A new chapter for carried interest – Where do we stand after the draft legislation?

The UK’s debate on carried interest has moved at speed since the Labour Government’s first call for evidence in July 2024, the Autumn Budget 2024 and a second call for evidence in October 2024. The Government’s June 2025 response confirmed that neither a new statutory minimum holding period nor a mandatory co-investment requirement would be taken forward. Instead, the Government recommitted to bringing the carried interest rules within the income tax rules and to revisiting the average holding-period requirements under the existing income-based carried interest (IBCI) rules. Draft legislation was published on 21 July 2025 and the consultation on that closed on 15 September 2025. While tweaks to the legislation may (hopefully) yet emerge, the direction of travel is now clear. CMS have participated throughout the process and have been represented on HM Treasury’s Technical Working Group. This article summarises the current position and highlights the practical consequences for fund managers, executives and investors.

1. From capital to income: the new charging structure

• A deemed trade.

From 6 April 2026, all carried interest receipts (regardless of when the carried interest was first awarded and regardless of the underlying source of the carried interest, i.e. capital gains, interest, dividends, rental income, etc.) will be treated as trading income (under Chapter 2 of Part 2, ITTOIA 2005). An individual who provides “investment management services” in respect of an “investment scheme” will be deemed to be carrying on a trade whenever a sum of carried interest arises. The definition of services is widened so that investment advice and incidental activities are squarely within scope (draft section 23Q ITTOIA 2005), to address the First-tier Tribunal’s decision in Millican v HMRC  [2024] UKFTT 618 (TC). The definition of an “investment scheme” will be expanded beyond investment trusts and collective investment schemes to now include AIFs and therefore corporates which would previously have been outside its scope (unless an OEIC).

• Two headline rates.

– Qualifying carried interest is taxed on 72.5 per cent of the amount realised. For an additional-rate taxpayer the effective combined income tax and NICs burden is 34.1 per cent. For those receiving carried interest where the underlying source is interest (e.g. credit funds), dividends or rental income (e.g. real estate funds), this will effectively result in a reduced tax liability. 
– Non-qualifying carried interest is taxed on the amount realised at normal rates (i.e. 45 per cent income tax plus 2 per cent NICs), giving an all-in headline charge of 47 per cent.

2. The new “qualifying” test – 40-month average holding period

Recognising that some of the concerns around the original IBCI rules had moved on (especially in relation to credit funds) and the IBCI rules had not been fully tested because of the carve out for employment-related securities, the existing IBCI rules have been recast and incorporated into a new and more generous average holding period (AHP) test. In order to be qualifying carried interest, a fund’s aggregate investments must be held for at least 40 months on average. This is measured by reference to the period from acquisition to disposal of each asset, weighted across the whole portfolio.

Where the average holding period is less than 36 months, none of the carried interest will be qualifying; there is a sliding scale between 36 and 40 months.

There will no longer be a carve out where the carried interest is employment-related.

The draft legislation makes three key amendments, aimed particularly at credit funds and fund of funds:

1. T1/T2 back-dating and post-dating. To address the difficulties caused by the fact that a credit fund will often (i) make its investment in a number of different tranches over time, and (ii) dispose of that investment in a number of disposals over time, the new rules identify a single date, T1, on which all investments are treated as made, and a date, T2, on which all disposals of those investments are treated as happening. Very broadly, T1 is the date at which the fund first makes a “significant debt investment” in the borrower group of at least £1 million or 5% of the total amounts raised or to be raised from external investors in the fund. All debt and equity investments in the borrower group made after T1 are backdated and treated as made on T1. T2 is the date on which the credit fund has disposed of at least 50% of the greatest amount it had invested at any one time in associated investments. Any associated investments disposed of before T2 are treated as disposed of on T2.
2. Extended pre-payment relief so that secondary loan positions benefit from the existing 40-month “deemed holding” for primary loans where a borrower (unexpectedly) repays ahead of schedule.
3. Commercial override. A restructuring or refinancing will not be treated as a disposal where there is no substantive change in economic exposure.

3. Territoriality and the non-resident executive

Subject to the application of any appropriate double tax treaty, non-UK tax residents (as determined under the statutory residence test, noting that in certain circumstances an individual may be treated as UK tax resident with less than 60 days in the UK) will be within the new trading income charge to the extent that their carried interest receipts are attributable to UK workdays.

For individuals subject to the new 4-year FIG regime, the non-UK trade part of qualifying carried interest will be treated as qualifying foreign income and therefore eligible for tax relief.  

