Carried interest is the share of the profit earned by the fund due to the investment managers on the funds’ investments.
The carried interest is structured as a relatively small investment into the fund and once the external investors have received the initial capital back, together with a fixed return (the hurdle rate, often set between 6%–8%), the carried interest holders will receive a return, typically 20% of the fund’s returns above the hurdle rate.
The definition and treatment of carried interest were historically set out in a Memorandum of Understanding between the British Private Equity & Venture Capital Association (BVCA) and HMRC in 2003. The memorandum set out that provided the carried interest met the definition agreed in the memorandum, the carried interest returns were incredibly tax‑efficient. The carried interest arising on disposals of investments would be taxed at normal capital gains rates and the availability of base cost shift would allow managers to pay tax on a gain far below the actual economic return.
However, over the years carried interest has been subject to several targeted rules which have increased the tax burden on carried interest and removed many of these benefits.
The 2024 and 2025 Budgets introduce the most significant changes to this landscape since the original BVCA/HMRC agreement, shifting carried interest towards income‑based taxation from April 2026.
How is carried interest taxed
When calculating the taxable gain on carried interest, a manager is only able to deduct the actual amounts paid for the carried interest and any amounts that have been subject to income tax. As the manager will have typically invested at the start of the fund’s life, any base cost will be minimal.
Transitional year – 2025/26
From April 2025, carried interest is subject to a new, higher Capital Gains Tax (CGT) rate of 32% for one year only.
This replaces the previous 28% carried interest rate during this transitional period.
From April 2026 – fundamental reform of carried interest taxation
From April 2026, carried interest will be taxed as trading income, and will therefore be subject to:
- Income Tax
- Class 4 National Insurance contributions
However, qualifying carried interest will benefit from a 72.5% multiplier, resulting in an effective tax rate of just over 34% at current tax rates.
Broadly to qualify, carried interest must meet a 40‑month holding period test.
Non‑qualifying carried interest from 2026 onwards will be treated as income and taxed at full Income Tax and NIC rates.
Who is taxable
In most circumstances, carried interest is taxable on the individual who has performed the investment services which have given rise to the carried interest distribution, even if the carried interest is legally owned by someone else.
It used to be common for carried interest to either be put into a trust or held by family members (spouse/minor children) to take advantage of their lower tax rate.
Now where carried interest is owned by someone else (or a trust) the carry will be taxable on the legal owner and the investment manager. This can give rise to a double tax charge.
Tax relief is given by a tax credit to the manager for the tax paid by the legal owner.
However, there can be specific problems for carried interest held in a trust structure, which used to be particularly common for non‑domiciled taxpayers. This is considered further here.
Internationally mobile managers
The 2024 Budget introduced important new rules for individuals moving into and out of the UK:
Profits attributable to all duties performed in the UK prior to 30 October 2024 are not taxable (grandfathering protection).
Profits will not be taxable if, in the relevant year, the individual is non‑UK tax resident and performs fewer than 60 UK workdays.
Profits attributable to UK duties can be treated as non‑UK duties where:
- the individual has been non‑UK resident for at least three tax years, and
- in each of those years, they worked fewer than 60 workdays in the UK.
These measures are particularly relevant for private equity professionals whose roles span multiple jurisdictions.
For more information, please contact Stephen Kenny.
