Key features of the new carried interest regime:
- Carried interest intrinsically linked to, or represented by, a participation held, directly or indirectly, in alternative investment funds is not taxable, provided such participation has been held for more than six months and does not represent more than 10% of the fund’s share capital. To ensure consistent treatment, tax transparency is set aside as far as the carried interest is concerned if the fund is tax transparent.
- Carried interest attributed on a purely contractual basis (i.e. not linked to, nor represented by, a participation held, directly or indirectly in the fund) is taxed as extraordinary income at a quarter of the applicable income tax rate (i.e. at a maximum of 11.45%, including the solidarity surcharge).
- The scope of eligible beneficiaries has been extended significantly. Both prongs of the new regime may benefit individuals who are fund managers or who are at the service of fund managers or management companies, meaning: (i) individuals who manage the fund’s investments in their capacity as employee, director, or shareholder of the fund manager, management company or of the fund; and (ii) individuals involved in the management of the fund as a service provider under an advisory agreement, entered into directly or indirectly through one or several entities. Such entities may be established outside of Luxembourg.
- The former requirement that carried interest may only be paid out once investors have recovered their investment has been removed. The new regime is therefore now suitable for deal-by-deal carried interest.
- The new regime, which is not subject to any caps or time limitations, is applicable from fiscal year 2026.
Full exemption of carried interest intrinsically linked to, or represented by, a participation in an AIF
Under the new regime, carried interest intrinsically linked to, or represented by, a participation held, directly or indirectly, in an alternative investment fund (AIF) is not taxable, provided the participation has been held for more than six months and does not represent more than 10% of the fund’s share capital.
General considerations
The notion of “participation” is not defined, but, according to the explanatory notes of the bill of law, it is to be understood broadly as shares, units, or other interests in the fund.
Further not defined is the notion of “alternative investment fund,” but it is safe to assume it should be construed in accordance with the Luxembourg law of July 12, 2013 on alternative investment fund managers, as amended. In the absence of any specific requirements, the regime should also be available if the alternative investment fund is established outside of Luxembourg.
In the case of tax-transparent alternative investment funds (e.g. funds in the form of a common limited partnership (société en commandite simple, SCS), special limited partnership (société en commandite spéciale, SCSp), or mutual fund (fonds commun de placement, FCP)), the tax transparency is switched off as far as the carried interest is concerned. This is to ensure that the tax treatment of the carried interest does not vary based on the nature of the underlying assets/income of the fund.
The regime applies regardless of how the carried interest is paid out (e.g. dividend distribution, redemption of carried interest shares, etc.) and is not subject to any caps or time limitations.
Carried interest represented by participation in the fund
Carried interest is “represented by” a participation in the fund if the right to participate in the fund’s outperformance is embedded in shares, units, or other interests in the fund. In other words, this means carried interest shares or, as referred to in the explanatory notes of the bill of law, carried invest. It is the most common way to structure and attribute carried interest in Luxembourg.
The participation may be subscribed directly by the beneficiary, or indirectly through a vehicle pooling the interests of carried interest holders (i.e. carried vehicle).
The following points from the explanatory notes are worth highlighting:
- In this scenario, the carried interest holder is not required to invest alongside regular investors to benefit from the full exemption of the carried interest. In other words, there is no requirement to have skin in the game. On that basis, we would take the view that there should be no minimum subscription amount to benefit from the exemption.
- If the carried interest holder acquires the participation for free or below its fair market value, the benefit derived therefrom (i.e. the difference between the subscription amount and the fair market value of the shares, units, or other interests in the fund) may be taxable under other provisions of the Luxembourg income tax law, e.g. as an advantage in kind derived from an employment relationship. This leaves open the question which valuation methods would be accepted by the Luxembourg tax administration. The tax authorities may issue pragmatic guidance in this respect in the near future.
Carried interest represented by a participation in the fund
Carried interest is “intrinsically linked” to a participation in the fund if the carried interest is attributed on a contractual basis (i.e. not embedded in shares, units, or other interests in the fund) contingent on an investment alongside regular investors. Thus, in this scenario, the carried interest holder must be required to have skin in the game to benefit from the full exemption of the carried interest.
The following points from the explanatory notes are worth highlighting:
- To benefit from the full exemption of the carried interest, the regular investment must not be devoid of any economic reality, meaning there should be an adequate investment amount and holding period.
- The exemption only applies to the carried interest. The regular investment would be treated according to ordinary Luxembourg taxation rules.
Preferential income tax rate for purely contractual carried interest
As under the former temporary carried interest tax regime, beneficiaries may be offered a carried interest on a purely contractual basis. To the extent the holder of such a contractual entitlement is not required to have skin in the game (see the “Carried interest intrinsically linked to a participation in the fund” section above), the carried interest is taxed as extraordinary income at a preferential rate equal to a quarter of the applicable income tax rate, i.e., at a maximum of 11.45% (including the solidarity surcharge).
The carried interest may be paid either:
- directly by the alternative investment fund
- by the fund manager, management company, general partner, or another relevant entity receiving the carried interest on their behalf.
The regime may not be used to convert all or part of a beneficiary’s professional income (e.g. employment income, bonus, director fees) into preferentially treated carried interest. This would for instance be the case if the employment agreement would state that a certain percentage of the salary is paid in the form of carried interest. Key is to be able to demonstrate that the amount paid to the beneficiary stems from the outperformance of the fund.
The regime is not subject to any caps or time limitations.
Extended scope of eligible beneficiaries
Unlike the former regime, which was only available to employees of alternative investment fund managers or management companies, the new regime benefits individuals who are fund managers or who are at the service of fund managers or management companies. Initially not defined in the bill of law, the notion of “at the service of the fund manager or management company” has been defined during the legislative process to cover the following categories of carried interest holders:
Individuals managing the fund’s investments as employee, director or shareholder
The first category concerns individuals who perform fund management functions in their capacity as employee, director, or shareholder of the fund manager, the management company, or the fund. Such entities do not need to be established in Luxembourg.
The explanatory notes indicate that by “fund management functions” is meant the management of the fund’s investments, such as portfolio or risk management. Purely administrative tasks would not qualify. It would therefore appear that the level of involvement in the management of the fund should be assessed based on the actual tasks performed by the carried interest holder.
Individuals involved in the fund’s management as a service provider
The second category covers individuals who contribute to the management of the fund as service providers under an advisory agreement. The advisory agreement may be entered into directly by the individual or indirectly through one or several entities. Such entities do not need to be established in Luxembourg.
Entry into force and other considerations
- The new regime is available for carried interest paid out as of fiscal year 2026. In the absence of any particular restrictions, the new regime should apply regardless of when the fund has been set up or when the carried interest entitlement has been attributed.
- Individuals still benefiting from the former temporary regime (which would expire in 2028), will automatically benefit from the new regime.
- The condition that the carried interest can only be paid out once all the investors have recovered their investment will be abolished. Hence, the new regime is now fit for carried interest triggered on a deal-by-deal basis.
- By “carried interest,” the new regime generally refers to the entitlement to participate in the outperformance of the fund. The regime does not impose any specific hurdle rates. The explanatory notes acknowledge that these would be set in the fund’s constitutive documents in accordance with normal market conditions. Artificially low hurdle rates might be challenged.
- The new carried interest regime only concerns Luxembourg resident individuals. Non-residents would generally not be taxable in Luxembourg on carried interest.
A request to dispense with the second vote has been filed with the State Council. Subject to this formality, the law should be published very soon.
Please feel free to reach out to our experts if you wish to discuss in more detail the new Luxembourg tax regime for carried interest.
