Tax Europa

In response to critics of the private equity industry's "excessive" renumeration, some jurisdictions around Europe have changed their taxation of carried interest income. This article is an expanded version of an article published in the November issue of PEI Manager. By Darren Docker, Gijs Fibbe and Christian Koedam of PricewaterhouseCoopers

Darren Docker is a tax advisor in the mergers and acquisitions and private equity group of PricewaterhouseCoopers in the UK and can be contacted at Gijs Fibbe and Christian Koedam are tax advisors in the mergers and acquisitions and private equity group of PricewaterhouseCoopers in the Netherlands. In addition, Gijs Fibbe is a lecturer in international tax law at the Erasmus University in Rotterdam. They can be reached at and

In recent years, private equity has received significant political attention in Europe. This has been driven by both anxiety regarding private equity ownership of companies which are household names, and the levels of leverage used to acquire them. Whether this attention will abate or intensify in the wake of the global financial crisis remains to be seen, but the expectation is that policy makers are concerned with other, more pressing, matters at the moment.

In reacting to this political attention, policy makers have – among other measures – focused on the tax treatment of private equity executives. This article is concerned with the resulting changes. It is too early to say whether the election of a new president in the United States will influence that country's taxation of incentivisation methods used in the alternative asset management industry, and if so, whether any changes in the US will induce policy makers on the other side of the Atlantic to undertake a further round of changes. But certainly tax changes in the US will be watched closely by European observers. In addition it is as yet uncertain how the private equity industry will weather the global recession. Towards the end of 2008 there were several high profile instances of large fund managers either publicly appealing to limited partners not to default on their commitments, or negotiating down the size of funds closed a number of years earlier. One feels that to the extent the industry is smaller, and hence has a lower profile, the scrutiny it attracts from tax policy makers will be less intense.

In this article, we examine at a high level six different European jurisdictions: the UK, the Netherlands, Sweden, Spain, Switzerland and Germany.

The European playing field
In most European tax systems, carried interest has historically been taxed as investment income. Traditionally, investment income is taxed at lower tax rates than income from employment and does not attract social security liabilities.

However, critics of the private equity industry have disputed the status of these returns as investment income. They argue that the restrictions which are attached to carried interest and co-investment schemes, such as ongoing participation in the schemes being conditional on continuing employment with the private equity house, and the fact that the participation in the schemes is generally not available to non-employee investors, mean that the returns should be taxed as employment income. Similarly the lack of investment when viewing carried interest on a standalone basis (i.e. ignoring any opportunity or obligation to co-invest) also leads critics to conclude that carried interest is a form of employment income, similar to a bonus.

It appears, however, based on the overview below, that actual tax reforms have spared carried interest and co-investment from being fully taxed as employment income with associated social security costs.

The Netherlands
In the Netherlands, new legislation has entered into force as from 1 January 2009. Under this new legislation, returns (i.e. income and capital gains) from qualifying “lucrative investments” are treated as a type of income which is taxed at similar rates as employment income.

The legislation has been adopted to discourage “excessive” remunerations. To fall within its scope, an investment should therefore qualify as a “lucrative investment”. An investment is deemed to be a “lucrative investment” if the returns, based on the facts and circumstances under which the employee shareholder receives these returns, were intended to be a reward for the activities undertaken by the employee shareholder. Although some guidance has been given in the form of case studies, exactly what is covered by this new legislation is not entirely clear due to the absence of a clear definition and the inclusion of a so-called catch-all provision. Where it concerns an investment in shares, in principle, no lucrative investment is taken into account:

  • • where the equity held by the individual belongs to a subordinated class of shares that forms at least 10 percent of the total outstanding share capital (e.g. including preference shares); or
  • • the equity concerns preference shares with a return lower than 15 percent per annum.
  • Please note, however, that the catch-all provision could still apply if additional leverage or additional returns (e.g. based on a ratchet) are created on the management investment. Where an investment qualifies as a lucrative investment, the rules provide for an exemption under which taxation of the returns can be mitigated to effectively 25 percent. For this exemption to apply, a holding entity should be interposed, the employee investor has to hold a substantial interest shareholding in this holding entity, and at least 95 percent of the returns realised by the holding entity will have to be paid out immediately to its shareholders. In order for the effective rate to amount to 25 percent, the holding entity should be entitled to the participation exemption or be subject to no or limited taxation (e.g. by using a foreign holding entity).

    The application of the new legislation under the tax treaties concluded by the Netherlands is likely to give rise to discussions and could possibly even trigger double taxation, as the qualification as “income from activities” is not likely to be followed by other countries that consider these returns as capital gains.

    Even if the tax, political or regulatory environments in some countries were to become sufficiently adverse that private equity fund managers consider relocating, other countries are actively attempting to attract private equity and other alternative asset management businesses by a range of policy measures

    If an employee investor has a lucrative investment on 1 January 2009 and is not a resident of the Netherlands at that moment (and did not perform any taxable activities in the Netherlands), but becomes a resident after 1 January 2009, the Dutch lucrative investment regime will be effective at the moment the employee investor becomes a resident of the Netherlands. As a result, the carried interest holder has a ‘step-up’ to the fair market value of his investment at the moment of becoming a resident of the Netherlands for Dutch tax purposes. Where the employee investor already was a resident or performed taxable activities in the Netherlands for Dutch tax purposes on 1 January 2009, no step-up applies and the original purchase price paid for the investment is taken into account when determining the taxable gains. Finally, please note that an individual is considered to perform taxable activities in the Netherlands if he is appointed as a statutory board member of a Dutch-based entity. In such case, if it is not clearly defined that the lucrative investment has been awarded in respect of other duties, there is the risk that part of or even all lucrative investment returns should be allocated to these Dutch duties and fall in the scope of Dutch taxation. Careful consideration should therefore be given to the structure of the lucrative investment.

    United Kingdom
    In the UK, reform was precipitated by trade unions, media and political pressure and in particular the discussions which representatives of the UK industry body, the BVCA, had with the UK Treasury Select Committee (a committee established by the House of Commons). It seemed possible that the UK government might introduce new law, or interpretations of current law, which would tax carried interest at the income tax rate of 40 percent and oblige UK private equity houses to pay social security costs on carried interest. Executive co-investment was not the subject of debate in the way that carried interest was, albeit there was a residual risk that this too could be recharacterised as employment income.

    Instead the measures introduced, effective from April 2008, were not specifically targeted at the private equity industry. Rather the reform concentrated on the rate at which capital gains are taxed. Capital gains tax is critical to the tax position of UK resident carried interest holders because a large element of carried interest payments are characterised as capital gains for UK tax purposes. However, many other (non-private equity) investors are also impacted by changes in the capital gains tax rate, including owners of small businesses and investors in commercial property.

    From 6 April 2008, the effective rate of tax on gains was fixed at 18 percent. Prior to that there was a complex system which, depending on the type of asset sold, would lead to a range of rates between 10 percent and 40 percent (it was considered that most carried interest payments and co-investment profits would be taxed at 10 percent, although this was not free from doubt given the complexity of the system).

    Many private equity investment professionals were publically critical of the change in tax rate to a flat 18 percent, arguing that taxation of profits arsing from entrepreneurial activity, which had previously been likely to benefit from the 10 percent tax rate, were now taxed at the same rate as, for example, investors in public equities. However it seems likely that privately the UK private equity industry considered the reforms a measured and reasonable response to public criticism, given that it represented a significantly better outcome than the worst case scenario of carried interest being taxed as employment income.

    In addition it should be noted that guidance on the valuation of carried interest for employment taxes purposes introduced in July 2003 has survived. As with many other jurisdictions, the UK taxes acquisition of an asset by an employee as deemed employment income when the employee pays less than the asset's market value. Carried interest however, which is treated as an asset which has the potential to give rise to such deemed employment income when acquired, is difficult to value, and following lobbying by the BVCA in July 2003 the UK tax authorities introduced a concession on valuation, the “memorandum of understanding”. The memorandum of understanding effectively eliminates the incidence of deemed employment income when an employee acquires carried interest at the outset a private equity fund. It had been assumed by many observers that this memorandum of understanding would be repealed in 2007 or 2008, leaving private equity executives with uncertain tax exposures on the acquisition of carried interest, but this repeal has not taken place.

    In Spain, the tax treatment of carried interest received by Spanish residents depends on whether an arms length consideration is paid for the carried interest shares.

    If an arms length consideration is paid for acquiring the carried interest shares, the gains and the income received from the carried interest shares will be taxed as investment income. The investment income tax rate is 18 percent. Income received from disposals, interest income and dividends will be treated in the same manner.

    It appears that actual tax reforms have spared carried interest and co-investment from being fully taxed as employment income with associated social security costs

    Where the consideration paid for the carried interest shares is less than an arms length consideration, the value of the carried interest so acquired will be taxed as employment income for Spanish tax purposes, and further more in Spain there is no equivalent of the UK's “memorandum of understanding”. The employment income tax rate applicable is 43 percent. Thereafter distributions should be taxed at 18 percent as above. An additional point to note is that where ownership of the carried interest is highly restricted and intrinsically linked to ongoing employment with the private equity house and individual performance, there may be a risk that an executive is deemed not to have acquired an investment at all, but rather all distributions of carried interest are taxed as employment income at 43 percent.

    The same rules on the taxation of valuable assets at the point of acquisition are also in point with regard to co-investment, albeit it is less likely that a significant transfer of value to the executive would take place on the acquisition of an interest in the fund portfolio under co-investment arrangements.

    In 2008, the Swiss tax authorities appear to have been attempting to attract alternative asset managers – such as private equity funds and hedge fund managers – to Switzerland. A key constraint was that income from carried interest was subject to Swiss income tax rates varying between approximately 15 percent to 40 percent. For Swiss tax purposes, there is no special tax regime for carried interest, which has been considered a constraint for private equity executives to go to Switzerland.

    The Swiss tax authorities announced in 2008 that to change the Swiss tax regime could effectively reduce the tax rate on gains economically similar to carry interest to nil. This should help to make Switzerland a much more attractive location for private equity fund executives.

    Although at the time of writing this article the exact changes were not published yet, the initial proposal distinguishes between proportionate and disproportionate returns. Disproportionate returns are treated as income and subject to income tax rates as stated before. However, where the gain is proportionate to a person's equity investment then it will be treated as a private capital gain not subject to tax in Switzerland. Critical is the fact that when looking at the question of whether a return is proportionate, the taxpayer only needs to take into account the amount of equity investment by the carryholder relative to other investors. Therefore even if a fund is primarily financed by investor loans, with equity being a minimal amount such that in aggregate the fund manager's return exceeds his proportion of the total capital, provided the fund manager's return is proportionate to their share of the equity capital, the rules are satisfied.

    Therefore while carried interest will continue to be taxed as income, it should be relatively straightforward to create funds providing for returns similar to carried interest but where the capital structure satisfies the proposed rules on proportionate returns.

    In the meantime, as long as the Swiss tax regime is not changed, in practice, it is commonly recommended to obtain a tax ruling regarding the Swiss tax treatment of carried interest shares from the Swiss tax authorities.

    In December 2003, the German tax authorities classified carried interest as a ‘professional service fee’ and not subject to tax as a capital gain. As a result, carried interest would have been subject to taxation at a rate around 50 percent. Of course, the view of the German tax authorities expressed in December 2003 contrasted markedly with the industry's view that carried interest should be taxed as capital gains. Following extensive debate among industry bodies, advisers and the tax authorities, a new scheme of carried interest taxation was agreed upon which represented something of a success for the German private equity industry, and which continues to the present day, although it was subject to a recent increase in the effective tax rate.

