Reforms to the UK tax treatment of carried interest

Summary

Significant changes to the UK tax treatment of carried interest were announced in the October 2024 Budget and are due to come into effect from 6 April 2026. Further detail has been published by the government relating to the extent of these proposed reforms, in the form of a response to a consultation launched following the initial announcements (see here).

The government’s response appears to take on board many of the concerns raised by the private equity industry about these changes. However, we are still awaiting the final details for how these changes will be implemented, with the draft legislation now expected before the summer recess in July 2025. In the meantime, individuals can now start to plan and review their affairs with greater confidence as to the likely impact of these changes and may find the latest iteration of these proposals to be more generous than anticipated.

Background

The UK tax treatment of carried interest arising to those in the private equity industry has long been a matter of scrutiny by UK governments.

In 2016, the concept of income-based carried interest (IBCI) was introduced for carried interest in funds which do not hold their underlying assets for at least 40 months on average (though only a proportion of the carry will be treated as IBCI if the average asset holding period is 36 months or more). IBCI is treated as profits of a deemed trade and is subject to income tax at marginal rates and national insurance contributions (NIC). However, significantly, the IBCI rules do not currently apply to employment related securities (ERS) and so do not generally apply where the individual providing investment management services is an employee, rather than a partner, in the structure.

As regards the tax treatment of carried interest which is not IBCI, this currently depends on the nature of the receipt. If the carry arises in capital form, it is subject to capital gains tax (CGT), albeit at the higher rate of CGT, which until 30 October 2024 was 28%; whereas if the carry arises in income form, it is typically subject to both CGT and income tax, but relief can be claimed to avoid double taxation.

In the Budget on 30 October 2024, it was announced that the CGT rate, where applicable to carried interest, would increase from 28% to 32% with effect from 6 April 2025. In addition, it was announced that with effect from 6 April 2026, carried interest would be reformed so that it would be taxed fully under an “income tax framework”.

In summary, it was proposed that:

• the exclusion for ERS from the IBCI rules would be removed (thereby widening the scope of who will be caught by these rules);
• b) where carry will not fall within the IBCI rules, it will instead be “qualifying carried interest”, which will be treated as profits of a deemed trade and similarly subject to income tax and NICs, but special computational rules will apply whereby the amount of the deemed trading profits will be subject to a multiplier of 72.5%, so that the effective rate of tax (assuming income tax at 45% and NICs at 2%) will be just over 34%; and
• the rules for determining qualifying carried interest will broadly follow the existing carried interest rules as regards its definition and when it is treated as arising, but it was announced that further conditions may also be applied, such as a minimum co-investment requirement or a minimum ownership period for the carried interest rights, which were to be subject to a consultation.

A consultation on those reforms was then launched, with many in the industry highlighting potential issues with the proposed changes. The government’s response to this consultation was published on 5 June 2025.

When announced in the Budget in October 2024, these income tax framework proposals were a particular concern to those individuals who were either considering relocation, or had already relocated, from the UK. This is because a key difference between qualifying carried interest being treated as profits of a deemed trade rather than as capital gains or income, is that the proportion of the carry which is regarded as relating to services performed in the UK will be taxable even if the individual is non-UK resident when it arises (subject potentially to relief under any applicable double taxation agreement (DTA)). In contrast, under current law, carried interest (other than IBCI) arising to a non-UK resident individual is generally speaking not taxed in the UK, unless the temporary non-residence rules are engaged, which may occur if the individual resumes UK residence within a certain period (typically, 6 tax years) of having ceased UK residence. (As IBCI has always been treated as profits of a deemed trade, this territorial issue already exists for carried interest subject to those rules, though similarly subject potentially to relief under any applicable DTA).

Summary of key points from consultation response

First, in light of the feedback in the consultation, the government has confirmed that they will not proceed with a minimum co-investment requirement nor with a minimum ownership period for holding carried interest rights.

