IFM36550 - Carried interest and profit related returns: Tax Distributions

ITA07/S809EZC & S809EZD

Background

A fund (IFM36132) may make an advanced payment to a fund executive to discharge a tax liability arising from that individual’s future entitlement to carried interest. Such a payment may be called a ‘tax distribution’ and may arise where fund executives are subject to tax in jurisdictions where carried interest is taxed on an accruals basis, which may mean that the tax charge will arise prior to carried interest being paid out.

Tax distributions will be provided for in the fund limited partnership agreement (LPA). Any sums advanced in this way will be deducted from the carried interest which arises to the fund executive.

Treating tax distributions as carried interest

It is possible that a tax distribution may meet the definition of carried interest at ITA07/S809EZC (IFM36520). Whether the sum is carried interest under this definition will depend on the specific facts and circumstances of the payment. All required conditions of ITA07/S809EZC must be met for the sum to be carried interest.

It is not expected that a tax distribution, as described, would normally meet the definition of a ‘sum treated as carried interest’ within ITA07/S809EZD (IFM36500).This definition can only apply to carried interest which arises after investors in the scheme have been repaid their investments and received a preferred return. In most circumstances, a tax distribution will be paid prior to this occurring.

It is possible however that a tax distribution paid to discharge a tax liability in respect of a deferred carried interest amount which has been held in escrow may be paid after investors have been repaid their investments and received their preferred returns. Under these circumstances it is therefore possible for the tax distribution to meet the conditions of ITA07/S809EZD.

Future carried interest payments

ITA07/S809EZD(2)(a) and S809EZD(3)(a) require that substantially all of the investments made by investors in the scheme must be returned to them before a sum can be treated as carried interest under ITA07/S809EZD. The receipt of a tax distribution prior to investors being repaid their investments does not automatically prevent future carried interest payments to that executive from being treated as carried interest under ITA07/S809EZD as long as the distribution was:

• for the amount of the tax due only,
• paid from the fund to the executive; and
• paid for no other purpose than to cover the outstanding tax charge.

The classification of the carried interest payment under ITA07/S809EZD will depend on the facts and circumstances at the time.