The taxation of carried interest

• Date: 01 December 2019
• Published date: 01 December 2019
• Record Number: btclq_v10_n4_a3
• Author: Michael Rudnicki
• Pages: 18-24
• DOI: 10.10520/EJC-1ac411e72f

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© SIBER INK

The Taxation of Carried

Interest

MICHAEL RUDNICKI*

ABSTRACT

‘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 part-

ner’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 partner-

ship) in an en commandite partnership (silent partnership) and is dispropor-

tionate 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 benef‌i-

ciaries, 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.

* Tax Executive, Bowman’s Attorneys, Johannesburg.