22 July 2016

Taxation of carried interest – a global view

The tax treatment of carried interest – the profit share used to reward successful fund managers – has been a hot topic in the private equity and venture capital industry for some time and, as the industry has expanded globally, many jurisdictions have been grappling with the question of how to treat it. Some have laid down specific rules or guidance which, therefore, now sit alongside the commercial and regulatory landscape as a factor influencing fund and fund manager choice of domicile. Governments are clearly well aware of that competitive tension. 

In the US, the debate has rumbled on for years; proposals are periodically brought forward to tax carried interest as income, but to date none has ever been enacted. That debate reared its head again on the presidential campaign trail, with both Republican and Democratic nominees criticising the current rules, to the concern of the US private equity and venture capital industry. It may be that the new president takes another look at this issue, but is likely to face as many challenges in getting changes agreed by Congress as their predecessor. On the other hand, there has been a sharper focus in the US (as in the UK) on other aspects of private equity executive compensation, in particular management fee waivers which have been used to fund co-investment.

The tax treatment of carried interest had also been well established in the UK, with capital gains tax treatment agreed with the government in the late 1980s‎. And, under new UK tax rules, access to that tax treatment has been preserved for most private equity and venture capital funds. The British government has always recognised the value of the industry to the economy and that carried interest is a long term, deferred, investor-aligned profit share. But in reality a great deal has changed in the UK, and access to this new regime is now subject to strict conditions. Carried interest in funds with an average investment holding period of less than 40 months will be taxed as trading income at 45% and, where capital gains tax treatment is still available, all carried interest returns are taxed at a minimum special capital gains tax rate of 28%, without any allowance for the acquisition cost of the underlying assets (abolishing the so-called "base cost shift").

Australia has also adopted a twin track approach: on the one hand, it has an established regime for venture capital funds which provides certain tax benefits.  In particular, carried interest can be treated as being on capital account, which may be advantageous in certain circumstances (for example, for resident partners who are able to apply the discount capital gains concession). On the other hand, the Australian Taxation Office tends to take the view that gains on disposal of traditional private equity investments should be on revenue rather than capital account. In addition, while there are certain concessions for non-residents investing into managed investment trusts (MITs), there are specific rules that treat carried interest in MITs as effectively being held on income and not on capital account.

Hong Kong, a relative newcomer to private equity, is the latest jurisdiction to step forward with its own carried interest proposals. Seemingly influenced by steps taken in Britain, the Hong Kong legislator has used the UK law concept of a 'self-funded' executive investment in a fund to define a 'genuine investment', and decided that anything else is liable to be taxed as income for services provided, with potential employment tax consequences (albeit in an environment with low income tax rates by international standards).

On the other hand, various EU jurisdictions have recently introduced (or plan to introduce) special carried interest tax regimes to qualify carry for taxation at capital gains tax rates, or rates lower than those applied to employment income. They are following the lead of their larger counterparts, Germany and France, who introduced their regimes in 2004 and 2002 respectively (with the French rules initially applying only to French firms and then, from 2008/09, to all EU and EEA private equity firms). These regimes have the merit of providing clarity and certainty for venture capital and private equity carried interest holders, so long as the required tests are met. That can be a competitive advantage in itself.

Governments in some other jurisdictions with no formalised system of carried interest taxation have taken a more reactive approach. Indeed, in Sweden, the tax authority actively went on the offensive to prove that carried interest was a 'performance bonus' and thus a form of income, and not capital gains. 2013 saw a ruling against the Swedish tax authority which had claimed retroactive additional taxes from private equity executives, arguing that carried interest paid should have been taxed as salary, with a higher tax rate and resultant employer's contributions. Much to the relief of many in the industry, the Swedish Supreme Administrative Court thought differently and gave a decisive ruling confirming the treatment of carried interest as capital gains and refusing the Swedish tax agency leave to appeal. Had the decision differed, Sweden's status as a hub for private equity could have been seriously compromised.

There is no doubt that taxation of carried interest will continue to be much debated, and making the economic case for capital gains tax treatment will be important.  But the fact that many countries have deliberately preserved it – often in the face of powerful lobbying to change it – will provide some comfort to those who argue that long term, deferred and realisation-based incentives, especially when combined with "skin in the game", encourage long term investment and help to stimulate economic growth while, like founder equity in a company, aligning the interest of the individual managers of a fund with those of the investors.

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We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

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