Taxation of Carried Interest Ahead of the Autumn Budget

As the autumn budget approaches, there is speculation about potential updates to the taxation of carried interest. Labour has previously made clear their intention to amend the current regime, although it is unclear what the government’s final position will be.

What is carried interest?

Carried interest, often referred to as “carry,” is a share of the profits that fund managers – primarily within the private equity industry – receive as part of their compensation. Unlike a salary or bonus, carried interest is contingent on the performance of the fund. Typically, fund managers receive carried interest only if the fund achieves a certain level of return, known as the hurdle rate.

The mechanism of carried interest involves fund managers receiving a percentage of the profits, usually around 20%, after the investors have received their initial investment back along with a preferred return. This structure aligns the interests of the fund managers with those of the investors, incentivising managers to maximise the fund’s performance.

Why is carried interest controversial?

Most financial incentives, such as bonuses and employment-linked share awards, are taxed as income. At the highest rate, this attracts a rate of 45%. Carried interest, on the other hand, can be taxed at the Capital Gains Tax rate of 28%.

This position has been accepted ever since the private equity industry agreed a memorandum or understanding with HMRC in 1987. However, some consider that carry should be properly characterised as income (as it requires no capital to be risked, unlike genuine co-investment) and believe it should be taxed accordingly. 

What might be implemented?

Labour’s aim to close what they refer to as the “carried interest loophole” will almost certainly result in changes to the taxation of carried interest, although there are several options they might choose:

• Taxing carried interest as income rather than as capital gains. This would be at the recipient’s marginal rate of income tax of up to 45% (47% including national insurance).
• Raising the CGT rate for carried interest. While gains on residential property are taxed at 24%, and gains on other chargeable assets are taxed at 20%, carried interest already attracts its own rate of 28%. This could go up – closing the gap to the top rate of income tax but not necessarily matching.
• Require fund managers to invest a certain percentage into a fund to access favourable carried interest rates although it is not clear whether this would be meaningfully different to existing co-invest arrangements.

Combined with the expected changes to the non-domicile regime, applicable to many private equity professionals who have come to work in the UK, the autumn budget appears likely to have a significant impact on the PE industry. Those affected should be prepared to take advice as to their options once the changes are announced.