[co-author: Nick Fagge]
The UK tax regime for carried interest is being substantially revised from April 2026.1 This Alert focuses on one particular aspect: the changes to how credit funds should calculate the average holding period (AHP) of their investments for purposes of determining whether carried interest paid by the fund should be treated as ‘qualifying carried interest’. Broadly, carried interest will be qualifying carried interest only where the AHP is 40 months or more (the ‘40 month AHP condition’).
This is important because carried interest holders receiving qualifying carried interest will pay income tax/National Insurance contributions (NICs) at an effective rate of 34.1%.2 Carried interest holders receiving non-qualifying carried interest will (as now) pay income tax/NICs at an overall rate of 47%.
To date, the difficulties for credit funds of meeting the 40-month AHP condition have not caused significant issues because of the employment-related securities (ERS) exception, by which carried interest granted to an employee (which was an ERS) was automatically qualifying carried interest. However, the ERS exception is abolished with effect from 6 April 2026, and from that date the distinction between qualifying and non-qualifying carried interest will be drawn, in every case, by the application of the 40-month AHP condition.
The changes to the calculation of the AHP for credit funds should make it significantly easier for credit funds to meet the 40-month AHP condition in appropriate cases. The main changes are as follows:
The T1/T2 rule
The new T1/T2 rule is intended to address the difficulties caused by the fact that a credit fund will typically make its investment (often both a debt and an equity investment) in a borrower group in a number of different tranches over time, and also dispose of that investment in a number of separate disposals over time. Under the current rules, each of those acquisitions and disposals is treated as the acquisition/disposal of a separate investment, which can significantly shorten the fund’s AHP for purposes of the carried interest rules.
The new rules address this by identifying a single date, T1, on which all investments in a borrower group are made, and a date, T2, on which all disposals of those investments in that borrower group are made.
T1 is the date at which the credit fund first makes a ‘significant debt investment’ of at least £1 million in the borrower group. All debt and equity investments in the borrower group made after T1 – the significant debt investments and all such other investments are together referred to as ‘associated investments’ – 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.
A further helpful change is that T1 is backdated to the date upon which the credit fund assumes an unconditional obligation to advance a loan where this pre-dates the date upon which the loan is actually made.
Commercial override for debt restructuring transactions
Under the existing rules, debt restructurings and debt-for-equity swaps can have the effect of significantly shortening a credit fund’s AHP as the restructuring event is treated as a disposal of the original debt investment for purposes of calculating the AHP, notwithstanding that there may be no change, commercially, in the credit fund’s exposure in relation to the borrower group.
The legislative changes try to address this. Where a new loan is extended to the same borrower group on substantially the same terms as an existing loan, or where, as a result of a transaction undertaken for commercial purposes, the credit fund is exposed to substantially the same risks and rewards in respect of the borrower group before and after the transaction, then the credit fund will not be treated as disposing of the original loan for purposes of calculating the AHP.
Prepayment extension
A credit fund’s AHP can also be shortened where a borrower chooses to make early repayment or otherwise prepay a loan. The existing AHP rules do acknowledge this by treating a credit fund as holding a loan for 40 months where the term of the loan was more than 40 months but the loan has been repaid early, but only for primary loans and only for primary loans that met certain qualifying conditions – and it could be difficult for a credit fund to identify whether a loan it had advanced was such a qualifying loan.
The new rules will treat a credit fund as holding any debt investment, whether a primary loan or a secondary loan acquisition, for more than 40 months where (i) the loan is repaid by the borrower less than 40 months after the date upon which the credit fund acquired the loan; and (ii) at the time that the credit fund acquired the loan, the loan had a remaining term of at least 40 months and the credit fund had a positive intention and ability to hold the loan to term. The concept of a ‘qualifying loan’ is also abolished.
Conclusion
There are of course some remaining imperfections in the draft legislation, but generally we see these changes to the calculation of the AHP as very beneficial to credit funds, many of which would have been in significant difficulties in establishing a 40-month AHP under the existing rules and following the abolition of the ERS exception.
The change to the T1/T2 basis for determining a single date of acquisition and single date of disposal is a valuable recognition of the way in which credit funds in practice build and dispose of their investments, and the removal of the arbitrary distinction between primary lending and secondary loan acquisitions (and abolition of the difficult-to-apply concept of the qualifying loan) is hugely welcome. The recognition that restructuring transactions in the debt of a borrower group are not, in commercial terms, disposals, is also important.
Overall, it is expected that these legislative changes will materially increase the chances that a credit fund is able to meet the 40-month AHP condition, and so grant qualifying carried interest (at a 34.1% tax rate) to its carried interest holders.
Endnotes
1For a discussion of the main changes, which will take effect from 6 April 2026, see our recent Client Alert issued on 18 August 2025. Alert on proposed changes to the carried interest rules].
2Under the existing rules, where qualifying carried interest is made up to any extent of interest or other forms of income (rather than capital gains), that income component is taxable at 45%. One of the other benefits of the new carried interest regime is that all carried interest is taxed solely under the carried interest rules – at 34.1% if it is qualifying carried interest, or at 47% if it is non-qualifying carried interest – and there is no other charge to tax, whatever the composition of the carried interest. This could be a significant advantage to a carried interest holder in a credit fund in receipt of qualifying carried interest made up of a substantial allocation of interest income.
3The abolition of the ERS exception and the introduction of the new rules for calculating the AHP for credit funds will both be effective for carried interest arising on or after 6 April 2026. Accordingly, where a carried interest is paid on or after 6 April 2026, whether it qualifies as qualifying carried interest will be determined solely by the application of the 40-month AHP condition. There are no transitional or grandfathering rules in the draft legislation (at present), so the fact that carried interest entitlement may have originally been granted to an employee in reliance on the ERS exception will not impact the tax treatment of carried interest paid on or after 6 April 2026.
4The legislation includes a new definition of a ‘credit fund’ which is, broadly, a fund where, at the start of its investment period, it is reasonable to suppose that more than 50% of the total value invested by the fund will be invested in debt, and more than 50% of the total value invested by the fund will be invested in debt which meets the 40-month AHP condition (as revised).
5There is an alternative method of identifying T2, but this is unlikely to be applicable in most cases.
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