It is fair to say that the funds industry had been collectively holding its breath up until chancellor Rachel Reeves delivered yesterday's Budget.
The Labour manifesto had set out that it would close the "carried interest loophole", which had been understood to mean that carried interest rates on capital gains (28 per cent) would increase to income tax rates (45 per cent).
Instead, Reeves announced that the government will raise carry taxes by 4 percentage points from April 2025, and the changes coming down the line from April 2026 may reduce taxes for some carry holders.
Under one reading, this was the "best possible outcome" given that we were emphatically promised tax rises on carried interest, and the 4 percentage point increase on carry tax rates is identical to the 4 percentage point increase on ordinary capital gains announced (up to 24 per cent from 20 per cent ).
To understand how the funds industry has managed to dodge a bullet, it is worthwhile to understand that carry is the key motivator of the funds industry. Namely, it provides the incentive for fund managers to achieve spectacular returns for the investors given that they will receive a share of those profits — generally, once the investors receive back their investment and a pre-agreed annual return (hurdle).
Carry is also popular with investors because it incentivises managers to ensure the fund is a success. Raising taxes on carry arguably reduces those key incentives.
The tax position until now
As part of the prior consultation on the carry tax regime, we had flagged to the Treasury and HM Revenue & Customs that the oft-cited 28 per cent tax rate for UK carry holders only applies to returns consisting of capital gains.
In practice, carry returns in most asset classes (other than venture capital) also consist of interest income and dividends, and the effective tax rate on carried interest can often sit between 30 per cent and 40 per cent, depending on the proportion of capital gains versus interest income and dividends. This effective tax rate is higher than many other European jurisdictions.
Second, although the risk of a mass exodus may have been overblown, a massive rise in taxes on carry is likely to encourage founders and very successful fund managers, who typically hold proportionally very large stakes of carry, to consider leaving the UK to other more tax-friendly jurisdictions, such as Spain and Italy.
Third, the UK carry regime has one of the most complex carry regimes on the planet. The UK economy and fund management industry would benefit greatly by simplifying the current tax regime, including replacing the current blended regime with a flat tax rate regime favoured in many European jurisdictions, and which imposes the same tax rate on capital gains, interest income and dividends — unlike the current UK tax rate which imposes different tax rates dependent on the nature of the return.
The Budget sea change
The changes announced in the Budget can be broken down into two:
