Carried interest reform - how it works

Overview of carried interest taxation

The carried interest legislation introduces a revised tax regime that sits wholly within the UK income tax framework. All carried interest is now deemed to be trading profits subject to income tax at a marginal rate of 45%, and Class 4 National Insurance Contributions (NICs) calculated at 2% on profits above the Upper Profits Limit.

For ‘Qualifying carried interest’, the rate of tax will be subject to a 72.5% multiplier, resulting in a 34.075% effective tax rate for an additional rate taxpayer (34.8% in Scotland).

Carried interest is ‘qualifying’ carried interest to the extent that the underlying assets of the fund meet the requirement of having an Average Holding Period (AHP) of at least 40 months. Where the fund has a AHP of between 36 to 40 months a proportion of the carried interest will be qualifying. Non-qualifying carried interest is carried interest from funds which do not meet the AHP requirements. This was previously known as Income Based Carried Interest (IBCI).

Where the carried interest is calculated over a specific asset on a deal-by-deal basis, or in a single asset co-investment or continuation vehicle structure, it may be that single asset alone which is considered for the calculation of the AHP. This can make the test more challenging to meet in these scenarios.

The profits from non-qualifying carried interest are fully subject to income tax and NICs so effective tax rates of 47% for an additional rate taxpayer.

In addition, the rules have been broadened to capture a wider range of structures within both the Disguised Investment Management Fees (DIMF) and carried interest regimes. Structures that may previously have been regarded as outside the scope of the rules should be revisited to assess whether they now fall within the revised definition of an ‘investment scheme’ for the purposes of these rules.

Average Holding Period rules

The AHP rules replace the former IBCI regime. The most notable change is that the AHP rules now apply equally to employees and non-employees, including LLP members. The exemption for Employed-Related Securities has not been maintained. This change will require AHP calculations for more funds, and is expected to widen the population within the scope of non-qualifying carried interest with the higher rate of tax.

The regime has been designed so that traditional private equity funds investing in equity of trading businesses with medium to long-term holding periods should generally meet the AHP requirements.

However, debt strategies and more recent market developments, such as continuation funds and evergreen structures, may find the conditions more challenging. In addition, the detailed and technical nature of the rules means that even conventional strategies will need to model outcomes carefully.

For certain investment strategies, which generate income but also satisfy the AHP conditions, the rules will allow returns to be taxed as qualifying carried interest, at a marginal rate of 34.075%, rather than interest and dividends being taxed as general investment taxed at 45% for additional rate taxpayers.

Targeted adaptations have been made for credit funds and funds of funds in recognition of the increased complexity of the rules and changes in market practice since the introduction of the IBCI rules. These changes are to support these new strategies in meeting the AHP conditions and accessing the reduced qualifying carried interest rate.

The changes to the AHP rules compared to the old IBCI rules are extensive. Given the complexity of the regime and areas of uncertainty, fund managers should take a proactive approach, reviewing investment periods for both existing and new funds to assess whether the AHP conditions are met and establishing robust processes to monitor and document their position.

When do the carried interest rules apply?

Both the DIMF and carried interest rules apply to arrangements involving ‘investment schemes’, defined as;

• a collective investment scheme (CIS)
• an alternative investment fund (AIF)

There is no longer a requirement for a partnership to be present in order for the carried interest rules to apply. A wider range of structures are expected to fall within the scope of the DIMF and carried interest regimes.

With a more varied investor base and the development of alternative structures in an evolving market, the application of these rules may become less clear. Both DIMF and carried interest regimes include broadly drafted anti-avoidance provisions which are intended to disregard arrangements where one of the main purposes is to fall outside the scope of the rules.

Exclusive carried interest tax charge

The carried interest charge operates as an exclusive charge where the carry is held directly by the relevant individual executive. In such cases, the charge displaces other income tax or capital gains tax provisions that might apply under general principles. For example, where amounts economically represent interest, dividends, or gains that would otherwise arise under general principles on an allocations basis at a different point in time.

Employment-related tax charges take priority. However, in practice, these should arise only where appropriate Employment-Related Securities (s431) elections have not been made.

An irrevocable election is also available to disapply the carried interest regime in respect of amounts that are already subject to tax as trading profits under general principles.

