On 21 July 2025, the UK government published draft legislation relating to its new carried interest regime. This Client Alert considers key aspects of the new regime and how it may apply to UK-based asset managers and non-UK based asset managers who regularly come to the UK or are considering establishing an office in the UK.
The definition of “carried interest” largely replicates that under current UK law, being a sum which arises by way of a “profit-related” return. This broadly requires that (i) the sum arise out of profits of the investments of the fund, (ii) the amount of the sum be variable by reference to those profits, and (iii) returns to external investors be determined by reference to those profits. However, a sum will not be carried interest to the extent that there is no significant risk that a sum would not arise to that individual.
The safe harbour under the current law has been retained. That is, an amount is treated as carry where — on a deal-by-deal or fund-as-a-whole waterfall — it only arises once all (or substantially all) of the investment of the participants in the relevant scheme has been repaid and external investors have received a compounding 6% return per annum.
As under the existing rules, consideration received for the disposal or variation of a right to carried interest is treated as carried interest, except to the extent that it is treated as a “disguised fee” arising to the individual taxable under the Disguised Investment Management Fee (DIMF) regime. However, a sum can only be a disguised fee for these purposes to the extent it is “untaxed”, i.e., it is not subject to tax as either employment income or brought into account in calculating the profits of a trade of the individual. Given that such consideration will be treated as carry and, therefore, profits of a deemed trade, it is hard to see many instances where the carveout for disguised fees could apply.
The draft legislation includes a provision clarifying that tax distributions may be treated as payments of carry (as opposed to, for example, disguised fees taxable under DIMF). However, the definition of a “tax distribution” for this purpose is narrow and does not cover all distributions which would generally be understood to be tax distributions.
The proposed definition of “tax distribution” is (broadly) a sum that (i) arises if the individual suffers tax as a result of their entitlement to carried interest and (ii) results in a corresponding deduction in the individual’s entitlement to carried interest. More specifically:
It remains to be seen whether the definition of tax distribution will be expanded in the final legislation.
The draft legislation expressly provides that co-investment returns (broadly, GP commitments where the individual’s return on investment is reasonably comparable to that of external investors) will not be carried interest. This is generally helpful. However, the relevant definition of co-investment is arguably narrower than the equivalent definition in the DIMF rules. It is not clear whether this is intentional.
From 6 April 2026, any sum (being money or something with a value that can be expressed in money) arising in respect of carried interest to an individual (less any deductible amount(s)) will be taxable as profits of a deemed trade carried on in the year the carry arises, and subject to Income Tax and Class 4 National Insurance Contributions, where the individual performs or has performed “investment management services” in any tax year directly or indirectly in respect of a fund (broadly defined).
For these purposes, the definition of “investment management services” has been expanded to expressly include the provision of investment advice and all activities incidental and ancillary to the other limbs of the definition. The definition of “investment scheme” has also been expanded to include arrangements relating to Alternative Investment Funds (AIFs), in addition to Collective Investment Schemes (CISs).
As under the current regime, a sum can arise to an individual not just when they receive cash or in-kind amounts but also when carried interest is received by (i) a connected individual, or (ii) any other person where the broad “enjoyment conditions” are met with respect to that sum.
Any deemed profits arising from Qualifying Carried Interest will be adjusted downward by applying a 72.5% multiplier, giving an overall highest marginal effective tax rate of about 34.1%.
Broadly, the percentage of carried interest that will be Qualifying Carried Interest will depend on the extent to which the fund satisfies the AHPC. Where a fund’s average holding period across its investments is between 36 and 40 months minus one day, a portion of the carried interest received will be “qualifying”. Where a fund has an average holding period of 40 months or more, all carried interest received will be “qualifying”. The AHPC is calculated with reference to specific rules set out in the draft legislation and which are discussed further below.
The only allowable deduction that can be made when calculating deemed trading profits is the cash/monetary consideration given “by or on behalf of the individual wholly and exclusively” for the acquisition of their entitlement to carried interest.
While this is consistent with the current regime, we note that “consideration in money” is more restrictive than the definition of consideration under the Employment Related Securities (ERS) regime. An individual may therefore be in a worse position if they acquire a right to carried interest for non-monetary consideration than if they had acquired their carry for monetary consideration (which would be a deductible amount) or if they had not given such non-monetary consideration, such that they would have suffered employment taxes on the unrestricted market value of their carry entitlement (in respect of which they could have claimed relief from double taxation, as discussed further below).