    The law implementing this new scheme of carried interest taxation was introduced in August 2004. Carried interest continues to be classified, according to the view of the tax authorities, as a professional service fee. However this professional service fee is subject to tax at a low rate. Carried interest enjoys effectively a “half income” tax rate because there is a 50 percent tax exemption which is applied to the distributions. This is due to decrease to a 40 percent exemption, thus leading to an increased effective tax rate, but clearly that treatment is preferable to taxation on a full income basis.

    There are conditions attached, however, which some funds may fail to fulfil. For example, carried interest should only be paid after all capital contributions have been returned to the fund investors (which can be potentially problematic for funds which operate a deal-by-deal carry structure). Also the beneficial rules which exempt 50 percent (or 60 percent under the new regime) are only applicable to funds which are classified as asset management partnerships according to German rules. Carried interest distributions sourced from funds which are business partnerships according to German tax classification, or from so-called deemed business partnerships, will not benefit from the exemption. While many funds' activities are arguably asset management in nature rather than “business” in nature (and guidance has been issued by the German tax authorities on this point), there are also structural triggers for deemed business categorisation which non-German funds with German resident managers may easily fall into.

    From a Swedish tax perspective, income from carried interest, and potentially co-investment profits, could be treated as either employment or active business income, which is taxed at high rates, or investment income which is taxed at lower rates. Often the structure of the private equity house and its Swedish operations will be the key determining factor. There are no specific rules or concessions which deal exclusively with the taxation of carried interest distributions or co-investment profits, rather, the regime is the result of the application of Swedish tax rules which apply to all Swedish individuals. The key question relates to the relationship between the advisory entity which employs the Swedish executive, and the fund's general partner. If the advisory entity is part of the same corporate group as the general partner and the carried interest holders/co-investors are also employees of the Swedish advisory entity, Swedish managers could be taxed on their carried interest and co-investment profits as active business income. Such income is generally taxed under the national income tax rate being 25 percent, the municipal income tax rate, which is around 32 percent and the pension fee rate, which is 7 percent. In other words, the aggregate tax rate is very high.

    However, if the general partner is separate from the advisory group's legal structure, within which Swedish managers are actively employed, the tax position of the Swedish managers could be improved. The managers may therefore fall within the scope of the investment income regime, and potentially be taxed at 30 percent on carry distributions and distributions of co-investment profits. Furthermore, it is commonplace for Swedish managers to hold their fund investments through companies which enable carried interest and co-investment distributions to be reinvested and Swedish taxation to be triggered only where money is repatriated to Sweden.

    However, even where the general partner and advisory company are legally separated, such that the likelihood of active business income classification is reduced, restrictions placed on the fund investments made by executives (more commonly relevant to the carried interest scheme, and specifically leaver restrictions, vesting restrictions or general transfer restrictions), could cause profits to be deemed to be intrinsically connected to employment by the Swedish tax authorities, and hence subject to the high rates of income tax.

    In reacting to public debate, European policy makers have introduced various tax changes. Executive co-investment is usually less of a controversial subject due to the material investments made executives that are directly comparable with those made by third-party investors in the private equity funds, so it is carried interest which has generated the most interest and debate.

    Some countries such as Germany have introduced specific tax treatment rules for carried interest, changes that are targeted at private equity executives.

    Other countries have not implemented a separate methodology for the taxation of carried interest; instead it fits within the overall scheme of personal taxation within that country (although there may be literature published by the tax authorities as to clarify or interpret how carried interest sits within that overall scheme). In a way, this is a logical approach. When a particular regime is introduced for carried interest, the next question that naturally arises is whether real estate funds, infrastructure funds and hedge funds are covered by the same regime. However, changes have nonetheless been introduced in these countries, and whilst these effect all individual taxpayers they have been at least partly inspired by private equity considerations. The UK and the Netherlands are countries which fall into this category, and though there was some consternation in the private equity community during the process by which these changes were introduced, the changes have generally not had the negative impact initially expected.

    In any case, even if the tax, political or regulatory environments in some countries were to become sufficiently adverse that private equity fund managers consider relocating, other countries, as evidenced by Switzerland in our sample, are actively attempting to attract private equity and other alternative asset management businesses by a range of policy measures, including taxation.