There has been much debate on how carried interest should be taxed. UK Chancellor Rachel Reeves has now announced a 4% increase, much less than signaled in the Labour Party’s manifesto published earlier this year. Labour had pledged to close the “carried interest loophole” that sees carried interest as a capital gain rather than income,

The increase will take effect from April 6, 2025, with further reform expected in April 2026.

What is ‘carried interest’?

Data, collated by the HMRC, shows that for the 2022/23 tax year £3.7 billion ($4.8 billion) of carried interest gains were reported on UK tax returns by just 3,100 individuals.

Carried interest is a form of performance-based reward for investment managers. It provides for executives to take a “carried interest” profit share in the funds they manage. The aim is to align the interests of the manager with those of the investors by incentivizing management to ensure that the fund performs well.

Currently, carried interest is taxed as capital gain at a special 28% rate (higher than ordinary capital gains tax rates but lower than the highest income tax rate) for UK tax resident and domiciled fund managers.

How the industry have reacted to the new rate

The industry had feared that the Government would increase the rate charged on carried interest to equate with the higher rate of income tax. However, by increasing the capital gains tax rate from 28% to 32%, the fears have been allayed and the increase has helped to close the gap between the original rate and the higher marginal rates of income tax at 45%.

Alex Viall, Chief Stategy Officer at Global Relay said: “I think this was a case of the government meeting the private equity sector halfway so that no one can feel too aggrieved, both the activists who wanted to see more punitive tax rates and the industry leaders who threatened mass exodus if the rise was significantly higher.

“I think the government will use the time to assess the impact and see how much tax it raises, and by the same token the PE industry will probably hold tight until 2026 to see where policy might head.”

Jaspal Pachu, a tax Partner with law firm CMS, explained how the new rate will work: “It appears that the new rate will apply to all carried interest, not falling within the existing income based carried interest rules, which is not delivered in the form of capital gain (for example dividends and interest).

“This may ameliorate the impact of the changes, especially for debt funds – which will expect to have significant interest income (otherwise subject to income tax at 45%). The existing income-based carry rules will remain but will also be revisited to explore introducing a minimum co-investment requirement and the minimum time period between a carried interest award and receipt. Accordingly, the changes may be attractive for some types of debt funds, but less attractive for those investing mainly in equities.”

International competitiveness

The Government is currently pushing a “growth” agenda for the UK and so it has needed to be very careful to ensure that any reforms avoid giving rise to a direct or indirect flight of capital and expertise.

“The change in the tax rate from 18% and 28% to a single 32% rate maintains a measure of international competitiveness.” said Joseph Adunse, tax partner at Moore Kingston Smith.

Viall agreed. “I would not expect this to have an immediate impact on PE’s current status located in the UK – the rise won’t encourage new PE entities to set up but I doubt it will result in many deciding to relocate.”

But is there a sting in the tail? Yes said Adunse: “Government intends to move the taxation of carried interest from the capital gains to income tax – and is likely to include national insurance being charged in addition.”

What happens from April 2026

From April 2026, Rachel Reeves also pledged to simplify the tax treatment of private equity earnings, with it being taxed within the income tax regime. Further details are to be announced. 

Richard Surtees, partner,  Employee Incentives, Eversheds Sutherland, said: “Major change is on its way in April 2026 with some rather fundamental reforms on the agenda that were released shortly after the Chancellor’s Budget statement. We are delving into the detail of HMT’s Summary of Responses and Next Steps to the recent Call for Evidence on the tax treatment of carried interest, but it is already clear that from April 2026 ‘carry’ will be taxed under the Income Tax regime as trading profits.

“Moreover, there will be no concessions given for existing funds/structures (no exclusions/grandfathering and no transitional provisions). We expect that naturally, many within the investment management industry will be disappointed with the future landscape of the carried interest regime, and may wish to explore all alternative incentive structures, but it will be a while before the full extent of the changes and their practical impact will be known and felt. Watch this space!”