Legal Lingo: Carried Interest Taxation - Don’t Get Carried Away!

Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our Legal Lingo series, which we've introduced to help break down this jargon, is an explanation of carried interest taxation.

Carried interest and its tax treatment is a hot topic for private equity and other alternative asset funds. How carried interest is taxed is often complex and has been subject to numerous legislative and policy changes in recent years. For fund managers, the way carried interest is taxed can make a significant difference to their reward for success and is a major focus through the fund’s lifecycle.

What is Carried Interest?

Carried interest is a share of the profits of an investment fund allocated to fund managers, typically after investors have received their initial capital and a preferred return. Distributions usually follow a “waterfall” structure, a heavily negotiated mechanism that sets the order and priority in which profits are returned to investors and managers. 

The carried interest profit share aligns the interests of managers with those of investors and incentivises strong fund performance. For a general introduction to the distribution waterfall and carried interest, see our Legal Lingo directory.

The Tax Angle: Capital or Income?

A key tax question is whether carried interest should be taxed as a capital gain or as ordinary income. This distinction can be crucial, as capital gains are typically taxed at lower rates than income, resulting in a substantial difference in after-tax returns for managers.

Globally, the tax treatment of carried interest is politically sensitive. Critics argue that taxing carried interest as capital gains provides an unjustified tax break for fund managers, while proponents contend that carried interest is genuinely non-income in nature (e.g., with a substantial risk of non-payment, no timing certainty, potential loss of invested capital, and other factors). 

As a result of the policy focus in this area, some jurisdictions have sought to make competitive, taxpayer-friendly changes to how carried interest is taxed, by introducing favourable regimes (including capital gains treatment or preferential rates). Conversely, other jurisdictions have tightened their rules, for example, by treating carried interest as income, or by introducing specific regimes with strict qualification requirements (such as extended holding periods or co-investment obligations).

The UK Government, for example, is in the process of introducing significant changes to carried interest taxation, effective 6 April 2026. Under the previous regime, carried interest was taxed as capital gains under bespoke rules, with rates of 32% applying since 6 April 2025, and 28% previously.

Under the new regime, carried interest will be taxed as profits of a deemed trade and subject to income tax at the individual’s full marginal income tax rate as well as national insurance contributions. However, “qualifying carried interest” arising from a fund that satisfies an average asset holding period requirement may be taxed at just over 34% (with the calculation of the holding period varying depending on the fund’s investment strategy). Qualifying carried interest under the new UK regime will be apportioned based on the location and timing of the related investment management services, with only the UK-related portion being taxable in the UK. 

International Comparisons

The tax treatment of carried interest varies considerably across jurisdictions:

• United States: Carried interest may be taxed at the lower capital gains rate if the underlying assets are held for more than three years.
• France: Carried interest can benefit from capital gains tax rates if certain conditions are met, including acquiring carried interest rights at market value, making minimum commitments, and meeting minimum holding periods.
• Italy: Qualifying carried interest is taxed as financial income at rates significantly lower than those applied to employment income.
• Luxembourg: The new regime distinguishes between contractual carried interest, which is taxed at one-quarter of the marginal income tax rate, and equity-linked carried interest, which relates to participation in an investment fund and is exempt if held for more than six months. However, if the participation exceeds 10% of fund capital, gains are taxed at half of the marginal income tax rate.
• Hong Kong: Qualifying carried interest can receive concessionary tax treatment, resulting in a total tax exemption.
• Singapore: Has no specific carried interest tax regime. The tax treatment depends on the structure and the legal form of the return. If, for example, structured as investment returns and paid out as dividends, it is generally not taxable. If structured as a performance fee or service compensation, it is likely taxable, but at relatively low rates.

The absence of international consensus regarding the tax treatment of carried interest creates challenges for funds with carried interest holders located across multiple jurisdictions. This variability complicates the design of tax-efficient structures that accommodate different jurisdictional requirements, whilst also increasing compliance burdens as funds must navigate differing rules and reporting obligations in each country.

Key Takeaways

Carried interest represents one of the two primary ways asset managers are compensated, alongside management fees. Whilst management fees provide steady income to cover operational costs, carried interest is the performance-based reward that drives fund economics.

In practice, carried interest vehicles feature prominently in fund structure charts, their entity type and location often driven by tax considerations, whilst diverging tax rates across jurisdictions can fundamentally affect net returns in a competitive marketplace. The taxation of carried interest is therefore not just a technical detail, it is a crucial factor that determines fund structures and significantly impacts the returns managers receive.

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