Introduction: Why a Continuation Fund Splits Your Two Tax Returns
A continuation fund lets your firm keep its best asset, yet it can make HMRC tax your carried interest today while the IRS waits years to tax the same profit. That gap is the whole problem for an American partner in London. Britain sees a realisation. America, in a well-structured deal, sees nothing at all. Consequently, you pay UK tax at up to 34.1% on money you never touched, and the credit for that tax sits unused on your US return until the eventual exit.
Most guidance on this subject covers one country only. US commentary explains tax-deferred rollovers and ignores HMRC. UK commentary explains crystallised carry and ignores the IRS. However, a US citizen or green card holder working in a London private equity house lives under both systems at once. This guide therefore sets the two analyses side by side, with 2026/27 UK rates and 2026 US rules, and a worked example with real numbers.
At TaxYork, we prepare US and UK tax returns for American fund partners, principals and portfolio company executives. In our experience, the rollover election form arrives with a thirty-day deadline and no tax modelling attached. Therefore, the time to understand the mismatch is before you sign, not when the January bill lands.
What a Continuation Fund Is and Why Sponsors Use One
A continuation fund is a new vehicle, managed by the same sponsor, that buys one or more portfolio companies from an older fund that is reaching the end of its life. The older fund's investors choose between cashing out at the agreed price and rolling their stake into the continuation fund. Meanwhile, new secondary investors supply the cash that pays the leavers. The sponsor keeps managing the asset, and the clock on its ownership effectively resets.
How a Continuation Fund Transaction Works Step by Step
The process usually begins with a price. A lead secondary buyer bids for the asset, often through an auction, and the fund's advisory committee reviews the conflict because the sponsor sits on both sides. Investors then receive an election pack and typically have around thirty days to decide. Furthermore, the sponsor negotiates new terms for the vehicle, which normally carry a lower management fee and a tiered carried interest that rewards further growth.
The market has grown quickly, and the underlying reward is the familiar one: carried interest, the share of profit paid to the deal team once investors clear their hurdle. Industry trackers report that the number of these vehicles closed globally rose from 13 in 2018 to 123 in 2025, with capital raised climbing from about $9 billion to about $75 billion. As a result, a transaction that was once exotic is now a routine exit route, and most senior professionals at a London buyout house will meet at least one during a fund cycle.
Why Buyers Expect You to Roll Your Carry
Secondary buyers want the deal team to stay committed. Accordingly, they generally expect the sponsor to reinvest all, or nearly all, of the carried interest that the sale crystallises. On single-asset deals the expectation is usually 100%, and on multi-asset deals it commonly sits at 75% to 80%. Additionally, buyers expect the team to roll its co-investment and sometimes to add fresh capital.
That commercial expectation creates the tax problem. You have earned the carry, the sale has fixed its value, and you never see the cash. Instead, your entitlement moves into the continuation fund. Whether that movement counts as a taxable event depends entirely on which revenue authority you ask.
How the UK Taxes Carry When a Continuation Fund Closes
HMRC generally treats the sale to the new vehicle as a real disposal, so carried interest arises to you even if you reinvest every penny. Under the rules in force from 6 April 2026, a sum arises when you receive it or have access to it. Choosing to redirect your entitlement into a new fund does not change the fact that you had access. Therefore, a rolled carry normally produces a full UK charge in the tax year of the transaction.
The 34.1% Charge From 6 April 2026
The Finance Act 2026 moved all carried interest out of capital gains tax and into income tax. Carry is now treated as the profit of a deemed trade, charged at 45% income tax plus 2% Class 4 National Insurance. However, where the carry is qualifying, only 72.5% of it falls within the charge. The effective rate is therefore 34.075%, which most people round to 34.1%. The government set out the policy in its paper on the reform of the tax treatment of carried interest.
No grandfathering applies. Carry awarded in 2019 and paid in late 2026 falls under the new regime. Moreover, the old exemption that made an employee's carry qualify automatically has gone, so every holder now depends on the fund's holding period.
The 40-Month Test and the Reset Problem
Qualifying status turns on the fund's cost-weighted average holding period. At 40 months or more, all of the carry qualifies. Between 36 and 40 months, a sliding scale applies in 20-point steps. Below 36 months, none of it qualifies and the full 47% rate bites. For the selling fund, a continuation deal on a long-held asset rarely causes trouble, because the asset has usually been owned for five years or more.
The continuation fund itself is a different story. We have found no rule that carries the old fund's holding period across to the buyer, so the new vehicle's clock appears to start on the day it acquires the asset. Consequently, a single-asset continuation fund that exits within three years could leave its fresh carry wholly non-qualifying at 47%. A claim for conditionally qualifying treatment can help early distributions, but HMRC retests the position later and collects any shortfall.
Payments on Account Turn One Bill Into Three
Because carry is now trading income, it falls within the payments on account system. A crystallisation in 2026/27 therefore produces a balancing payment on 31 January 2028. In addition, HMRC demands two payments on account for 2027/28, each equal to half of the 2026/27 liability, on 31 January 2028 and 31 July 2028. You can apply to reduce them if next year's income will be lower, but you must make that claim actively and you bear interest if you get it wrong.
Well-drafted fund documents include a tax distribution, which releases enough cash from the rolled amount to meet the liability. Importantly, check whether your documents calculate that distribution on the UK charge alone or on the higher of your UK and US exposure.
How the US Taxes the Same Rollover
The IRS generally does not tax a properly structured rollover at all. Under section 721, a partner recognises no gain when contributing property to a partnership in exchange for an interest in it. Sponsors therefore structure the rolling investors' side of the deal as a contribution in kind, often after a distribution of the asset or through a partnership division. As a result, your crystallised carry moves into the continuation fund with its built-in gain intact and untaxed.
Section 721 Deferral and the Disguised Sale Trap
Deferral is not automatic. The disguised sale rules in section 707 recharacterise a contribution as a sale to the extent you receive cash in connection with it. A tax distribution paid to fund your UK bill is cash. Depending on the structure, part of your rollover may therefore become taxable in America precisely because Britain taxed all of it. Furthermore, any portion of your carry that the sponsor settles in cash, rather than rolling, is a straightforward taxable allocation.
The deferred gain does not vanish either. Special allocation rules track the gap between the asset's value and its tax basis, and they allocate that built-in gain back to the rolling partners when the continuation fund eventually sells. Hence, a US rollover is tax-deferred, never tax-free.
Section 1061 and the Three-Year Clock
Section 1061 converts carried interest gains into short-term gains, taxed at up to 37%, unless the underlying asset has been held for more than three years. In a tax-deferred rollover, the continuation fund generally takes over the old fund's holding period for the contributed share of the asset. In contrast, the share that new investors fund by purchase starts a fresh clock. Your rolled carry also generally keeps its character as carried interest for these purposes, so reinvesting it does not turn it into ordinary invested capital.
Notice the reversal. In an ordinary fund, the US three-year test is easier to meet than the UK 40-month test. In a continuation fund, the US clock may already be satisfied on day one through the carried-over holding period, while the UK clock appears to restart. Therefore, the same exit can be long-term gain at 20% in America and non-qualifying carry at 47% in Britain.
The Net Investment Income Tax Stays Outside the Credit
Long-term carry gains attract the 20% federal rate plus the 3.8% net investment income tax. The foreign tax credit does not reduce that 3.8%. Following the Federal Circuit decisions of 31 August 2026, the treaty route to a credit against it is closed as well. Consequently, treat the 3.8% as a permanent extra cost on top of whatever Britain charges.
The Timing Mismatch: UK Tax Now, US Tax Later
The foreign tax credit works best when both countries tax the same income in the same year. A continuation fund rollover breaks that alignment. You pay UK tax in early 2028 on a gain the IRS will not recognise until the continuation fund exits, perhaps in 2030 or 2031. Fortunately, the credit rules anticipate timing gaps, but only up to a point, and three separate conditions decide whether your UK tax actually offsets your US tax.