A day will count as a UK workday if the individual spends more than 3 hours performing investment management services in the UK (whether or not under the arrangements in question) on that day. Services performed whilst travelling to or from the UK will be treated as being carried on overseas, beginning with when the individual boards the aircraft, ship or train, and ending with when they disembark.

For qualifying carried interest only, certain safe harbours are introduced:

• All workdays before 30 October 2024 are automatically treated as non-UK workdays.
• Any workdays in a tax year in which the executive is non-resident and performs fewer than 60 UK workdays are deemed to be non-UK workdays.
• Once an individual has been non-UK resident for three consecutive years (each with less than 60 UK workdays), all earlier workdays are deemed non-UK workdays.

For non-qualifying carried interest the safe harbours do not yet apply, leaving open the uncomfortable possibility that a single UK workday could taint the entire receipt. We understand that a number of respondents have pressed the Government to extend the safe harbour. Whether Treasury officials accept that point will hopefully become clear before the Finance Bill is laid before Parliament in early 2026.

Interestingly, the effect of deeming carried interest receipts to be profits from a trade may mean there is a mismatch in the classification of the receipt in the UK and the other jurisdiction. How this is resolved following the Supreme Court decision in Fowler v HMRC [2020] UKSC 22, which placed limits on the statutory fiction created by a deeming provision of UK tax, remains to be seen. HMRC seem to take a position which is at odds with their own arguments in Fowler.

4. ERS and other regimes – how the pieces fit together

In a point we made repeatedly to the Government, carried interest already inhabits a crowded legislative landscape—

1. The Employment Related Securities (ERS) rules will still be relevant wherever carried interest is acquired in connection with employment. Any charges under the benefit in kind and ERS rules will take priority over the new carried interest rules, with the ability to make a claim (i.e. it is not automatic) for relief for any double taxation. Where the ERS rules apply, it will (amongst other things) be key to understand (i) whether the terms of the 2003 BVCA MOU apply to the acquisition, (ii) if not, the unrestricted market value of the carried interest at the time of acquisition, (iii) that all appropriate tax elections under section 431 ITEPA 2003 have been made on a timely basis; and (iv) what happens where carried interest is reallocated or if there is any corporate or other reorganisation which may affect the value of existing carried interest.
2. The Disguised Investment Management Fee (DIMF) rules – these are broadly unaffected by the changes to carried interest save that the definition of “investment scheme” will be broadened in line with the new carried interest rules to bring a wider range of corporates within their scope.
3. Co-investment returns - co-investments arising to a UK resident will continue to be subject to CGT at 24% or income tax at the dividend rate of 39.35%, as applicable. Co-investments arising to a non-UK resident, will continue to be subject to the temporary non-residence rules for income tax and CGT purposes.
4. Partnership taxation – where a carried interest vehicle is itself a partnership, the long-standing rules in Part 9 of ITTOIA 2005 govern allocation of profits or loss to individual partners. The new regime overlays, but does not replace, that framework.
5. Double taxation relief – many executives will have US or other overseas filing requirements. The existing legislative credit mechanism and treaty provisions will remain vital, though the safe harbours described above should narrow the occasions on which relief is required.

5. Timing, compliance and cash-flow

• Real-time PAYE is out; self-assessment is in. The Government has confirmed that carried interest will not be subject to withholding. Instead, any amounts must be reported on the individual’s self-assessment return by 31 January following the tax year in which it arises.

• Payments on account. Carried interest taxed in one year will automatically form the basis of the next year’s payment on account instalments. Executives whose carried interest will be lumpy will need to proactively engage with HMRC to reduce payments on account to avoid substantial over-payments.

6. What managers should be doing now

1. Consider when carry will arise – and whether it will be subject to the existing regime or the new regime from April 2026.
2. Audit historic work-patterns – non-resident partners must map back UK workdays to understand any potential apportionment under the new rules.
3. Model fund-level AHP – credit and real estate debt funds, in particular, should run the new T1/T2 calculations to see whether their executives will qualify for the 72.5 per cent multiplier.
4. Review GP and carried interest vehicles – consider whether existing ERS elections remain fit for purpose and whether partnership agreements should be revisited.
5. Revisit waterfalls – many partnership agreements allow the fund manager to allocate sources of income profits and gains such that carry participants receive capital rather than income; for qualifying carry, this may no longer be necessary or attractive. 
6. Accounting for tax – consider the expected stream of carry and how the tax payment profile (i.e. payments on account) is expected to work and prepare to make any requests for adjustments.
7. Engage with the legislative process – although the consultation window for the draft legislation has closed, there may be continuing ways to engage with the legislation. Draft guidance is also expected in the coming months and we hope HMRC will take into account constructive comments.