As part of the Autumn Budget 2024, the Government announced that the capital gains tax rate on carried interest (a performance-related reward for fund managers enhancing the performance of a fund) will increase from 28% to 32% from April 2025. This is an interim measure before more comprehensive reforms take effect in April 2026.
This is a much lower rate than the 45% top rate of income tax and so could perhaps be seen as not as bad as first feared by fund managers. However, in addition to this announcement, the Government has also launched a new consultation on proposed revisions to the taxation of carried interest (off the back of its previous consultation) which would have a far larger impact if adopted. The Government believes there is a "compelling case for reform" and so the measures would seem likely to see the light of day in some form.
New tax regime
From April 2026, carried interest will be taxed as trading income and will be subject to Income Tax (current rates being up to 45%) and Class 4 National Insurance contributions. This change aims to simplify the tax regime and ensure that carried interest is taxed within the income tax framework (whilst retaining a number of familiar concepts from the existing regime).
New effective tax rate
'Qualifying carried interest' will benefit from special computational rules which will apply a 72.5% multiplier (i.e. giving a 27.5% reduction) to the amount of these deemed trading profits. This gives an effective tax rate of 32.625% for additional higher rate taxpayers (plus National Insurance Contributions) on current rates.
Qualifying carried interest conditions
"Qualifying carried interest" will have to: (a) not be Income Based Carried Interest ("IBCI"); (b) meet the existing average holding period test; and (c) satisfy further conditions that are the subject of the consultation but may include: (i) the amount of capital invested; and (ii) the amount of time between the right to carried interest being awarded and payout.
Territorial scope
The deemed trade will be treated as carried on in the UK to the extent that the investment management services are performed in the UK. This means that non-UK residents will be subject to UK Income Tax on carried interest only to the extent that it relates to services performed in the UK (subject to double tax treaty provisions).
Changes to IBCI rules
The existing exclusion from the IBCI rules for employment related securities will also be removed to address inconsistencies in treatment. This will have the effect of bringing self-employed carry holders within the IBCI rules (although it is stated that this change will not affect the application of existing rules to carried interest awarded to employees). There is an acknowledgement that this change may have a disproportionate impact on credit funds which will be addressed prior to implementation via targeted amendments.
Returns on co-invest
The consultation states that co-investment returns (including those received by fund managers) will be unaffected by these changes.
Consultation period
The Government is consulting on the design of these conditions until 31 January 2025.
Implementation timeline
The new tax regime will be fully implemented by April 2026, with the interim measure of the CGT rate increase taking effect from April 2025. Draft legislation for the more wide-reaching reform will be published during 2025.
Impact on existing funds
The consultation states that the rules will apply to existing fund structures and that it does not consider there is any case for grandfathering or transitional provisions.
Next steps
The reforms are stated to be "part of a broader effort to make the tax system fairer while maintaining the UK's position as a global asset management hub". The consultation period will clearly be key in ensuring the competing objects are balanced in a way that keeps the UK fund management industry competitive.
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