As expected, the government has confirmed that they will legislate to remove the exclusion for ERS from the scope of the IBCI rules. Various technical amendments will also be made to the IBCI rules, where they are currently considered to be too restrictive. However, no change is being made to the mechanics for calculating the average holding period itself.

On tax compliance/administration matters, the government has confirmed that under the revised tax regime for qualifying carried interest, income tax and national insurance contributions paid in the previous tax year on carried interest will be relevant to the calculation of any payments on account due, notwithstanding the unpredictable and irregular nature of carried interest payments. However, they note that there a mechanism for taxpayers to make a claim to reduce or cancel payments on account to avoid overpayments of tax.

As regards the key change, to bring “qualifying carried interest” into the income tax framework too, the government’s stated position is that where services are performed in the UK, carried interest should be taxed in the UK. In particular, the government is “not willing to maintain a position in which a fund manager can spend many years working in the UK, only to become non-resident shortly prior to receiving carried interest and thereby not be subject to UK tax on the reward”. However, they also wish to maintain the UK’s attractiveness as an international hub for investment management activity and so have sought to balance these dual aims with these reforms.

The government’s view is that a typical DTA will allocate taxing rights to the UK in respect of carried interest received by a non-resident which is attributable to a UK permanent establishment (under the provision of the DTA which relates to Business Profits, typically Article 7). They say that the UK’s domestic legislation will reflect this fact. However, they acknowledge that there may be uncertainties about how the other contracting states will treat this situation.

Consequently, the government intends to introduce three statutory limitations on the territorial scope of the revised regime. The statutory limitations, which will apply where qualifying carried interest arises to a non-resident, are as follows:

• In order to provide proportionate transitional rules, any services performed in the UK prior to Autumn Budget 2024 (30 October 2024) will be treated as if they were non-UK services;
• Any UK services performed in a tax year in which an individual is neither UK tax resident nor meets a new UK workday threshold will be treated as if they are non-UK services. The UK workday threshold will be met if an individual who is not UK tax resident spends at least 60 workdays in the UK in the relevant tax year; and
• Any UK services performed in a tax year will also be treated as if they were non-UK services if three full tax years (in addition to the then current tax year) have passed during which time the individual was neither UK tax resident nor met the UK workday threshold. [emphasis added – see below]

As regards how carried interest is apportioned between investment management services performed in the UK and those performed outside the UK, the government will mandate a time-based apportionment method, by reference to the number of UK workdays in the relevant period.

The consultation response summarises the position as follows: qualifying carried interest which arises to a non-resident will only be subject to UK tax where it relates to services performed in the UK (determined by reference to the number of UK workdays) and all of the following apply:

• The UK services were performed within the previous three tax years [emphasis added – see below];
• The UK services were performed in a tax year in which the individual was UK tax resident or met the UK workday threshold; and
• Where there is an applicable DTA, the UK services are attributable to a UK permanent establishment of the relevant individual.

These statutory limitations potentially reduce quite significantly the extent to which non-UK residents who have previously performed services in the UK will in fact be taxable on carried interest.

However, it is unclear how the second statement quoted in bold above accords with the first statement quoted in bold above. The former seems to suggest that any UK services will fall out of account after three complete tax years have passed, whereas the latter suggests that UK services will only fall out of account once the individual has been non-UK resident and not met the UK workday threshold for at least the previous three tax years. The exact scope of this “three-year rule” should be clarified once the draft legislation is received, but, in the meantime, it would be prudent to assume, and seems to be generally understood, that the more restrictive wording will apply. The draft legislation is expected before the summer recess in July 2025 for technical consultation. These territorial limitations also seem to be specific to qualifying carried interest and there does not appear to be any intention to extend them to the IBCI rules.

