Our Alert issued on 14 Jan. 2025 discussed the UK government's consultation and call for evidence ("Consultation") on its proposals to reform the tax treatment of carried interest.
The Consultation proposed that from April 2026 all carried interest would be taxed exclusively under the income tax and NICs regime, but that "qualifying" carried interest which met certain conditions would be adjusted by a 72.5 percent multiplier, so that "qualifying" carried interest would be subject to income tax and NICs only at an effective rate of 34.075 percent.
For purposes of distinguishing "qualifying" carried interest from "non-qualifying" carried interest – which is the same as the existing "income-based carried interest" (IBCI) – the government proposed supplementing the existing average holding period (AHP) condition1 with one or both of two additional conditions. The two proposed new conditions were (i) a minimum investment manager's co-investment condition, measured at a "team" level; and/or (ii) a minimum "vesting period" between the award of an entitlement to receive carried interest and its receipt.
Government Response and Policy Update
On 5 June 2025, the government published the outcome of the Consultation, in the form of a Government Response and Policy Update on the Tax Treatment of Carried Interest ("Policy Update").
The Policy Update indicates that the government will not proceed with the introduction of either a minimum co-investment condition or a minimum vesting period condition. It will continue to be the case after April 2026 that, as now, the average holding period (AHP) condition will be the only condition that will apply to distinguish "qualifying" carried interest from non-qualifying carried interest (IBCI).2
Territorial Scope of the Carried Interest Regime
The Policy Update confirms that it is the government's broad intention in bringing "qualifying" carried interest into the income tax (and NICs) regime – alongside IBCI – that "qualifying" carried interest should be subject to UK tax/NICs so far as the carried interest either arises to a UK-resident holder or, in the case of a non-UK resident carried interest holder, the carried interest is attributable to services performed by the carried interest holder in the UK. It will no longer be automatically the case that "qualifying" carried interest arising to a holder who is a non-UK resident at the time that they receive the carried interest will escape UK tax.
However, the government has always recognised that this principle – that carried interest should suffer UK tax to the extent that it is attributable to services performed in the UK – is difficult to apply to non-UK residents who make short and/or infrequent business trips to the UK. It has acknowledged that, under the UK's double tax treaties, the carried interest received by such a holder will suffer UK tax only where the holder spends a sufficient amount of time in the UK to be treated as having a UK "permanent establishment", but these permanent establishment rules can be difficult to apply in practice and also have no relevance where the holder is resident in a non-treaty country.
Accordingly, the Policy Update also proposes statutory limitations, where HMRC will not treat "qualifying" carried interest received by a non-UK resident as attributable to services performed by the holder in the UK (but will instead treat such carried interest as attributable to non-UK services). These limitations are:
- First, where the non-UK resident holder does not meet a UK workday threshold of 60 workdays in the tax year in which the UK services are performed; and
- Secondly, where three full tax years (in addition to the tax year in which the carried interest is received) have passed since the tax year in which the UK services were performed, and in none of those tax years was the holder either UK resident or over the UK workday threshold of 60 workdays.
- Additionally, it will remain the case (as discussed above) that where a non-UK resident carried interest holder is resident for the tax year in which UK services are performed in a jurisdiction with which the UK has a double tax treaty, a part of the carried interest will be treated as attributable to those UK services – and hence potentially liable to UK tax – only where the non-UK resident had a permanent establishment in the UK for the tax year in which he performed those UK services.
The government also intends to provide clarity on how carried interest is apportioned between investment management services performed in the UK and those performed outside the UK, and to this end will mandate a time-based apportionment method, by reference to the number of workdays in the relevant period.
Position of Private Credit and Debt Funds
As discussed above, the government's decision not to add further conditions when drawing the line between "qualifying" carried interest – subject to income tax/NICs at the effective 34.075 percent rate – and non-qualifying carried interest/IBCI – subject to income tax/NICs at 47 percent – means that the average holding period (AHP) condition remains the only test to be applied in making this determination.
However, the government has also recognised that some private credit and debt funds face considerable practical difficulties in applying the AHP condition to their investment strategy despite in substance following a long-term investment strategy, that should be treated as meeting the AHP condition. Accordingly, the Policy Update sets out a number of proposed detailed changes to the AHP condition in this context designed to improve its operation and make the rules more straightforward to apply. Broadly, the specific changes proposed include widening the range of circumstances in which the AHP condition can be met by direct lending funds; introducing a new provision for all types of credit fund which will make it more straightforward to identify the specific times of acquisition and disposal of credit assets; revising the rules governing when disposals of unwanted short-term investments can be disregarded in working out the AHP (because such disposals would otherwise distort the AHP) and addressing various other technical issues, such as the treatment of tax distributions.
Conclusion
The government's recognition of some of the difficulties inherent in the current carried interest regime, and its decision not to add further conditions to the tests for identifying "qualifying" carried interest, are very welcome. We understand that the government's proposals will now be embodied in draft legislation for technical consultation, which should be helpful in resolving any remaining glitches ahead of the anticipated inclusion of the legislation in the upcoming Finance Bill.
Footnotes
1. Broadly, the average holding period condition (which will remain in place) requires a calculation of the average value-weighted holding period of all assets in the fund at the time that a sum of carried interest arises to a carried interest participant. Only if that average holding period is greater than 36 months at the relevant time will some part of the carried interest be treated as "qualifying" carried interest. The relevant period must be greater than 40 months for all of the carried interest to be treated as "qualifying" carried interest.
2. Some carried interest holders currently rely upon the so-called "ERS exception" under which carried interest is automatically "qualifying" carried interest (and is not IBCI) where the entitlement to receive carried interest is an "employment-related security" (ERS) – i.e., an entitlement that is granted to a carried interest holder who is an employee and who receives the entitlement (or is deemed to receive the entitlement) "by reason of employment". However, the government has confirmed its intention to abolish the ERS exception from April 2026, so that satisfaction of the average holding period condition will, with effect from that date, be the only means by which carried interest can be "qualifying" carried interest.
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