Where the carried interest is not held by the relevant individual executive, there is the potential for a secondary charge to arise. Where sums arise to another person or entity, but the individual or anyone connected to them has the ability to benefit from or control those sums, the legislation may deem the carry to arise to the executive under certain ‘enjoyment’ provisions, thereby bringing them within the carried interest charge. It is important to consider whether the ‘deeming provisions’ apply.

Where carried interest is held by a family member or through a structure, such as family investment companies, trust structures or a business vehicle, general tax principles will determine the tax treatment for that holder.

In practice, such arrangements are often driven by broader considerations such as succession planning, divorce settlements, governance requirements, or non-UK tax factors. The rules in these cases can be complex. Provided the position is correctly analysed and reported to HMRC, we would not generally expect an unrelieved double tax charge to arise.

Timing and payment of the carried interest charge

As carried interest is now treated as trading profit, it falls within the income tax payments on account regime, with significant cash flow implications.

Payments on account are HMRC’s mechanism for collecting self-assessment tax in advance. Rather than settling the full liability once a year, individuals are required to pay two instalments of 50% of their prior year’s income and NIC liability.

Most private equity employees were not typically subject to payments on account previously. However, the recharacterisation of carried interest to income means that income tax and Class 4 NIC liabilities arising on carry will now feed directly into these calculations to bring them into the regime. As a result, cash flow management becomes a key consideration for carried interest holders.

Example

If £250,000 of qualifying carried interest is received in 2026/27 (ignoring reliefs), the expected payment profile would broadly be:

• 31 January 2028
  • Balancing payment for 2026/27:  £85,187.50  (34.075%)
  • First payment on account for 2027/28:  £42,593.75
• 31 July 2028
  • Second payment on account for 2027/28:  £42,593.75

For an employee coming into the payments on account regime for the first time, this equates to them needing to plan for a tax reserve of over 68% on each carried interest receipt during 2026/27.

Of course, where returns constitute non-qualifying carried interest, now taxed at up to 47%, in the first year of significant carry receipts the combined effect of the balancing payment and payments on account can result in a substantial upfront cash requirement.

Individuals receiving carried interest must proactively ensure that adequate tax reserves are set aside, or risk significant and unexpected cash flow pressures when liabilities fall due from January 2028 onwards.

It is possible to reduce payments on account where a lower current-year liability is expected, but underestimating liabilities can give rise to hefty interest charges on underpaid tax and HMRC currently charges late payment interest at 4% above the Bank of England base rate.

In-house tax and finance teams can play a critical role by modelling expected carried interest returns to help individuals accurately calculate payments on account. Failing to do so could leave executives facing material funding shortfalls when tax becomes payable with limited mitigation possible.

Making Tax Digital for Income Tax

Making Tax Digital for Income Tax (MTDfIT)is the new way for individuals to report income from trades or property rental businesses to HMRC.

From April 2026, individuals who are self-employed or who directly own property rental businesses and whose income exceeds the relevant thresholds will be required to comply with MTDFIT Read more on the mechanics of MTDfIT.

Under the new carried interest regime, as individuals are deemed to be carrying on a trade, they are expected to fall into the MTDfIT regime in the same way as any other trades;

• Carried interest will be treated as trading income from 2026/27
• The corresponding tax return must be filed by 31 January 2028
• The earliest date from which MTDfIT will apply to carried interest is 6 April 2028

Individuals who carry on other trades, including deemed trades under DIMF or the old IBCI rules, or rental businesses may be brought within MTDfIT earlier. In particular, where such income was reported in 2024/25, the corresponding MTDfIT obligations may arise from 6 April 2026. Please note that profits from an LLP, although deemed self-employment, are not caught by these rules.

The introduction of MTDfIT creates a number of practical challenges:

• Increased compliance requirements eg quarterly reporting and digital record-keeping
• Greater administrative burden for individuals and their advisers
• Data and systems readiness, where carried interest is received through complex fund structures
• Coordination with in-house finance teams, who may need to support data collection and reporting processes

Early assessment of the liability to file under MTDfIT is important. The liability will require systems, processes and responsibilities to be aligned in advance of the first reporting periods.

Double taxation

The legislation continues to provide relief for other UK taxes paid in connection with carried interest. However, the mechanism for granting this relief has been revised and is now more complex, reflecting the need to accommodate both tax and NIC charges.

Under the new regime, relief is no longer given through a straightforward tax credit. Instead, it is provided via an adjustment to the amount of carried interest subject to tax, effectively reducing the taxable profits accordingly.

The legislation also provides for unilateral relief for foreign capital gains tax paid in relation to carried interest.