To illustrate the significance of these territorial limitations, take the example of Mr A:

• Mr A is a partner of B LLP which provides investment management services to a fund.
• Mr A was awarded carried interest rights in the fund on 30 October 2020 at a time when he was UK resident.
• Up until 6 April 2026, Mr A carries out 60% of his services for B LLP in the UK.
• Mr A becomes non-UK resident with effect from 6 April 2026 but continues to perform services for B LLP in the UK for 75 days per tax year thereafter.
• Carried interest arises to Mr A on 30 October 2030.

According to the consultation response, all of the services which Mr A performed in the UK up to 30 October 2024 will be treated as non-UK services, even though 60% were actually performed in the UK. As regards the services performed between 30 October 2024 and 30 October 2030, and assuming the more restrictive interpretation of the three-year rule mentioned above, all of the services performed in the UK since 30 October 2024, i.e. from 30 October 2024 to 30 October 2030, should be included as UK services, because Mr A will have met the UK workday test (of 60+ days) in each tax year of his non-UK residence. The question would then be whether Mr A’s new country of residence has a DTA with the UK under which he might qualify for some relief.

There is no mention in the response document of the temporary non-residence rules, but as things stand, the temporary non-residence rules would not apply to the non-UK source element of the deemed trading profits and so it would not appear to be necessary for Mr A to remain non-UK resident for 6+ tax years in order to protect this from charge – it should only be necessary for him to be non-UK resident in the tax year of receipt.

By way of a different example:

• Mrs C is a partner of D LLP which provides investment management services to a fund.
• Mrs C was awarded carried interest rights in the fund on 30 October 2020 at a time when she was UK resident.
• Up until 6 April 2026, Mrs C carries out 80% of her services for D LLP in the UK.
• Mrs C becomes non-UK resident with effect from 6 April 2025 but continues to perform services for D LLP in the UK for 36 days per tax year thereafter.
• Carried interest arises to Mrs C on 30 October 2026.

As with Mr A, all of the services which Mrs C performed in the UK up to 30 October 2024 will be treated as non-UK services, even though 80% were actually performed in the UK. As regards the services performed in the UK between 30 October 2024 and 30 October 2026, only such services performed during the period from 31 October 2024 to 5 April 2025 (i.e. whilst she remained UK resident) will be treated as UK services. From 6 April 2025, Mrs C is no longer UK resident and does not meet the UK workday test and so her further services performed in the UK will be treated as non-UK services. This should be the case regardless of the exact terms of the three-year rule mentioned above. Consequently, it appears that none of Mrs C’s carried interest will be taxable in the UK if she is non-UK resident in 2026/27, and even if she were to resume UK residence in 2027/2028.

The impact of these reforms

Whilst some of the details are still to be clarified, the response to the consultation shows that the government has listened to industry concerns and hopefully these last details will be clarified when the draft legislation is published in July 2025. However, it will remain to be seen how these reforms will impact on individuals’ decision making about their long-term plans for the UK.

As noted above, under current law, non-UK resident individuals in receipt of carried interest (other than IBCI) who have previously been UK resident, typically need to maintain their period of non-UK residence for 6 complete tax years to protect the carried interest from charge to CGT or income tax. It does not matter when during the period of non-UK residence the carried interest arises, as long as the non-UK resident period is of sufficient duration. Under the proposed new income tax framework for qualifying carried interest (and subject to the transitional rule mentioned above), it seems that an individual may need to be non-UK resident (and keep their UK workdays below a 60-day per annum threshold) for at least three tax years to protect carried interest then arising to them in the fourth or later such tax year of non-UK residence from charge. If the carried interest arises sooner than that, at least a proportion of it will still be chargeable to tax in the UK (subject to any relief which might be available under any applicable DTA).

The transitional rule for services performed before 30 October 2024 is surprisingly generous (particularly as no transitional rules had been expected at all) and will no doubt be welcomed by many of those affected by the changes. It may however also mean that individuals wishing to relocate before receiving their carried interest may decide to do so sooner rather than later, i.e. to maximise the proportion of their carried interest deemed to relate to non-UK services.