Draft legislation was published on 21 July to treat all carried interest as trading income, following changes to the carried interest regime announced in the 2024 Autumn Budget. The draft legislation is subject to a technical consultation running until 15 September, and whilst there are likely to be some technical changes made in this period, we can assume the key economic conditions are fixed.
As such, we can expect the new rules to apply from April 2026 to all carried interest received after that date with no grandfathering provisions.
The new rules build on the existing rules and the definition of carried interest remains the same, but it is worth noting that the definition of “Investment Schemes” has been broadened to include Alternative Investment Funds (AIFs) under the Alternative Investment Fund Managers Regulations 2013, which is broader than the previously narrow definition of the Collective Investment Scheme under s.235 FSMA 2000.
Changes in the draft legislation:
Two of the previously announced conditions have been dropped:
- Co-investment requirements
It was originally proposed in the Autumn Budget that there would be a minimum co-investment by managers to qualify for carried interest.
- Minimum holding period
It was also proposed that there would be a minimum holding period for fund interests to qualify for carried interest treatment.
The dropping of these is welcome, as they would have created an additional burden for funds and unfairly impact smaller funds, funds with restricted liquidity and certain investment strategies. It also helps keep the UK carried interest regime more in line with international norms and internationally competitive.
Confirmation of treatment:
The draft legislation has confirmed that carried interest will be subject to Income Tax, replacing the previous capital gains treatment.
Qualifying carried interest will have a 72.5% multiplier, giving an effective rate of 34.1%. Non-qualifying carried interest will be taxed at the full Income Tax and National Insurance rate of up to 47%.
The qualifying carried interest conditions will broadly replace the previous income-based carry rules.
To be considered qualifying carried interest, the investments in the fund will have to have an average holding period of 40 months or more. The rules for working out the average holding period are similar to the old income-based carry rules.
It is important to note that whilst the income-based carry rules did not apply to carry, which was taxed under the employment-related securities (ERS) regime, this exclusion is not carried over into the new rules. As such, the qualifying conditions will apply to all carried interest.
Whilst under the new regime, generally, carried interest will only be subject to Income Tax, it is possible for a charge to also arise under the earnings provision or employment related securities provision of ITEPA03. In those circumstances, there will be a “just and reasonable” adjustment to the carried interest tax charge to prevent a double tax charge.
Internationally mobile managers
As expected, the carried interest rules will apply to non-residents if the carried interest arises from UK-based services. As such, these rules will apply to carried interest arising from investment management services performed in the UK, regardless of the individual’s residence status.
However, the draft legislation contains a number of important concessions which have reduced the impact of the rules for non-residents:
- Non-residents will only be subject to tax on carried interest if they have 60 or more workdays in the UK in a tax year. The workday definition will be the same as in the Statutory Residence Test (SRT), a workday being defined as a day on which the individual does three or more hours of work in the UK
- Individuals will not be subject to UK tax on their carried interest if they have three full years of non-residence and have not breached the 60 day test
- There will be transitional rules. Services provided prior to 30 October 2024 will not be treated as UK work days.
As well as the above concessions, if a non-resident is resident in a country with a double tax treaty with the UK, such profits will also need to be attributable to a UK permanent establishment of the individual for the UK to have taxing rights. It is expected that HMRC will provide guidance on what is considered a permanent establishment.
If you have any questions about the treatment of carried interest or the upcoming changes please contact Stephen Kenny.
