Private Equity Manager: New legislation was released in 2008 and 2009 clarifying what rules private equity managers should follow in order for carried interest to be treated as capital gains rather than ordinary income. What changed for fund managers?
Olivier Dumas: Before the new legislation, the carried interest of a private equity fund could receive a capital gain tax treatment if the fund managers fulfill two main conditions: they should receive a normal income, a salary, and they should also invest a certain amount in the fund, which wasn’t clearly determined by the tax administration. Those were the only rules that were applied.
With the new legislation, several new rules have been implemented. One is that the amount the manager has to invest in the fund has been clearly determined. The amount is now 1 percent of the total commitments of the fund for a carried interest with a rate of 20 percent, except in the cases of venture capital funds that invest in innovative companies or in European small businesses companies. For those funds, the amount the manager has to invest in the fund is not 1 percent of total commitments, but o.25 percent, again for a carried interest with a rate of 20 percent. In general the idea is that the manager has to take a financial risk in the investments of the funds. And the capital gain tax treatment of carried interest is the result of the risk taken by the managers of the funds.
PEM: Does the fact that French funds tend to calculate carried interest based on the total returns of the fund, rather than on a deal-by-deal basis, make a difference in how carried interest is perceived by tax authorities?
OD: In France, it's a market practice, and prevention against the requalification of carried interest as a salary, that the carried interest is calculated on the total return of the fund, and not deal by deal. For the same reasons, carried interest, and sometimes, the reimbursement to the manager of their paid-in capital, can’t be distributed to the manager until after investors have received, at least, distributions in an amount equal to the capital paid into the funds. By the way, it’s also a market practice to implement a contractual mechanism to prevent distribution of carried interest in excess, in the middle of the life of the fund, before the investors’ commitments have been completely drawn and reimbursed.
Another effect of the new law is that to receive capital gains treatment, the fund by law must indicate that carried interest will be distributed only after the investors have been returned all of the capital they committed to the fund. Carry can only be treated as capital gains if there is a real financial risk of investment, a risk that is greater than the risk that is held by the investor.
With the new legislation, you also can’t distribute the carried interest and paid in capital to the manager before five years have passed.
PEM: In the US, regulators don’t seem to think carried interest is sufficiently “at risk”. Why is the attitude different in France?
OD: So the difference with US funds is that, in principle, the carried interest is not tied to an investment in the funds. In principle, the manager has to invest in the fund but they invest on the same terms as all the other investors in the fund. For example if the manager of a US fund has to invest 1 percent of the total commitments of the fund, they receive exactly the same capital gains as all the other investors in proportion to their investment in the fund. The manager also holds a special right on the results of the fund which is called carried interest, but this right has no cost for them and is not subordinated to a special financial risk.
In France, in principle, as carried interest is formalised by a special unit class in the fund that managers subscribe, the right to hold the carried interest has a cost. And this cost is the amount that the manager has to invest in the fund. And this commitment is more at risk than those hold by investors, because the manager receives its returns after the limited partners.