Carried interest tax changes will reshape fund manager compensation

Fund managers should take the opportunity to input to the government consultation relating to the scope of the reforms.

What is carried interest?

Carried interest refers to the performance-related rewards received by fund managers, primarily in the private equity industry. Unlike other rewards, carried interest can currently be taxed at lower capital gains tax (CGT) rates, compared with income tax rates of up to 45%. The government believes that the current tax regime does not accurately reflect the economic characteristics of carried interest or the risk assumed by fund managers and so is planning to implement, first interim and then more sweeping, reforms.

The treatment of carried interest as a capital gain rather than as income subject to income tax was originally based on the view that carried interest represented a return on investment rather than compensation for services.

The current 28% carried interest rate is only relevant to the extent the profit represents capital gains from underlying disposals in a fund. If carried interest comprises interest income, it is already subject to income tax at up to 45% and dividends are subject to income tax up to 39.35%.

The position has evolved, however, over the years. In 2015, the UK introduced the Disguised Investment Management Fee (DIMF) rules, which aimed to tax certain management fees as income rather than capital gains. This was followed by the introduction of the Income-Based Carried Interest (IBCI) rules, which further aligned the tax treatment of carried interest with income tax principles.

Both the DIMF rules and IBCI rules can be applied to classify carried interest at trading income which is taxed at up to 47% - 45% income tax plus 2% National Insurance Contributions (NICs).

The recent changes announced in the 2024 Budget represent the latest step in this evolution, with the government seeking to ensure that the tax regime for carried interest reflects its economic characteristics and aligns with broader tax policy objectives.

Interim changes

One of the key announcements was the increase in the CGT rate on carried interest from 28% to 32%, effective from 6 April 2025. This interim measure is designed to bridge the period until more comprehensive reforms take effect in April 2026.

The immediate rate hike aims to align the tax treatment of carried interest with other forms of income, ensuring a fairer and more stable tax regime.

Comprehensive reforms from April 2026

Starting from April 2026, carried interest will be taxed as trading profits under the Income Tax framework. This shift means that carried interest will no longer be subject to CGT but will instead be taxed as income, at rates of up to 45% plus Class 4 NICs with special computational rules applying a 72.5% multiplier to ‘qualifying carried interest’.

This approach reflects the long-term investment nature of carried interest and aims to ensure that fund managers' tax rates align with the economic characteristics of these rewards.

Income-Based Carried Interest (IBCI) rule amendments

The Budget also announced amendments to the (IBCI rules. These changes will remove exclusions for employment-related securities, ensuring consistent application across all fund managers.

Additionally, for non-UK residents, carried interest will be subject to income tax only on the portion related to services performed in the UK, mirroring the approach taken under DIMF rules.

Impact on fund managers

The interim increase in the CGT rate to 32% from April 2025 will result in higher tax bills for fund managers in the short term. The shift to taxing carried interest as trading profits from April 2026 will give rise to an effective tax rate of 32.625% plus NICs – i.e. 34.075%, in aggregate – for additional higher rate taxpayers.

Under the upcoming reforms, the character of the returns – gains, interest, dividends – will not be required to be considered when applying the relevant taxation rate. Instead, the rate will be determined with reference to whether carried interest is “qualifying” or not - i.e. whether the new flat rate of 34.075% or the up to 47% rate, including NICs, applies.

Essentially, this will mean that, where the “qualifying carried interest” conditions are met:

• returns from a fund generating predominately capital gains, for example, a venture capital fund, will be taxed at a higher rate – 34.075% versus 28% previously and 32% in 2025/2026;
• returns from a fund generating mostly interest, for example, a credit fund, will be taxed at a lower rate – 34.075% versus 45% previously.

Examples of impact on compensation

When the proposed changes take effect in 2026, there will be a flat rate of income tax of 32.625% for qualifying carried interest. The effective tax rate with class 4 NICs is 34.075%, examples of which, assuming the carried interest represents capital gains, are demonstrated below:

• short-term impact: a fund manager who receives £1 million in carried interest in the 2025/2026 tax year will see their tax liability increase from £280,000 under the previous 28% CGT rate to £320,000 under the new 32% CGT rate. This immediate increase in tax will reduce their net compensation by £40,000;
• long-term impact: from April 2026, the same fund manager receiving £1 million in carried interest will be taxed as if making trading profits. Assuming the effective tax rate of 34.075% including NICs, their tax liability will be £340,750, reducing their net compensation by £60,750. This is slightly higher than the interim CGT rate but reflects the comprehensive nature of the new tax regime;
• ·non-UK residents: a non-UK resident fund manager who performs 50% of their services in the UK and receives £1 million in carried interest will be taxed only on the portion related to UK services. Under the new rules, they will pay income tax on £500,000, resulting in a tax liability of approximately £170,375 – 34.075% of £500,000.

Further examples for fund managers

For a fund manager earning £5 million in carried interest, the tax liability under the new regime would be £1,703,750 – 34.075% of £5 million. This represents a significant increase compared to the previous CGT rate, an increase of £303,750, where the tax liability would have been £1,400,000 – 28% of £5 million.

A fund manager earning £500,000 in carried interest will see their tax liability increase from £140,000 under the previous 28% CGT rate to £160,000 under the new interim 32% CGT rate in the short term. From April 2026, their tax liability will be £170,375 – 34.075% of £500,000.

New consultation on qualifying conditions

The proposed reforms are to apply to all funds, including existing funds. Fund managers therefore need to consider whether they will have qualifying carried interest. Any employed managers who were excluded from applying the IBCI rules, because of the employment related securities exemption that will be removed, will be brought within those rules and so will need to look at the investment holding periods of the fund investments to determine the extent to which they will have qualifying carried interest.

The criteria for qualifying carried interest are still to be finalised, but the government has indicated that it will align more closely with regimes in other European countries. To ensure that preferential tax treatment aligns with long-term investment, the government is exploring additional qualifying conditions, including a requirement for a minimum amount of co-investment to be made and minimum period between the award and receipt of carried interest. Its consultation, open until 31 January 2025, will assess the viability of these conditions, aiming to create a regime that enhances the UK's appeal in asset management while maintaining fairness and clarity.

Fund managers are encouraged to participate in the consultation process by submitting written responses, attending meetings, engaging with industry associations, providing case studies, and staying informed.

Managers will need to consider how the rules apply to both new and existing carried interest arrangements.

Co-written by Chloe McMenemy of Pinsent Masons.