Carrying the Credit Forward Ten Years
Under section 904, unused foreign tax credits carry back one year and forward ten. UK tax paid on a rolled carry therefore survives as a carryforward, provided the continuation fund exits within the window. Most do, since these vehicles typically run for four to six years. The mechanics sit on Form 1116, and you must report the carryforward every year, even in years when you use none of it. Additionally, a cash-basis taxpayer claims the credit in the year of payment, so the 2028 payment dates matter for your 2028 US return, not your 2026 return.
The Sourcing Question Under Section 865
A credit only offsets US tax on foreign-source income. For an American living abroad, section 865 treats a gain on shares as foreign-source only where a foreign country actually taxes that gain at 10% or more. In the exit year, however, Britain taxes only the growth since the rollover, because it already taxed the earlier gain. The older, larger slice of your US gain therefore bears no fresh UK tax in that year. Whether it still counts as foreign-source is a question you should model carefully before the exit. The treaty offers a re-sourcing route, yet that route places the income in its own separate credit category, where ordinary carryforwards cannot follow. The texts are in the US-UK tax treaty documents.
What Never Earns a Credit
Two slices of UK cost are lost in every scenario. The 2% Class 4 National Insurance element is a social security charge, and IRS Publication 514 denies any credit for social security taxes paid to a country with a totalisation agreement, which the UK has. Similarly, UK interest and penalties earn nothing. Therefore, calculate your creditable UK tax on the income tax element alone. The ICAEW tax faculty and the Chartered Institute of Taxation both publish technical commentary on the 2026 carried interest rules for readers who want the UK detail.
Illustrative Case Study: An American Partner Rolls £2 Million of Carry
Consider Daniel, a US citizen and UK resident who is a partner at a mid-market buyout firm in Mayfair. He has lived in London for nine years, so the four-year foreign income and gains regime no longer helps him. In November 2026, his firm's fourth fund sells its strongest portfolio company to a single-asset continuation fund. The fund has held the company for six years. Daniel's crystallised carry is £2,000,000, and the lead buyer requires him to roll all of it.
In Britain, the carry is qualifying. HMRC charges 47% on 72.5% of £2,000,000, which is £1,450,000. His liability is therefore £681,500, made up of £652,500 income tax and £29,000 Class 4 National Insurance. On 31 January 2028 he owes the full £681,500 plus a first payment on account of £340,750, a total of £1,022,250. A second £340,750 follows on 31 July 2028 unless he claims a reduction. In America, the rollover qualifies for deferral, so his 2026 US return shows no gain at all.
Four years later, in 2030, the continuation fund sells and Daniel's rolled stake is worth £3,200,000. The IRS now taxes the entire £3,200,000, since his basis is negligible. At 20%, the regular tax is £640,000 in sterling terms, and the 3.8% net investment income tax adds £121,600. Meanwhile, suppose HMRC taxes the £1,200,000 of growth as an investment gain at the 24% main rate shown in the capital gains tax rates, which is £288,000.
If everything aligns, Daniel's carryforward of £652,500 plus the current £288,000 comfortably covers the £640,000 regular US tax. His total burden is then £681,500 plus £288,000 plus £121,600, or £1,091,100. That equals 34.1% of the £3,200,000. However, if the carryforward fails to match because of sourcing or category errors, up to £400,000 of US tax on the original £2,000,000 falls due on top. Getting the paperwork right is therefore worth £400,000 to him.
US Reporting for Your Continuation Fund Interest
A continuation fund organised in Jersey, Guernsey, Luxembourg or Scotland is a foreign partnership for US purposes, and your rollover is a reportable contribution. The compliance burden rises in the year of the deal and stays higher until exit. Importantly, the penalties for missed reporting here are large, automatic and unrelated to whether any tax was due.
Form 8865 and the $100,000 Contribution Rule
You must file Form 8865 as a contributor if you hold at least 10% of the foreign partnership afterwards, or if the property you contributed in a twelve-month period exceeds $100,000 in value. A rolled carry of £2,000,000 clears that threshold many times over. Under section 6038B, the penalty for failing to report is 10% of the value contributed, capped at $100,000 unless the failure was intentional. Moreover, the IRS can require you to recognise the deferred gain immediately. Where the contribution runs through a feeder or carry vehicle, establish early who the reporting transferor is.
