Cornwell Dauds

Introduction

  1. The favourable tax treatment of private equity profits has been a cause for concern for many revenue authorities, precisely because of the apparent tax base erosion effect. In some countries, even the public has expressed its outrage at the favourable manner in which private equity profits are taxed.
  2. As an emerging economy, South Africa relies heavily on investment and, like many other economies, government uses a number of options at its disposal – including tax measures – to encourage investment into the country. The South African National Treasury has acknowledged the benefits of private equity investment by stating that private equity transactions can contribute to economic growth in various ways. Even so, the tax benefits thus far enjoyed by private equity fund managers have raised concerns.

Nitty gritty of private equity

  1. Private equity funds are often set up as partnerships which, in turn, comprise a number of investors (mostly institutional) such as pension funds, for instance. If set up offshore, the fund will typically be organised as a limited liability partnership (an LLP). If set up onshore, the fund tends to be legally known as an en commandite partnership (a limited liability partnership). Often the partnership will have a general partner (“GP”) who is responsible for the management of the affairs of the partnership. The GP is rarely an individual – in fact, in most cases it is itself a partnership consisting of a number of individual partners.
  2. Alternatively, the funds of the partnership (the investors) may be managed by an investment management company (this may be unwise though, as the same profits will be taxed twice – when they are earned, and again when they are distributed). The brief of the GP, or investment management company, typically includes the identification, evaluation, and negotiation of investment opportunities – and the monitoring and realisation of those investments on behalf of the fund. For this, the GP, or management company, earns a management fee – typically amounting to 2% of the fund value.
  3. To align the interests of the fund manager with those of the investors, the GP, or investment management company, may be required to co-invest with the investors in the fund. This requisite co-investment is typically as little as 1 – 2% of the total capital in the fund. In return, the fund manager becomes entitled to up to 20% of the total growth of the fund. However, 18 – 19% of this (20%) entitlement is only triggered once the fund manager has achieved a certain agreed level of performance, and the ordinary investors have received their specified return. Since the fund manager only contributes 1 – 2% of the fund’s capital, yet becomes entitled to 20% of the fund’s growth, the 18 – 19% constitutes what is often referred to as “carried interests” (otherwise simply known as “the carry”).

Current tax treatment

  1. The fund manager does not receive carried interests in return for any corresponding capital contribution to the fund. Rather, the carry is based solely on the fund manager’s performance which in many jurisdictions enjoys favourable tax treatment in that it tends to be taxed at capital gains tax (“CGT”) rates, instead of the ordinary rates which may be as high as 45% for individuals in South Africa.
  2. Fund managers often organise themselves into partnerships so that the carry is taxed in their hands as individuals at the maximum effective CGT rate, which in South Africa is 16.4%. In other words, the carry is treated as capital, rather than revenue, and taxed accordingly (i.e. at CGT rates). This treatment has unleashed vigorous criticism in many jurisdictions where carried interests is taxed favourably at CGT rates. Even the South African National Treasury has on occasion said that the tax treatment of carried interests, which according to them constitute a reward for services rendered by fund managers, and which (reward) may take the form of shares/equity, should be investigated with a view to, ultimately, taxing the carry at ordinary rates (rather than the more favourable CGT rates) for individuals.

Should carried interests private equity fund managers earn be taxed as capital or revenue?

  1. There appears to be agreement that any growth in the investment of the ordinary investors constitutes a capital gain, and therefore deserve be taxed at the favourable CGT rates since the shares purchased on behalf of these investors are typically held as capital assets. However, it is contended by some commentators (a view seemingly shared by the South African National Treasury) that, when 18 – 19% of the shares/equity (which appreciated in value) are transferred from the investors to the fund manager as reward for the manager’s performance, the shares undergo a change in character and become ordinary income in the hands of the fund manager, and should thus on this basis be taxed as ordinary income. This proposed treatment is supposedly supported by the argument that the shares, though held as capital by the investors, in the fund manager’s hands constitute compensation for services rendered by the manager. More specifically, the shares represent performance fees.
  2. The counter-argument goes along the lines that the shares do not, and should not, undergo a change in character when they flow from the investors to the fund manager – even if the fund manager provided services rather than capital for those shares. According to this argument, to maintain that the shares undergo a character change is tantamount to imposing an artificial re-characterisation on the shares. What was capital in the hands of the investors should apparently remain capital in the hands of the fund manager, unless the manager unequivocally makes the decision to acquire and hold the shares as trading stock.

Settling the debate

  1. While the debate rages over how precisely carried interests in private equity deals should be taxed, and National Treasury as far back as 2008 undertook to investigate the issue by developing a discussion document which raises options and elicits public comment, we appear to be nowhere close to settling the debate!