Where an individual’s carried interest is connected to any UK employment duties, UK employment taxes may also arise in connection with their carry. While such tax will not be a deductible amount, an individual who is subject to both UK employment taxes and income tax under the new regime in respect of their carried interest will be able to make a claim to HMRC to reduce the income tax charge and avoid double taxation. Relief can also be claimed where another person pays UK tax in relation to an individual’s carried interest. Under the current law, there is a technical question with regard to whether relief for non-UK taxes can be claimed under the (soon to be) predecessor of this clause, though HMRC’s position is that such taxes are not covered. The draft legislation would put this position beyond doubt going forward, and relief for foreign taxation would need to be claimed in accordance with general principles.
As noted above, the percentage of carried interest that will be Qualifying Carried Interest is determined by reference to the extent that the fund satisfies the AHPC. Broadly, these rules key off the general UK tax principles governing when an investment is treated as being acquired and disposed, unless a specific rule applies to deem the acquisition or disposal to happen at a different time (or not to have occurred). These specific computational rules are intended to apply to investments and strategies where the default provisions may produce a result inconsistent with the intention of the legislation.
As the AHPC will now have far broader application (given the removal of the exclusion for carry within scope of the ERS rules), the government previously committed to making targeted amendments to the rules to ensure they operate effectively, especially for private credit funds, which can struggle to meet the AHPC as currently enacted. In general, the draft legislation is helpful and addresses many of the issues with the current IBCI rules. There are still, however, a few aspects of the draft legislation in relation to the AHPC which we expect will be the subject of discussion with the government over the coming weeks.
The draft legislation introduces new rules specifically for credit funds (replacing the rules for direct lending funds). For these purposes, a credit fund will (broadly) be a fund that does not fall within one of the other fund categories covered by the AHPC, where it is reasonable to suppose that, at the time the fund begins investing (i) more than 50% of the total fund’s investments will comprise debt investments and (ii) more than 50% of total fund’s investments will be invested in investments which are held for 40 months or more.
The rules for calculating the application of the AHPC look a lot more workable than under the current IBCI rules. For “significant debt investments” (being at least £1 million or 5% of the total commitments raised or to be raised by the fund), follow-on debt or equity investments (in respect of which the borrower or a member of the borrower’s corporation tax group is the debtor or the investee entity) are treated as made at the time of the initial significant debt investment. A disposal event would then occur only when the fund has disposed of at least 50% of the greatest amount invested in any of those investments, or the investment is worth less than £1 million or 5% of the value invested (tested immediately before the disposal). For all debt investments, where there is an unconditional obligation on a fund to advance money under a loan, the debt investment is treated as being made at that time (subject to such investment being pooled with a significant debt investment per the above and being treated as acquired at an earlier date).
There are also helpful new rules which (broadly) ensure that no disposal event occurs as a result of a transaction if the credit fund continues to be exposed to substantially the same risks and rewards, or if the debt investment is extended on substantially the same terms.
It should also be easier to monitor the application of the rules, since a debt investment with a repayment date of at least 40 months after the investment is made should satisfy the AHPC, provided the fund positively intended and had the ability to hold the investment until such repayment date, regardless of whether the debtor repays early (provided that the debtor’s decision to repay was not influenced by the rules applying to Qualifying Carried Interest).
The existing rules applicable to funds of funds and secondary funds have been simplified, and the draft legislation now contains one single rule to cover all such strategies. A “fund of fund” is defined (broadly) as a fund with at least 80% of its total value invested in other funds or the acquisition of portfolios of investments from unconnected funds, where more than 50% of its investments will be held for 40 months or more, and it is a “qualifying fund” for the purposes of the UK’s Qualifying Asset Holding Company regime. This assessed at the time the fund starts to invest.
For the main part, these rules then work similarly with respect to the calculation of the relevant timing of acquisitions and disposals for assessing the AHPC as the rules applicable to funds of funds currently in place. Namely, that:
As for credit funds, the draft legislation includes a helpful provision which sets the date of acquisition of an investment by a fund of funds in another fund as the earlier of the making of the investment and the time at which an unconditional obligation to subscribe for an interest in the fund arises. However, as currently drafted, this does not cover an unconditional obligation to acquire an existing interest in a fund.
