Potential changes to the tax treatment of carried interest

How is carried interest taxed?

The focus on carried interest or ‘carry’ is not new and the tax treatment of private investment funds has evolved since a memorandum of understanding between HMRC and the BVCA in 1987. 

The current tax regime for carried interest derives from anti-avoidance rules, introduced in April 2015, which are known as the Disguised Investment Management Fees (DIMF) rules. The DIMF rules were intended to ensure that amounts which represent compensation for investment management services were subject to tax as trading profits (up to 45% Income Tax and Class 4 National Insurance Contributions) rather than by reference to the underlying items.

The DIMF rules include an exemption for amounts, which meet the definition of carried interest. From July 2015, such carried interest amounts have been subject to a special regime which imposes a minimum Capital Gains Tax (CGT) charge (up to 28%) on carry distributions and rules for determining the ‘location’ of such gains.  

From April 2016, an exclusion to the carried interest exemption was introduced. Where carry is Income Based Carried Interest (IBCI), it will remain taxable as a trading profit. The IBCI rules require one to assess the average holding period for relevant fund assets whenever carry arises. Where the average holding period is more than 40 months, the IBCI rules will not apply and the CGT treatment mentioned above applies. Should the average holding period be less than this, some or all of the carry will be IBCI and be taxed as trading profits, though an exemption may be available if the average holding period test failed because the fund is in its early days. 

In the years that followed, the tax treatment of carried interest remained largely unchanged, though a number of clarifications were included in HMRC guidance released in the period.

However, in January 2022 HMRC revised its guidance to prevent relief for foreign taxes paid on carry. In order to mitigate the impact of these changes, Finance Act (No.2) 2023 introduced the option of an irrevocable fund-by-fund election, which is likely to be of most interest to US taxpayers. 

The future of carried interest

At this stage, it’s too early to be sure whether Labour will come into power in the next general election. Even if they do, it’s unclear how the abolition of the carried interest exception would be implemented and what transitional/grandfathering rules would apply.  

However, what does seem likely is that the abolition of the exemption would further increase both the complexity of carried interest taxation as well as the tax burden for investment managers. Additional rate taxpayers could be paying an extra 17% (the differential between 45% Income Tax and 28% (CGT), plus National Insurance Contributions on carry distributions if these amounts are taxed as trading profits rather than capital gain. The reclassification of capital gains as trading profits would also impact payments on account and the ability to offset losses. 

It's possible that the proposed changes could result in investment managers leaving the UK in order to escape punitive rates of tax. However, if carry is treated as trading profits and the manager has or will continue to work in the UK after becoming non-UK resident, a UK tax charge could still arise for those who have left.

There’s a vast amount of legislation with respect to carried interest and it can be difficult to ascertain how your carried interest will be taxed, as well as recognising any exemptions and elections you can benefit from. For professional advice on how your carried interest will be taxed, or if you want advice on any elections and claims you can make, please fill out the form below and one of our experts will be in touch to discuss your requirements and how we can help.