European Funds Comment: Taxing Carried Interest in the United States

16 February 2018
Issue 26

The recent US tax reform, rather hurriedly finalised at the end of last year, made some very significant changes to the tax treatment of various private equity activities. These changes included new restrictions on the tax deductibility of portfolio company interest expense, and an ill-defined withholding tax on certain sales by non-US investors of interests in partnerships that are engaged in a US trade or business (which has disrupted a certain amount of deal activity in the secondary market). But perhaps the most headline-grabbing change was to the tax treatment of carried interest. However, in this respect, the US followed a global trend: the tax reform confirms the existing tax treatment of carried interest, providing that it meets certain criteria.

During the Presidential election campaign in 2016, both Donald Trump and Hillary Clinton said they would reform carried interest (at least, in the case of Donald Trump, for hedge funds) and, under the Obama administration, various proposals were introduced to treat carried interest as ordinary income (rather than capital gain, which is eligible – in the case of long-term capital gain realised by US individuals – for a reduced US tax rate). In the end, the reform acknowledged that carried interest should be re-characterised as short-term capital gain income (taxed at ordinary income rates) only if the underlying portfolio investment is held for three years or less; a recognition, perhaps, that long-term carried interest creates alignment between investors and fund managers, and it is more closely related to founder equity than to annual salary and performance-related bonus.

This is a strikingly similar position to that adopted in the UK in 2016, although there is a crucial difference. In the UK, carried interest that relates to a fund whose average holding period is less than three years is all subject to income tax, while any carry in a fund whose average holding period is at least 40 months is subject to a (lower) tax rate of 28% (although it could be higher, depending on the source of the underlying proceeds used to make the payment). (There are provisions in the UK law to deal with average holding periods between 36 and 40 months, to avoid cliff-edge scenarios.) No similar rules are included in the US reform, where the average holding period of the fund is not relevant and each deal is treated separately.

Partly as a result of this differing approach, the US does not have a myriad of complex rules to identify when a particular carried interest qualifies for long-term capital gains tax rates and when it does not (although, admittedly, the US legislation is very recent). The UK tax authority – after extensive discussions with the industry – laid out a series of “safe harbours” for certain types of funds, with special rules applying for follow-on investments and early realisations from funds. To some extent, of course, it is logical that the US rules treat each realisation separately, because of the widespread use of “deal-by-deal” carried interest – and because US tax rules mean that each realisation is generally a taxable event, even if carried interest does not arise at that time.

However, the difference in the holding period requirement to access long-term capital gain treatment (more than three years for carried interest holders, but one year for investors) may exacerbate conflicts between investors and managers – a question widely discussed when the UK changes were being developed – because carried interest holders will be subject to income tax at the higher ordinary income tax rate on early realisations, even if they would be in the investors’ interests. In the US, that is true even if the average holding period of the fund as a whole exceeds the three-year minimum.

Notwithstanding this important difference, in general terms the UK and the US positions are similar to the view taken in many other jurisdictions, which have recognised that the particular characteristics of private equity carried interest mean that it is too simplistic to regard it as salary, and doing so could have some unintended and perverse effects. On the other hand, policy-makers recognise that encouraging longer-term investments can promote wider policy objectives.