n Business Tax and Company Law Quarterly - The taxation of carried interest - research

Volume 10 Number 4
  • ISSN : 2219-1585


‘Carried interest’ is a term that is defined as the super profit that a private equity professional will earn if a private equity fund generates a profit in excess of its ‘hurdle rate’. Carried interest forms part of the general partner’s interest (the general partner bears the risk of loss of the partnership to the extent that it exceeds the limited partners’ contribution to the partnership) in an en commandite partnership (silent partnership) and is disproportionate to its co-ownership in the underlying partnership assets. Partnerships are attractive from a tax perspective, as they are see-through vehicles that allow income and capital proceeds to flow directly to the partners of the partnership. Private equity professionals are employed by a fund manager and acquire their interests in the ‘carry’, typically in the form of a beneficiary interest in a vested trust. The vested rights to income are awarded to private equity professionals based on their seniority and experience. The award of carried interest is usually characterized by a direct link to employment and, because the legal mechanism to acquire the benefit of the carry is in the form of a beneficiary interest in a trust, the acquisition is likely to constitute an equity instrument for purposes of section 8C of the Income Tax Act, 1962. The equity instrument is acquired up front and is unconditional, and therefore if the instrument is not restricted in terms of section 8C, the tax event from an employees’ tax perspective arises at acquisition. There is a dichotomy, though, in the disparity between the value of carry acquired up front (regarded internationally as being nominal given the various probability variables in determining the future super-profit) and the potential gainful outcome which private equity professionals may generate, to the extent that the partnership assets perform favourably. As the employment benefit is acquired and taxed up front (on the basis that the equity instrument is unrestricted), future benefits acquired by beneficiaries, in the form of income or capital proceeds derived by the trust, will retain their tax character in terms of legislated conduit pipe principles. The disparate tax treatment has caused a number of international legislators to apply particular tax rates, or to remove inflationary benefits to capital gains generated by the carried interest, which passes though the private equity structures, ultimately to the private professionals. Emphasis on this analysis suggests that the beneficiary interest is unrestricted for section 8C purposes. However, forms of disposal restrictions and so-called ‘leaver’ provisions are often required by various stakeholders, such as the remuneration committee and the limited partners, which may not achieve the same tax result.

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