Where a fund acquires an investment from an associated fund entity, the disposal by the initial fund is disregarded for the purposes of the AHPC and the associated fund is treated as acquiring the investment at the time it was acquired by the initial fund. Funds are associated for these purposes if an investor in one of the funds would reasonably regard that investment as an investment in the arrangements as a whole.
While the applicability of this rule will be highly fact-dependent, we expect this will be helpful for sponsors when dealing with warehousing arrangements or undertaking intra-fund restructurings. However, it is unlikely to benefit continuation vehicles and may not apply to transfers between all investment vehicles of a fund, which invest in generally the same pool of assets, such as between a fund and a highly negotiated separately managed account for a cornerstone investor investing alongside it.
The existing IBCI rules include a specific rule for “unwanted short-term investments”. However, it is generally understood that these rules are overly narrow. While the limit on the type of investment assets that can be “unwanted short-term investments” has been removed, the definition otherwise remains largely the same in the draft AHPC rules. In short, this definition only covers investments which were necessarily acquired as part of making a larger investment, which at the time of the investment were intended to be disposed of within 12 months and which are actually disposed of within that time period (provided that the returns from such disposal do not materially bear on whether a sum of carry arises).
Stakeholders had expected that more changes would be proposed to these rules given that the sorts of disposals and syndications which this provision is intended to cover are highly fact-specific and may not all be completed (or contemplated to complete) within the narrow 12-month window. This is a provision regarding which we expect there to be more debate in the coming weeks.
The “scheme director condition”, which required funds to have rights to appoint board members to benefit from special rules, has been replaced with a test looking at whether the fund has a direct or indirect entitlement to exercise relevant rights. This is a helpful change, and the definition of relevant rights is sufficiently broad to capture the rights that sponsors (including venture capital investors) typically require on equity investments.
The extraterritoriality of the new regime and interaction with non-UK taxation has been the subject of much debate since the government announced its proposal to reform carried interest taxation in 2024.
As carried interest will become taxable as profits of a deemed trade from 6 April 2026, UK residents will generally be subject to tax in the UK on the full amount of any sum arising to them in respect of carried interest. A non-UK resident will be subject to UK income tax on the profits of their deemed trade allocable to the UK, unless an exclusion applies, and subject to the terms of any applicable double tax treaty.
The draft legislation includes specific rules governing the allocation of profits from Qualifying Carried Interest to the UK on the basis of “workdays”, as well as certain helpful limits on the UK’s ability to look back at UK workdays in prior years. However, it should be noted that there are no such limits on the extraterritoriality of UK taxation with respect to non-qualifying profits (in line with the UK’s current taxation of IBCI under DIMF).
Key to the allocation of profits between the UK and other jurisdictions is the concept of a “workday”. In particular, the portion of qualifying and non-qualifying profits treated as arising from a trade carried on in the UK is the portion of “applicable workdays” (as defined) which are “UK workdays” (as defined).
The draft legislation defines an “applicable workday” as a day in a “relevant period” on which the individual performs any investment management services and a “UK workday” as a day in the relevant period on which the individual spends more than three hours performing any investment management services. Any services performed in transit to/from the UK are assumed to be performed outside of the UK. In each case, the investment management services performed do not need to relate to the fund in respect of which carry will arise.
As the allocation of profits to the UK is made with reference to the number of UK and non-UK workdays in the relevant period, individuals will be incentivised to track not just their UK workdays but also their non-UK workdays. However, given the three-hour threshold for UK workdays and the fact that any investment management services count for the purposes of defining a workday (not just investment management services performed with respect to the fund paying the relevant carried interest), it may be logistically challenging to track this in practice. Fund sponsors are likely to need to give some thought as to how this is managed, and whose responsibility this should be.
Further, the expansion of the “investment management services” definition to include “ancillary” activities is likely to increase this administrative burden. In this context, we note that the hurdle for a day to be a “workday” for these purposes is lower than that applicable to other regimes. For example, a day where only incidental duties are performed would not count as a workday for the purposes of the UK’s PAYE concession for short-term business visitors. The fact that the tests for the two regimes are different will mean that some individuals and/or sponsors will need to keep two different sets of records in parallel.
