Travers Smith's Alternative Insights: Taxing incentives in private markets

A regular briefing for the alternative asset management industry.

The appropriate tax treatment of carried interest has been a perennial discussion topic for decades. Perhaps, though, it has never been under greater pressure than it is now. In the coming months, the UK will finalise reforms announced last year, and the new US administration has also put carried interest back on the agenda.

In the UK, there is a risk that the reforms that were announced last autumn are seen as a done deal, and unlikely to do much harm to the private markets sector. That assumption would be unwise – the significant reforms will undoubtedly affect UK competitiveness, and further changes are still under discussion. The outcome of those continuing discussions will be crucial.

The current rate – a minimum of 28% – will rise to 32% this April, and then settle at an effective rate of around 34.1% from 6 April 2026. Non-qualifying carried interest will be taxed at full income tax rates (so up to 47%) from that date.

Even the 34.1% rate will put the UK at the top of the European league table, just a smidgeon ahead of France, and significantly above Germany (whose effective headline rate is 28.5%). (For more detail, see our 2024 Budget briefing.)

Although much better than it could have been – a direct result of extensive industry engagement – the rate hike is a blow to the sector, especially when combined with other changes to the domestic tax rules, most notably the abolition of the "non dom" regime. No doubt conscious of that, the government has already taken some steps to soften the rules that will replace the non dom regime, but the rules for temporary residents will be less generous than previously.

It is very hard to estimate what long term impact that will have on the British private capital industry, including the investment and expertise it delivers to innovative UK companies. It certainly won't be helpful and, over time, could herald a gradual erosion of the UK's dominant position in Europe.

But there are significant aspects of the UK government’s plans beyond the rate change. First, the new rules will not only increase the rate of tax, but (from April 2026) they will tax carried interest as income and not as capital gains. This is a fundamental change, not widely mooted in advance, which will have a number of knock-on effects.

These effects are complex. Perhaps the most important is the impact it will have on individuals who are not UK tax resident. Since the UK generally taxes non-residents on their UK trading income, but not their capital gains, the government considers that an executive's carried interest will fall within the UK tax net to the extent that it arises from work performed in the UK. That can result in a mismatch with the tax position in their home country, which may not be catered for in a double tax treaty.

        
    
The government is certainly listening to the industry, including through a working group for stakeholders (which includes members of the Travers Smith tax team).   There remains hope that the harm can be limited.

Secondly, the bar for carried interest to be "qualifying" could be set too high. The government has already confirmed one condition – that the carried interest must not fall within the UK's complex "income- based carried interest" (IBCI) rules which, broadly, require a fund to hold its assets for a minimum period. Importantly, these rules will be extended to apply to all executives; currently, employees are out of scope.

In addition, the government is considering adding two further conditions for "qualifying" status: a co-investment condition, and a minimum holding period

Of course, the UK trade association, the BVCA, is all over this. It has been in active dialogue with policymakers for several years and has just published a comprehensive response to the recent consultation on the two additional conditions. It firmly rejects the case for both, pointing out the significant technical and practical complexities that they would generate, and observing that the rate rise is already being seen by key competitor jurisdictions as a way to attract talent away from the UK.

The BVCA also raises a number of practical concerns with the new regime, including its application to internationally mobile executives and the need to update the IBCI rules to reflect developments in private fund arrangements since their introduction ten years ago (such as the use of continuation vehicles) and to address long-standing technical difficulties in applying them to certain strategies (such as private credit).

The government is certainly listening to the industry, including through a working group for stakeholders (which includes members of the Travers Smith tax team). There remains hope that the harm can be limited. Some comfort can be taken from the recently announced reversal of a controversial tax policy change relating to LLP partners in response to industry feedback.

More recently, the news came that the White House's budget proposals for the US include a plan to increase tax on carried interest. This is the second time that President Trump has made such a proposal, but his position is stronger this time and he may garner support from the Democrats – who have recently made attempts of their own to close what they describe as a "loophole". As one would expect, the industry associations have launched a robust defence of the current position, and several previous attempts to change the rules have ultimately been unsuccessful – so change is far from certain.

As the private capital industry points out, carried interest awards executives a share of realised profits. That means it aligns interests and focuses asset managers on long-term outcomes. In that respect, it is very different from a bonus – and it would be a retrograde step to discourage its use by taxing it as such.

It is therefore critical that carried interest tax reforms are carefully calibrated. In the UK, this is likely to require compromises from the government. If the rules are not tailored to address the concerns of the private capital industry, they could be an economic own goal.

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