The election of the Labour Party has introduced new dynamics to the fiscal landscape, particularly concerning the tax treatment of carried interest. While the Labour manifesto lacked detail, there is growing concern about its implications for private equity fund managers and the broader investment and asset management industry in the UK.

Carried interest has long been a cornerstone of private equity and hedge fund compensation, designed to align fund managers’ interests with those of investors by rewarding them for superior performance. However, its favorable tax treatment, which enables it to be taxed at the lower capital gains rate rather than as ordinary income, has become contentious. The UK is not unique in offering favorable tax treatment for carried interest, similar regimes exist in the US and much of Europe.

In a classic fund structure, the fund manager is typically entitled to 20% of the investment profits, but only after investors have recouped their initial investment plus a preferred return, commonly set at about 8%. This performance-based compensation, known as carried interest, is then distributed among the team members to promote retention and incentivize strong performance.

Labour’s Tax Overhaul

The Labour Party has identified reforming the taxation of carried interest as one of its signature tax policies. Rachel Reeves, now Chancellor of the Exchequer, has signalled a shift that could provoke significant backlash from the private equity industry. Reeves stated “Private equity is the only industry where performance-related pay is treated as capital gains. Labour will close this loophole”. The proposed changes aim to raise between £400 million and £500 million.

Currently, carried interest benefits from capital gains tax rates, which critics argue do not reflect the economic reality of the earnings. Reeves suggests that carried interest should instead be classified as a performance-related bonus and taxed in the same category as income. This reclassification could result in effective tax rates rising as high as 53% on carried interest, a drastic shift from the current capital gains taxation rate of 28% in the UK.

It remains uncertain whether a blanket employment income tax rate will be applied, or if an adjusted capital gains tax on carried interest will be introduced. The issue has sparked polarized debate, with proponents of the reform viewing it as a move toward greater tax equity. In contrast, opponents contend that it could undermine the UK’s appeal as a hub for investment management, potentially diminishing its attractiveness as a domicile for private equity and hedge funds.

A Shift in Administration Approach

Firms may respond by adopting phantom-based carry, which allocates notional shares reflecting the performance of real equity interests without conferring ownership. Unlike direct carried interest, phantom carry is taxed as ordinary income upon payment. This approach can be particularly advantageous in a higher tax environment, where there is lower or no tax advantage of implementing a direct carry structure, as it offers flexibility in compensation structures and simplifies administration.

Dominic Elias, Chief Advisory Officer at EWM Global, remarked, “A significant drawback of a direct carry plan is the requirement, for tax efficiency, to allocate the carried interest in the fund’s early stages. In contrast, phantom plans offer notable advantages by enabling more precise targeting of awards to those contributing the most over time. Many Private Equity firms are already leveraging phantom plans, and we anticipate this trend will grow if the taxation of carry changes as expected.” 

By deferring taxable events until the phantom carry is disbursed, firms can strategically align tax liabilities with recipients’ tax planning needs. The ease of administration and the ability to defer taxes make phantom carry an appealing alternative under stricter tax regimes, enabling firms to maintain similar economic incentives without the complexities of direct equity participation.

The Conflict in Regulatory Strategy

The proposed changes to carried interest taxation seem to contradict recent regulatory shifts, such as the removal of the banking bonus cap under the previous Conservative government. The removal of the cap, which had previously limited the banker’s bonuses to 100 per cent of their salary, was intended to make the UK more competitive globally by attracting top talent to its financial sector. In a positive move for the UK financial services industry, Reeves has stated that the Labour government “does not have any intention of bringing that back” and emphasized her commitment to supporting a thriving financial services sector in the UK.

In contrast, the planned reform of carried interest could discourage investment professionals and firms from operating in the UK, creating a conflict in regulatory strategy. While one set of policies aims to boost the UK’s appeal to financial professionals, the other may inadvertently undermine it.

The future of carried interest taxation in the UK remains uncertain, but it is likely to shift toward higher tax rates. Whether this will result in the full equalization of carried interest with income tax or the establishment of a different rate of capital gains tax on carried interest payments, remains to be seen. As the new government outlines its fiscal policies within the Chancellor’s autumn budget, the private equity market will closely monitor the developments to understand and mitigate the impacts on their operations and overall compensation strategies. Should changes be implemented, investment professionals will be particularly focused on the regulatory changes to existing undistributed carry awards.