Executive summary

In keeping with the political priorities and commitments outlined in the coalition agreement released following the 2023 elections, the Luxembourg Government, on 24 July 2025, submitted draft legislation (Draft Law) to Parliament that significantly reforms the existing carried interest regime.

The proposed regime establishes a tax framework for carried interest granted to individuals involved in managing an Alternative Investment Fund (AIF). It differentiates between two types of carried interest: (1) contractual carried interest, which is granted to individuals without requiring them to acquire a (direct or indirect) stake in the AIF, and (2) participation-linked carried interest, which is inseparably linked to an individual's (direct or indirect) stake in the AIF or participation in a carry vehicle.

Under this new framework, contractual carried interest is classified as speculative income and taxed at one quarter (25%) of the recipient's global income tax rate, up to a maximum of 11.45% based on the 2025 income tax rates. Participation-linked carried interest will be tax-exempt if the individual's stake represents not more than 10% of the AIF and is held for at least six months, regardless of the AIF's legal structure (e.g., whether a tax-opaque corporation or a tax-transparent partnership).

The new regime would take effect starting from the 2026 tax year.

Detailed discussion

The current carried interest tax regime was established in the context of transposing the European Union's (EU's) Alternative Investment Fund Manager (AIFM) Directive. Twelve years later, it has become evident that the performance-related incentives paid to AIF managers can take various forms and the wording of the current law no longer suits today's circumstances because it allows for different interpretations, leading to legal uncertainty. Furthermore, the current carried interest regime foresees taxation at a reduced rate, but this tax treatment was only available under certain conditions and for a limited period and no longer applies to individuals who would be granted a carried interest today.

As a result, the Draft Law aims to revise the tax regime to better reflect current market practice regarding both the scope of the carried interest regime and its beneficiaries.

Scope: Contractual and participation-linked carried interest

The Draft Law distinguishes between:

• Contractual carried interest: Under this model, carried interest is granted to the beneficiary on a contractual basis, with no requirement that the beneficiary acquire a (direct or indirect) participation in the AIF. This carried interest would generally be granted for free and be paid by funds derived directly or indirectly by the AIF once the predetermined hurdle rate is achieved.

Under the Draft Law, this carried interest would be taxed as extraordinary income at one quarter of the beneficiary's global tax rate (i.e., a maximum of 11.45% based on 2025 income tax rates). The beneficiary is entitled to invest in the AIF, like any other investor or limited partner, but the income derived from this participation would not benefit from the proposed carried interest tax regime and would be taxed according to the normal tax rules.

Carried interest is tax-exempt if the individual's participation represents not more than 10% in the share capital of the AIF and the interest is held for at least six months. Again, this tax treatment only applies to the carried interest and not to any other income that the holder would derive from his/her participation.

This applies irrespective of the legal form of the AIF, meaning that the look-through approach normally applicable to a tax-transparent fund vehicle (e.g., a special limited partnership) is set aside for purposes of applying the carried interest regime.

The Draft Law would no longer require that investors recover their initial investment before the AIF manager begins receiving any carried interest. The new carried interest regime would therefore also apply to AIF managers benefitting from US-style waterfalls in which carried interest is applied on a deal-by-deal basis rather than on a whole-fund basis.

Beneficiaries: Individuals involved in management of the AIF

The Draft Law considerably expands the scope of eligible beneficiaries, which the current law restricts to individuals employed by the AIFM or the management company of the AIF. Given that it is market practice to also offer participation in the outperformance of the AIF to other players, the carried interest tax regime is extended to all individuals who are, directly or indirectly, involved in the management of the AIF. This includes, for example, employees of an investment advisory company, as well as individuals not bound by an employment contract, such as independent directors of the AIF or shareholders of the management company.

Entry into force

If enacted into law, the proposed provisions would apply as from tax year 2026.

Next steps and implications

The Draft Law will now go through the legislative process, which involves analysis of the text by a dedicated parliamentary commission, collection of opinions from different advisory bodies (most importantly, the Council of State), discussion of and vote on the text in a parliamentary session and finally its publication in the Official Gazette (Memorial). The entire process may take a couple of months.

Taxpayers potentially affected by the Draft Law should remain aware of its progress through Parliament and consult with their tax advisors to fully understand the opportunities it offers.