Form 8938, Schedule K-3 and Entity Classification
An interest in a foreign partnership is a specified foreign financial asset. You therefore report it on Form 8938 unless Form 8865 already covers it, in which case you still identify that form on Form 8938. The interest itself is not an FBAR account. Additionally, ask the sponsor in writing whether the new vehicle will issue Schedule K-3 data, because you cannot compute your credit without it. Our guide to Schedule K-3 for US partners in UK funds explains what to request.
Check classification too. A feeder or holding entity that defaults to corporate status can be a passive foreign investment company, which brings Form 8621 and a punitive tax regime. Confirm each entity's US status before closing, while elections remain available.
Planning Before You Sign the Rollover Election
The decisions that fix your tax outcome are made in the thirty-day election window, so your modelling must happen inside it. Five questions matter most, and each has a deadline that falls before closing rather than at filing time.
Match the Timing Where You Can
Pure deferral on the US side is not always the best answer for an American in Britain. Because HMRC taxes the rolled carry regardless, a structure that also recognises the gain in America in the same year lets the UK tax offset the US tax immediately. The regular US tax of 20% disappears against the 34.1% UK charge, and your basis in the new vehicle steps up. In contrast, deferral preserves a US liability that depends on a carryforward surviving several years of sourcing and category tests. Ask the sponsor's tax team which route the documents permit for individual partners.
Negotiate the Tax Distribution and the Co-Investment
Secure a tax distribution that covers your real cash cost, including the payments on account. Then ask how that cash is treated for US purposes, since it may erode your deferral. For your co-investment, the position differs again. A rolled co-investment may be a disposal for UK capital gains tax under the partnership rules in Statement of Practice D12, although sponsors often structure it to be neutral. Confirm which treatment applies to you, in writing.
Plan for a Move Back to America
Many American partners return to the US before the continuation fund exits. From 6 April 2026, Britain taxes a non-resident on the share of carry that relates to UK workdays. Relaxations exist for tax years with fewer than 60 UK workdays, and a three-year tail eventually ends the exposure for qualifying carry. Therefore, keep a workday diary from the day you leave. Our article on UK carried interest and US tax for private equity partners covers the wider regime in detail.
How TaxYork Can Help
TaxYork prepares both the UK Self Assessment return and the US federal return for American private equity professionals, so one team reconciles the two treatments of the same rollover. We compute the UK charge under the 2026 regime, track the 40-month position on the continuation fund, and build the foreign tax credit carryforward schedule that links your 2028 payments to the eventual exit. Furthermore, we prepare Form 8865, Form 8938 and Form 1116 together, which keeps the figures consistent across every form the IRS will compare.
We also work with clients who rolled into an earlier vehicle and never reported the contribution. Missed reporting of a foreign partnership interest is common among fund professionals, and it is fixable when you act first. Our US tax return preparation for expats and FBAR and FATCA reporting services cover those catch-up filings. For the credit position itself, see our tax treaty and foreign tax credit work.
Conclusion
A continuation fund is a sound commercial tool, yet it produces one of the sharpest timing mismatches in US-UK tax. Britain charges 34.1% on carry you rolled and never received. America defers the same gain, then taxes all of it at exit, with 3.8% that no credit can reach. The outcome depends on whether your UK tax and your US gain finally meet in the same category, with the same source, inside ten years. Ultimately, an American partner who models both returns before signing keeps the total near 34%. One who signs first can pay far more.
Contact Us
If your firm has announced a continuation fund, or you have already rolled carry into one, speak to us before your next filing deadline. You can book a consultation with the TaxYork team, email hello@taxyork.com, or call 020 3488 8606. We prepare US and UK tax returns for dual filers across London and the wider UK, and we will review your election pack alongside both sets of rules.
Disclaimer
This article provides general information only and does not constitute tax, legal or financial advice. Tax rules in the United States and the United Kingdom change frequently, and their application depends on your individual circumstances and on the specific structure of each transaction. The figures in the case study are illustrative. You should obtain professional guidance tailored to your situation before making any election or filing any return. TaxYork accepts no liability for actions taken on the basis of this article.