Taxation of carried interest: where are we now?

United Kingdom

Reform of the taxation of carried interest has long been Labour policy. It was one of first tax policies announced by Rachel Reeves after becoming the Shadow Chancellor in Spring 2021, shortly prior to the Labour party conference in Autumn of the same year.

In the period between that announcement and the delivery of Labour’s manifesto on 13 June, there was some uncertainty over whether those proposals remained part of Labour policy. Those affected may have been buoyed by the absence of the policy from the Labour party’s conference in 2023 – and its omission from the three key tax policies highlighted in Labour’s pre-manifesto publication on “making the tax system fairer”.

However, the publication of the Labour party manifesto confirms that reform of the taxation of carried interest remains firmly on the table. The details of those proposals remain unclear – and recent comments from Rachel Reeves suggest that she / the party itself remains undecided.

What has actually been proposed?

As noted above, the Labour party’s public comments tend to refer to the “appropriate” tax treatment of “private equity bonuses”. Receipt of carried interest is not a “bonus”, but the manifesto makes clear that Labour’s current view is that carry has the characteristics of “performance related pay” and therefore should be taxed accordingly (at the higher rates of employment income tax) rather than at 28% (the higher rate of capital gains tax which, under current legislation, applies to carried interest receipts).

Beyond the references to “reforming the taxation of private equity bonuses”, details remain thin on the ground. It is clear from the Labour party’s manifesto that such references do refer to reform of carried interest, with the costings document referring specifically to “revenue from closing [the] carried interest loophole”.

What might be proposed?

In brief, the following are the three key permutations that we consider Labour will currently be considering:

1. Taxing carried interest at the recipient’s marginal rate of income tax (i.e., up to 45%). 

This would be the “nuclear option” (and would in some respects fully accord with the comments to date which suggest Labour view carried interest as a “bonus”). The likelihood of this option materialising has arguably increased recently, with Rachel Reeves telling the Financial Times that she expected most carried interest would be taxed as income under current plans.

It is not yet clear whether Labour intends for carried interest amounts to be taxed as income (with the associated consequences on national insurance contributions, the apprenticeship levy, and possible tax deductions against direct taxes), or simply at a comparable rate to income tax rates.

2. Taxing carried interest at a higher rate of capital gains tax. 

Carried interest is already taxed at the highest rate of capital gains tax (being 28% - for comparison, the main rate for additional rate taxpayers is 20%, and the rate for gains on residential property has recently been reduced to 24%). That rate could be raised so that there is a smaller gap between the rate at which carried interest is taxed and the top rate of income tax – but leaving enough of a gap for the UK to remain a competitive jurisdiction for private equity managers. This policy might satisfy Labour’s manifesto pledge, but keep an incentive for private equity managers to remain in the UK.

3. Requiring private equity managers to personally (or collectively) invest a certain amount or percentage in the fund, in order to access the beneficial carried interest regime and rates.

Recent comments by Rachel Reeves made to the Financial Times suggest that this is the direction that the policy is moving in: “if you are putting your own capital at risk it is appropriate that you pay capital gains tax”. Any regime requiring personal (rather than collective) investment as a condition of beneficial tax treatment would be less attractive and commercially feasible for more junior managers, but would allow those more senior and established in the industry to retain the existing benefits of holding carried interest (rather than, say, receiving a bonus linked to fund performance).

It is possible that Labour may intend to replicate the rules in other countries (notably Italy), which broadly require that the managers’ aggregate co-investment is equal to a certain percentage (in Italy, 1%) of the total fund in order for carried interest to be taxed as capital.

Of course, there also remains a question mark over Labour’s policy regarding raising capital gains tax rates – or even equalising those rates with income tax rates (which was last the case between 1988 and 2008). Labour’s constant refrain has been that there are “no plans” to raise capital gains tax, and that there are no plans to increase taxes on “working people”. However, recent comments by both Sir Keir Starmer and the Shadow Chancellor indicate that Labour really mean not increasing taxes on work rather than “working people” – and so it is not out of the question that, during the course of a Labour government, capital gains tax rates would rise.

Should that be the case, this would of course affect the attractiveness of the carried interest regime, without the need for specific reform. In addition, it is worth noting that equalising capital gains tax and income tax rates would likely create pressure on an incoming Labour government to replicate historic regimes for inflationary gains and taper relief for assets held for long periods. Such reform would help mitigate any equalisation or increase in the capital gains tax rate.

Is there a chance the policy is dropped?

As noted above, the plan did seem to disappear from Labour party policy at times. However, it now seems highly unlikely that we hear no more of this from Labour should they (as is widely predicted) find success on 4 July. The party’s manifesto costing document specifically allocates the estimated £565m raised from “revenue from closing [the] carried interest tax loophole” to specific spending pledges – although it is notable that there is an explicit recognition in that document that Labour have left a considerable amount of leeway between estimated revenue raised and spending pledges. This would afford Labour the ability to reallocate revenue from other measures to those specific spending pledges and still “balance the books”.

Additionally, recent comments made outside of the manifesto indicate that Labour will consult on any carried interest reform before its introduction. There is no formal timetable for the publication of tax consultations (although they often are released in “bulk” at Spring Budgets and Autumn Statements) – so we could see that consultation as early as “day one” of a Labour government.

Those currently holding carried interest may also be interested in whether any changes would apply to existing unrealised holdings of carried interest or would only apply to carried interest which is granted once any new legislation comes into effect. Unfortunately, the answer to that question also remains outstanding.

As such, while carried interest reform clearly remains “on the table”, what that reform looks like and when it is implemented is left outstanding, perhaps helpfully to be dealt with outside of the heat of a general election campaign and, possibly, after further appropriate lobbying from industry.

Next steps

As a preferred advisor of many private equity firms, we are closely monitoring all proposals made and commentary in this area and continue to reflect on possible alternative structures and solutions for current carried interest holders. With the benefit of CMS’ pan-European network, we are also monitoring possible carried interest reform in other jurisdictions, as well as jurisdictions where similar regimes may remain advantageous. The promise of a consultation is certainly encouraging and provides advisors and those affected with an opportunity to make representations.

Please do get in touch with any of our Key Contacts or your usual CMS tax contact if you would like to discuss this issue further.