Autumn Budget 2024: Carried interest reform

Amidst the uncertainty over what tax measures will be announced at the Autumn Budget, there are a few areas of the tax system where the Government has already set out their stall and on which we should expect changes to be announced on 30 October 2024. Reform to the taxation of carried interest is one such area, regularly cited throughout the election campaign as one of Labour’s flagship revenue-raising tax policies, the Government reconfirmed their commitment to take action to ensure fairness in the tax system and released a call for evidence on 29 July 2024. 

In this article we explore the current taxation of carried interest, the proposed changes by the Government alongside our response to the call for evidence and the potential impact of these changes.

How is carried interest currently taxed?

Carried interest is a form of performance-based reward for investment managers, typically structured as a share of the profits generated by an investment fund managed by those investment managers. For private equity and venture capital funds, these profits are primarily derived from capital gains arising on realisation of the underlying assets held by those funds.

Carried interest is currently taxed at a rate of 28% (higher than ordinary capital gains tax rates, but lower than the highest income tax rates), reflecting the long-term and capital gains-based nature of carried interest, driven by growth and capital appreciation of investments.

However, current UK tax legislation already provides a number of existing measures where the specific capital gains tax rate is not available and returns are taxed as income. This includes:

• where carried interest is satisfied by way of income profits (for example in the form of interest income or dividends)
• the Income Based Carried Interest (IBCI) rules where returns on investments held for the shorter-term (<40 months) are taxed at income tax rates
• the Disguised Investment Management Fees (DIMF) rules which prevent fund managers from converting what is effectively trading income into a capital receipt
• the employment-related securities rules, whereby carried interest awards which are granted to employees with market value in excess of the consideration paid, may be brought within the charge of income tax and NICs in certain circumstances.

While much of the debate surrounding the taxation of carried interest has focussed on the private equity and venture capital industry, this form of incentive reward is used throughout the private capital industry, across all asset classes (including private credit, real estate, infrastructure) and funds with a range of different strategies.

What is the Government proposing to change?

The Government has committed to reform the tax treatment of carried interest to ensure it appropriately reflects its economic characteristics and the level of risk assumed by the fund managers who receive it. The call for evidence focused on gathering stakeholder input on the economic characteristics, market practices and global comparisons of the taxation of carried interest rather than providing a roadmap for what reform could look like.

Following closure of this call for evidence, the specifics of how and when reform could be implemented remain uncertain and it has been confirmed that further detail will be provided at the Budget on 30 October 2024. 

Changes to the tax rate applies to carried interest

At the crux of the issue though, is the current differential in the tax rate applied to carried interest, which is taxed at capital gains tax rates rather than the (often higher) income tax rates.  With this differential regularly cited by Labour as the “carried interest loophole”, the expectation is that the Government will look to close this differential in rates. It was initially feared that practically this could either be achieved by increasing the rate of CGT charged on carried interest to equate with income tax or to alter the underlying tax treatment of carry so it is subject to income tax.

In our response to the call for evidence, we highlighted that:

• To protect the private capital ecosystem, the tax regime of private capital funds and carried interest must encourage investment without imposing punitive rates that could drive capital elsewhere
• Categorising carried interest as performance income could reduce the alignment of incentives between investors and investment managers which may have inadvertent outcomes, such as a focus on short-term, high-frequency investing
• Several non-UK jurisdictions have adopted specific tax regimes in respect of carried interest and regulatory policies in an attempt to compete with the UK as a leading global asset management hub – any policy changes should ensure the UK remains a viable and attractive jurisdiction for investment management and private capital

These concerns were echoed throughout the industry and there has been media speculation that the Government is now looking for a “compromise” so as not to hit fund managers with the top 45% tax rate. Rachel Reeves told the Financial Times (6 October) that “we are approaching this in a responsible way and we need to make sure we aren’t reducing investment in Britain.”

