suggested more fundamental change with a view to “ensuring that reward is taxed in line with its economic characteristics”. The new rules will instead establish that carried interest will, as a starting point, be characterised as trading income – a reward for the provision of investment management services, which some argue reflects the true nature of carried interest returns.

Others would say that the change is more ideologically driven and that carried interest is already taxed in line with its economic characteristics under the current regime. However, from a new baseline of full income tax treatment, the inclusion of the special computational rules for certain “qualifying” carried interest reflects at least a dose of pragmatism in recognition of the unique nature of carried interest and the importance of the investment management industry to the UK economy. Just how pragmatic, though, will depend on the precise nature of the qualifying conditions coming out of the newly launched technical consultation (which launched on Wednesday and will close on 31 January 2025).

The Proposed Post-April 2026 Regime – In Detail

• Income Tax Framework: All carried interest (apart from carried interest that falls within the Income Based Carried Interest (IBCI) rules, which is charged to income tax under the Disguised Investment Management Fee (DIMF) rules) will be fully taxed as trading profits (at 45%) arising from a deemed trade in the UK (similar to the DIMF rules). CGT rates will no longer be available – income tax treatment will apply regardless of the nature of the carried interest return (e.g. capital gain, dividend or interest). Disposals of rights to carried interest will also be treated as carried interest amounts.
• Territorial scope: Carried interest returns will be treated as arising from a deemed trade performed in the UK where they relate to investment management services performed in the UK. Non-residents may therefore be subject to UK income tax on their carried interest to the extent it relates to investment management services performed by them in the UK (again, similar to the position under the DIMF rules).
• Class 4 National Insurance Contributions (NICs): Self-employed NICs will also be charged (at 6% for profits from £12,570 to £50,270, and 2% for profits above £50,270).
• Deductions: As under the current regime, the amount brought into charge (before the application of any multiplier for qualifying carried interest) will take account of certain permitted deductions (broadly, any consideration paid for the right to receive those carried interest amounts and any amount treated as income on grant of the award).
• Multiplier for “qualifying” carried interest amounts: As noted above, a 72.5% multiplier will be applied to amounts of “qualifying” carried interest in determining the amount subject to income tax and self-employed NICs. Assuming an additional rate taxpayer, this result in an effective tax rate of circa 34.1% (including Class 4 NICs).
• Qualifying Conditions: The Government is consulting on two potential conditions for carried interest to be “qualifying” for these purposes. It is unclear from the consultation document whether these are alternative or cumulative conditions.
  • A minimum holding period requirement: This refers to the time between a fund manager being awarded their right to carried interest and when they actually receive it (i.e. when it pays out). It would be assessed on an individual basis and be unrelated to the asset holding period of the fund. Some respondents to the previous call for evidence quoted an average waiting period of seven years. However, the Government acknowledges that there is significant variation depending on investment strategies and some may hold their rights for a shorter period.
  • A minimum co-investment requirement: Any minimum co-investment condition would likely be based on a percentage of total investor commitments (potentially measured on an aggregate basis), similar to regimes in other countries (e.g. France, where a 1% commitment is required). However, the Government recognises that this presents several practical challenges given the complexity of fund structures and is seeking input on how this could be measured at a team level to prevent arbitrary or distortive outcomes, especially for junior members with less capital to invest.
• Transitional arrangements: The consultation document suggests that no transitional measures will be included for existing structures as part of the proposed reforms.

Additional Points to Consider

• The income tax charge under the new carried interest regime will be an exclusive charge, regardless of the character of the carried interest received. This could theoretically yield a lower effective tax rate than under the current regime where a material portion of the return takes the form of interest and/or dividends. However, any holding period condition may well make this an unlikely outcome in practice.
• The qualifying carried interest rules will sit alongside the DIMF and IBCI rules, providing a comprehensive income tax regime for investment management compensation. The IBCI rules will also be amended so that they apply to all carried interest awards (removing the carve-out for carry arising in respect of an employment-related security), meaning that employees and directors will also fall within the scope of the IBCI rules.
• The changes to the carried interest rules coincide with the replacement of the non-dom rules with a new four-year foreign income and gains regime. Very broadly, this new regime will provide 100% relief on eligible foreign income and gains for new arrivals to the UK in their first four years of tax residence, provided that the new arrivals have not been UK tax residents in the ten tax years immediately prior to their arrival (under the domestic statutory residence test, rather than pursuant to a treaty). Qualifying carried interest which relates to non-UK services may benefit from relief under this regime.

Concluding Thoughts

The Government’s proposals leave the investment management industry and its advisers with a lot to digest, but fortunately some breathing space in which to do so. With the status quo largely in place for the next 18 months (save for the rate increase in April 2025), hasty restructuring of carried interest arrangements can thankfully be avoided. However, the lack of any transitional measures for existing structures leaves carried interest holders uncertain about their future UK tax treatment. While the Government aims to create a simpler, fairer regime that remains globally competitive, the complexity and practical challenges are clear. Moreover, leaving aside the potential minimum co-investment and/or holding period conditions, the UK’s effective carried interest tax rate of circa 34.1% will still rank among the highest in Europe.