Autumn Budget 2024: Taxation of Carried Interest for UK Executives

Following the release of the UK budget, we have summarised below the increased carried interest tax rate and new carry tax regime, together with some initial recommendations.

1. Tax Rate Increase

The government has announced an increase in the minimum effective tax rate for carried interest from 28% to 32%:

• This increase will apply from April 2025.
• The UK currently taxes carried interest at a minimum effective tax rate of 28%. This rate is a minimum because it applies in addition to the tax paid by executives under the usual tax rules (nil for return of the amount invested; 20% for gains, before the budget; 38.1% for dividends and 45% for interest) with the executive claiming credit for the lower rate of tax. For example, carry paid entirely as return of investment or gains is taxed at the 28% minimum effective gains tax. In contrast, carry paid entirely as interest is taxed at 45%.
• The minimum effective tax rate will increase to 32% from April 2025. Following that increase, carry paid entirely as return of investment or gains will be taxed at 32% and carry paid entirely out of interest will continue to be taxed at 45%.
• The increase will therefore affect executives whose carry is mostly paid as return of investment or gains, which would typically be the case for private equity funds.

Funds that have flexibility over when to realise carried interest, may wish to consider realising carried interest before the rate increase in April 2025.

2. New Regime

The government has announced that it will introduce a new regime for carry taxation with effect from April 2026:

• All carried interest will be taxed as trading income (subject to 45% income tax and 2% self-employed NICs) unless the carried interest satisfies certain qualifying conditions.
• The qualifying conditions are not final, but the government is considering:
  • A minimum co-investment requirement; and/or
  • A minimum time requirement between the award and receipt of carried interest.

If the carried interest satisfies the qualifying conditions, the amount of distributions taxed as trading profits will be adjusted by applying a 72.5% multiplier (so only that proportion of carried interest will be taxed as trading profits) resulting in an effective tax rate of 34.1%.

• The disguised investment management fee rules (DIMF) and the income based carried interest rules (IBCI) will continue to apply, so that the adjusted rate for qualifying carried interest is only available if the carry is not caught by DIMF (i.e. truly represents carry rather than management fees) or the income based carry rules (i.e. the fund's investment portfolio is held for an average holding period of 40 months or more).
• The IBCI rules currently apply to executives who are self-employed LLP members but not to employees. The IBCI rules will be extended to employees.
• The new regime will apply to existing funds so that carried interest which does not satisfy the qualifying conditions is all taxed as trading income.
• The government intends to introduce this new regime from April 2026 and has launched a consultation on the technical aspects.

Funds being raised now should consider including the flexibility to satisfy the proposed qualifying conditions, noting that the final form of these proposals is uncertain. This could include an acknowledgement by both investors and executives that they will assist in satisfying the qualifying conditions at the request of the fund. In addition, fund managers whose executives are employees and so have not needed to consider the IBCI rules should consider how those rules will apply to their funds.

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