With this in mind and with speculation that there could be wider increases to capital gains tax rates, we predict that the tax rate for carried interest will increase beyond these rates but not as high as the top income tax rates.

Co-investment

Another area where we expect further detail in the Budget is whether all carried interest will be taxed in the same manner.  Rachel Reeves has previously been quoted in the Financial Times (18 June) stating that “if you are putting your own capital at risk it is appropriate that you pay capital gains tax.”, indicating that reform could be more nuanced depending on the underlying fact pattern. Rachel Reeves was also quoted as noting the amounts required to be invested by fund managers were “lower than many other countries require” to qualify for favourable tax treatment.

In our view, this commitment to co-invest lends to the argument, though is not the sole factor, that carried interest retains some of the economic characteristics of capital gains, by reflecting the investment risk taken by investment managers. This can often reach substantial amounts of capital at risk by the investment manager collectively.

Many countries such as France and Italy require the fund manager and/or the executives to make a minimum co-investment in the funds they manage, aligning the interests of managers and investors, promoting responsible investment practices. However, these requirements may create a barrier to awarding carried interest to junior staff who may be unable to contribute significant amounts of co-investment. As outlined in our response to the call for evidence, the Italian regime looks at co-investment made collectively by the fund manager rather than on an individual basis, which could alleviate this concern.

Next steps?

Practically, there is little that can be done before we receive some clarity with respect to the proposed reforms on 30 October. Of course, there may be some individuals who look to relocate to jurisdictions where the tax treatment of carried interest is more certain and more favourable. However, there are an array of considerations both from a personal tax perspective for the individual relocating and for the investment manager which will need to consider direct tax consequences for the entity such as corporate taxes and transfer pricing, in addition employment laws, regulations and other commercial issues of establishing a presence in another jurisdiction.

Management fee, carried interest and co-investment terms are negotiated and agreed with the investors at the outset of the fund and typically cannot be amended without the approval of the investors. Any changes following announcements on 30 October will need to be considered carefully from a legal and tax perspective and therefore fund managers may wish to review the terms of their existing and prospective funds.

While there is no guarantee of their inclusion, we stressed in response to the call for evidence the importance of including “grandfathering”, tapering, or transition period adjustments in our representations given the closed-ended nature of most private funds, to provide clarity, reduce undue tax outcomes for existing fund structures, and prevent an immediate exodus of investment management professionals.

Consideration will also need to be given to how the changes impact different asset classes and/or investment strategies, and how the tax regime interacts with other regimes worldwide in the event of double taxation.

In conclusion

The Government's proposed changes to the taxation of carried interest have far-reaching implications for the private capital industry. It is crucial to strike a balance between ensuring fair tax treatment and maintaining the UK's attractiveness as a leading global financial centre. A stable and favourable tax regime for long-term, performance-based investments will reinforce the UK's position and support its economic growth objectives.

The UK is not alone in taxing carried interest at rates different from income tax, many other jurisdictions around the world also have similar regimes.  Thus, our central message in our representations to Government on that matter is that any changes to the prevailing tax treatment of carried interest should be carefully considered in the context of the UK’s attractiveness as a globally leading hub for alternative investment management.

The UK faces stiff competition from other jurisdictions like Luxembourg, Ireland, Spain, Italy, France and the US, which offer bespoke tax and regulatory regimes for carried interest. To remain competitive, the UK must ensure that any changes to the tax regime do not disadvantage its private capital industry. Clear and consistent tax policies will be essential to attract and retain investment expertise, support job creation, and foster economic development.

The best regimes have clear legal frameworks, appropriate levels of guidance and precedence, and are easy to administer. We consider that the UK’s existing framework that governs the taxation of carried interest falls into this category and we hope that any proposed reforms maintain this. 

We can help you plan for any upcoming changes by assessing the impact of different scenarios on you and your investment structures, in addition to helping you comply and understand the impact of those changes once announced. If you would like to discuss these changes or your structures more generally, please contact Terry Heatley and Ami Shah.