Top of the watch-list for most private capital managers at this year's Budget was what reforms the government would make to the UK's carried interest tax regime.
As announced at the despatch box, the headline carry capital gains tax rate will increase from 28% to 32% for the 25/26 tax year. However, this is just a 1 year stop gap, as the Government intends to introduce major structural reforms to the carry rules from 6 April 2026 onwards. Taking inspiration from the German carried interest regime, carry arising from April 2026 will be brought fully within the UK income tax code, and taxed as deemed trading income (at combined income tax and NI rates of up to 47%), regardless of the underlying character of the carry return. However, a discount mechanism will apply to so-called "qualifying carried interest". Under this mechanism, 27.5% of any qualifying carry will be taken out of the UK tax net, resulting in an effective tax rate for additional rate taxpayers of ~34.1% (72.5% x 47%).
Whilst the discount mechanism will significantly reduce the UK's headline carry rate from full income tax rates, it will put the UK rate at the very top of the European mainstream (above the German rate at 28.5% and on par with the French rate at 34%). The move from capital gains to income tax treatment is also likely to introduce significant technical complexity, including in relation to double tax treaty relief claims by non-UK resident carryholders. However, given the new tax regime will effectively apply a discounted flat rate of income tax to all carry returns, regardless of their underlying character, there may be some private capital strategies that end up better off under the new rules (although we will need to await the detail of the new regime).
"Qualifying" Carried Interest and Changes to the IBCI Rules
Key to the new rules will be understanding what constitutes "qualifying carried interest".
1. Minimum holding period for the fund
The starting point is that qualifying carried interest will be carried interest which is not caught by the UK's long-term carried interest rules (known as the 'income based carried interest rules'). These are the rules which require a fund to have held its assets for a sufficiently long period of time: broadly, defined as an average holding period of at least 40 months. The existing rules will largely stay the same, subject to one important change: the rules will be extended to bring employees within the scope of the rules (the current rules only apply to self-employed LLP members). This change has the potential to significantly impact private credit funds, in particular. Helpfully, the government has indicated that there may be scope for amendments to the existing IBCI rules to ensure they work appropriately for these funds.
2. Further limitations
In addition to the minimum holding period for the fund requirement, the government is exploring introducing either or both of two further conditions for carry to be treated as qualifying.
- A minimum co-investment requirement, such as is seen in the French and Italian carried interest regimes. In an important concession for industry, the government has confirmed that any such condition would only apply on a team (rather than individual) basis, and the government has expressly recognised the importance of not disproportionately impacting junior executives.
- A minimum holding period of the individual, such that, in addition to the fund's minimum average holding period, individual executives would have to hold their right to carried interest for a minimum time period before receiving carried interest returns. In this regard, the government notes that the responses it received to the call for evidence suggested that 7 years was a typical individual holding period.
Of the two conditions, the latter may be the government's preference as it notes the "practical challenges associated with implementing a co-investment condition".
No decision has been made on the conditions, but, if either were introduced, it would represent a significant tightening of the requirements to access preferential carried interest tax treatment.
The public consultation on these additional conditions closes on 31 January 2025.
Transitional rules
In an unwelcome (but not unsurprising) announcement, the government confirmed that it does not consider that there is any case to exclude existing fund structures from the new regime once it takes effect in April 2026 or to provide any other transitional provisions (other than potentially in limited circumstance if either of the further limitations is introduced).
Interaction with new FIG regime
Qualifying carried interest that relates to non-UK services performed by an executive should benefit from relief under the new 4-year FIG regime.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