These changes address many concerns raised during the drafting process that the double tax provisions were too narrow, albeit the interaction with international regimes still requires careful consideration.

Transfers of carried interest

The historic charging provisions that can tax the individual where there has been a disposal, variation, loss or cancellation of carried interest entitlements by the executive have been extended to cover a ‘relevant person’. The extension of these rules would cover certain disposals of carried interest made by some family members and family trust structures.

Death

In the case of the death of the individual, there are provisions that subject the beneficiary of the estate who receives the carried interest to tax as qualifying or non-qualifying carried interest and to income tax and NIC. It should be noted that the double taxing relief provisions would include relief for Inheritance Tax paid on carried interest.

Foreign Income and Gains (FIG) regime

The FIG regime allows new UK residents to exempt foreign income and gains from UK tax for their first four years of tax residence, provided they were non-UK residents for at least ten consecutive years prior. Learn how the UK FIG regime works.

For fund executives eligible under the FIG regime, the legislation contains definitions for ‘workdays’ and ‘UK workdays’, to determine the amounts that may qualify for tax relief. Broadly, foreign workdays are days where the executive carried out any investment management services abroad with no minimum number of hours required. UK workdays require that more than three hours of investment management services are provided on any fund in the UK. There are also prescriptive rules to allocate international travelling time as either UK or foreign for these purposes.

Different rules apply to non-qualifying carried interest. The amount which can be treated as foreign sourced and eligible for relief is restricted to the amounts arising in relation to pre-UK arrival services only.

Territorial scope of carried interest regime

As the new carried interest regime treats carried interest as trading profits, this greatly increases the UK’s taxing rights over non-UK residents. To the extent that carried interest is qualifying, there are some key statutory limits which apply to non-UK residents intended to limit the impact of the rules:

• For a non-UK resident, any services performed in the UK prior to 30 October 2024 will be deemed to be non-UK services
• The rules will disregard any UK workdays performed in a tax year in which an individual is non-UK resident and does not meet the 60 days ‘UK workday threshold’
• There will be a time limit to the ‘tail’ for a non-UK resident. Any carried interest received after they have been non-UK resident for three full tax years will be outside the scope of taxation under the carried interest regime, provided that in each tax year they did not meet the UK workday threshold

Any day in the ‘relevant period’ where the individual performs any investment management services is an ‘applicable workday’. UK workdays are only counted where the individual spends more than three hours working in the UK.

A new objective definition of the ‘relevant period’ has been introduced. This starts from the later of:

• When the first external investor is admitted to the relevant investment scheme
• When the individual first started providing any investment management services in respect of the scheme

In practice, this means that the relevant period will often begin before the carried interest is granted, since carried interest is generally awarded at final close.

The ‘relevant period’ then ends on the earlier of:

• The last day of the tax year that carried interest arises from the scheme
• When the individual ceases providing any investment management services to the scheme

The rules for DIMF and non-qualifying carried interest are different, they will be subject to the normal territorial scope applicable for trading profits. However, there are provisions to allow non-qualifying carried interest to be treated as ‘conditionally qualifying’ if specific conditions are met.

For those non-residents who are subject to tax in the UK, HMRC believe that treaty relief may be available under the Business Profits article of a double taxation agreement between the UK and the individual’s county of residence, provided that the individual does not have a ‘permanent establishment’ in the UK.

Once an individual has ceased to be UK resident, they should seek advice on the steps needed to ensure that they do not have a fixed place of business giving rise to a ‘permanent establishment’ in the UK. It would be important, wherever practically possible, to avoid the typical indicators of a fixed place of business. Whether this is achievable in practice would depend on the individual’s role and pattern of their work.

Temporary non-residents

We have seen many people leave the UK in the last few years. The Temporary Non-Residence (TNR) rules limit the tax benefit of becoming non-UK resident for just a short period. An individual can fall within the TNR rules if they were UK tax resident for at least four of the seven tax years prior to the period of non-residence and the period of non-residence does not exceed five years. In many cases, the TNR rules will apply unless the individuals complete six tax years of non-UK residence.

Where historic carried interest capital gains arise to an individual during a period of ‘temporary non-residence’ in the 2025/26 tax year or earlier, the individual will be subject to tax on the profits in the year they return to the UK under the new qualifying carried interest regime, ie taxed at 34.075%.

The TNR rules are complex so professional advice should be sought.