The Future of Tax in the UK – Carried interest

General Election 2024

As the UK General Election campaign rumbles on, focus on the taxation of carried interest received by Private Equity principals continues to increase. Labour originally outlined their intention to ‘close the carried interest loophole’ over two years ago¹. Based upon analysis undertaken by the Civil Service it is estimated that additional revenue of c. £500m² could be raised by Labour’s proposals.

The broader context is that many incumbent UK resident Private Equity principals will find themselves impacted by both the cancellation of the non-dom regime and a potential increase to the tax rate that applies to carried interest. 

Some commentators have questioned whether the estimates made around the additional expected revenue received as a result of the non-dom regime’s cancellation and a change to the taxation of carried interest accurately capture the potentially behavioural response of these overlapping cohorts of taxpayers. 

Labour’s focus on growth during the election campaign has been clear; with much effort having been made by Rachel Reeves to court the City of London and the broader business community. The question remains as to whether such fundamental reforms to the UK tax landscape will enable the UK to remain an attractive destination for investment by comparison to its European counterparts.

This note sets out further background to the history of the taxation of carried interest and provides a comparison to other jurisdictions’ regimes.

What is carried interest?

The origins of carried interest can be traced back to the 16^th century. At the time, given the risks involved in transporting goods across oceans, ships’ crews were rewarded with a material portion of the profits realised by merchants. It was typical that up to 20% of the profit was ring-fenced for the crew to compensate them for the personal risk they were taking.

This concept has been borrowed by the funds community where carried interest generally refers to a share of the profits allocated to fund managers to reflect their role managing the investments of the fund, rather than as a result of any personal investment.

The UK’s carried interest regime

Under the current legislation, sums arising to fund managers are treated as carried interest where they constitute a ‘profit related return’. Distributions are regarded as a ‘profit related return’ where (i) profits actually arise to the fund; (ii) the sum which arises to the fund partnership is variable with reference to those profits, and (iii) sums to be realised by external investors are determined with reference to the same profits. 

Absent the application of anti-avoidance provisions, commonly referred to as the Disguised Investment Management Fee rules (“DIMF”), carried interest distributions are subject to taxation on the recipient as Capital Gains at a rate of up to 28%. Where the anti-avoidance provisions apply, the distributions are subject to tax as UK source trading income typically at a rate of up to 47% (assuming the top rate of Income Tax at 45% plus a 2% National Insurance contribution).

Given that funds are typically constituted as partnerships, the carried interest distributions represent an allocation of the income and/or capital gains which have arisen to the partnership deriving from proceeds realised on the sale of fund investments, dividends from portfolio companies and interest paid on debt provided. As partnerships should be regarded as transparent for UK tax purposes a UK tax charge may arise for executives prior to the receipt of any distributions, commonly referred to as a ‘dry’ tax charge.

To mitigate the risk of double taxation on receipt of distributions, a tax credit should be available to frank any tax due as a result of the distribution of previously taxed income and gains. This should also be the case where the anti-avoidance provisions apply. HMRC guidance has provided that a tax credit should only be available for UK tax suffered.

Interaction with the existing UK ‘non-dom’ regime

When it comes to non-UK domiciled individuals who are subject to taxation on the remittance basis the taxation of carried interest distributions is more complex. Under the current rules, non-dom executives may shelter an element of distributions received from UK taxation where they perform a portion of the investment management services outside of the UK (and those distributions are retained outside the UK under the remittance basis of taxation). 

There is no hard and fast rule as to how the carry should be split between the performance of UK and non-UK duties, and HMRC guidance provides that any such apportionment should be on a just and reasonable basis fairly reflecting “the time spent by the individual working in the UK and abroad and, where relevant, the relative value and importance of the work performed in the UK or abroad”.

Competitiveness – the European Landscape

Given many jurisdictions have a distinct set of rules that apply to Private Equity funds, it is an oversimplification to provide a comparison of the tax rates that apply to qualifying carried interest. That being said the below table provides an overview of the taxation of carried interest for Private Equity executives based in the following European countries: France, Italy, Germany, Spain, and Sweden.

Next Steps

Please contact your J P. Morgan team should you wish to have a further discussion on this topic with the Wealth Advisory team.

¹ https://www.theguardian.com/politics/2021/sep/19/labour-plans-to-raise-500m-by-closing-fund-managers-tax-loophole

² https://assets.publishing.service.gov.uk/media/65e9d03a5b65240011f21bc6/240223_Opposition_costing_-_Carried_Interest_FINAL.pdf

³ https://www.dlapiper.com/en-gb/insights/topics/carried-interest

⁴ https://kromannreumert.com/files/media/document/Nordic%20Tax%20Views%20-%20Carried%20interest_0.pdf