The number of UK workdays is tested against the number of workdays in the “relevant period”. For these purposes, the period begins on the first day on which the arrangements from which carry arises “contained provision” that contemplated that carried interest may arise to the individual. It ends on the last day on which a sum of carried interest arises to the individual from the fund in the relevant tax year.
The time at which the relevant period begins is broadly drafted in a number of respects. First, “arrangements” are defined as any arrangement, understanding, scheme, transaction, or series of transactions (whether or not legally enforceable). Second, the reference to carried interest arising refers back to an earlier provision that scopes when amounts fall within the carried interest regime. While this provision refers to carried interest arising to the relevant individual, it is not clear whether the reference in the definition of a “relevant period” is to the individual’s right to carried interest in particular or carried interest being payable by that fund more generally. While our expectation is the latter, we hope that this drafting is clarified prior to becoming law.
Taken together, the breadth of the drafting raises a number of questions. Is the first day of the relevant period the day when (prior to the raising of the fund and the LPA being drafted) a broad set of terms was agreed, which contemplated the payment of carried interest? Alternatively, is the first day of the relevant period the day on which a draft LPA contained carried interest provisions or the day the LPA (containing such provisions) was signed? If the relevant individual is not a member of the original management team and/or not initially expected to receive carry, would the answer be different? It remains to be seen if this aspect of the legislation is clarified.
The following are not treated as UK workdays for the purposes of Qualifying Carried Interest:
In addition, if the individual is tax resident in a jurisdiction with a double tax treaty with the UK, such profits will also need to be attributable to a UK permanent establishment of the individual for the UK to have taxing rights. It is not yet clear exactly what is required to constitute a personal permanent establishment of an individual in the year in which carried interest arises (including, for example, where the individual is not present in the UK in that year but previously had UK workdays), though we understand that HMRC plans to provide guidance on this element of the rules.
As noted above, applicable workdays which are not UK workdays are important to the determination of the amount of profits allocable to the UK. Therefore, individuals will still want to retain evidence of all applicable workdays, including those which would be UK workdays but for the application to the exclusion set out above.
For the sake of completeness, where a sum arises to an individual who provides or has provided investment management services to the relevant fund and that sum is (broadly) not carried interest, the repayment of capital in respect of an individual’s co-investment or an arm’s-length co-investment return, it will fall to be taxed under the DIMF rules as profits of a deemed trade (but without the application of a multiplier in any scenario). The definition of “investment management services” under the DIMF rules will also be expanded in line with the wider definition applicable to carried interest.
Two targeted anti-avoidance rules will apply to the new regime and counteract any advantages from seeking to:
These targeted anti-avoidance rules are particularly broad and will need to be properly considered by individuals, sponsors, and advisors with respect to all facts relating to any relevant structure, arrangement, grant, disposal, and/or allocation of relevant profits, particularly in light of the strict interpretation of similar targeted anti-avoidance provisions adopted by HMRC and the courts in recent years.
While not expressly referenced in the draft legislation, the government has confirmed that the payment on account rules (which require self-employed persons to make advanced payments to HMRC on account of their expected future tax liabilities) will apply to carried interest. Given the potential unpredictability and irregularity of carried interest payments, carry recipients and sponsors will need to consider these rules and the impact they may have on recipients from a cashflow perspective.
The draft legislation retains the possibility for taxpayers to elect to accelerate the timing of tax payable in respect of carried interest, which was introduced to help alleviate difficulties with claiming foreign tax credits. This is particularly relevant for US citizens subject to UK tax, given that individuals subject to US tax tend to be required to pay tax in respect of carried interest prior to carried interest actually arising to them.
While the draft legislation is substantively as expected, the rules are complex — the draft legislation runs to 48 pages. The allocation of UK workdays and non-UK workdays is fiddly and likely to be challenging to manage in practice. Further, while the AHPC rules are certainly improved, they are still likely to be administratively burdensome to track, and there will undoubtedly be areas where they still do not work as intended. We understand that HMRC is open to fine-tuning the legislation, and so some of these issues may be resolved before the legislation takes effect next year.