Carried Interest: the discussion carries on

As the Chancellor, Rachel Reeves, had already made clear her intention to close the carried interest ‘loophole’, budget announcements affecting carried interest were hotly anticipated, particularly by those in the private equity and venture capital industry. Over the summer, there was a call for evidence to engage with interest parties ahead of the budget and to help shape Labour’s policy. In this article, we examine the changes and what they may mean for fund managers and the sector.

On budget day, the Chancellor announced that from April 2025 the Capital Gains Tax (CGT) rate on carried interest will be increased by only a few percentage points to 32% – not quite the hike everyone feared. However, it was also made clear that this was only to pave the way for further reform, that will take effect by April 2026, allowing for a period of technical consultation in the meantime.

The proposals for reform are fully outlined in the government’s 28-page response document to the call for evidence. In short, the intention is for carried interest to be taxed as trading profits and subject to income tax and Class 4 National Insurance contributions.

However, taking into account the unique nature of the reward, ‘qualifying’ carried interest will be adjusted down by applying a 72.5% multiplier. Qualifying carried interest will be all such interest, save for that within the Income Based Carried Interest rules, which will in turn be taxed fully at 45%.

Currently, there is no suggestion of grandfathering or transitional arrangements for existing fund structures – the new rules may apply in all cases from day one of the new arrangements.

The technical consultation will come to an end in January 2025, with draft legislation being produced thereafter. The new regime is therefore not fully settled, and the industry will no doubt be looking to respond to the consultation.

Whilst the consultation process will provide the industry with the opportunity to voice their concerns in respect of the increase, it is also likely that private equity houses are going to need to reconsider how they structure their investments going forward. They will need to take into consideration not only the carried interest changes but also the increase in CGT paid by their investors. The split of any economic interest between investors and the private equity individuals is going to be closely analysed against the need to incentivise the management team (who will also be looking at their own tax position). Finding a balance here is likely going to be become more difficult to achieve.

Of course, the government also has a difficult line to tread. On the one hand it needs to ensure the UK remains ‘open for business’ and recognise the importance of the investment management industry to the UK economy, particularly given the government’s overall aim to boost economic growth. On the other, it has a stated aim of implementing a ‘simpler, fairer and better targeted’ system that ensures the reward is taxed ‘in line with its economic characteristics’ and boosting tax revenue.

However, there is a real risk, particularly when viewed alongside other changes affecting internationally mobile taxpayers (i.e. non-doms), that those in this industry will be driven to other jurisdictions with more attractive and more certain tax regimes. Whether or not this helps to deliver the outcome the government is after, we will wait and see.

What is carried interest?

Carried interest is a form of performance-related award received by fund managers, primarily within the private equity sector. Unlike other such rewards, which are taxable at income tax rates, carried interest is currently taxed at CGT rates (18% or 28%). The lower rates of tax were designed to recognise the risk many fund managers take when they co-invest in funds and that their return is dependent on the performance of the underlying investments and their ability to generate a prescribed preferred return for their investors. The rates also took into account the amount of time in which investment profits are distributed, the return not being immediate.

Whilst carried interest may at first glance appear to directly affect relatively few, the impact on the sector and wider economy is not to be underestimated. There are some big numbers at stake, for example, in the 2023 tax year 3,000 dealmakers earned £3.7 billion in carried interest.