More Interest on the Taxation of Carried Interest
27 January 2021
Dear Colleagues and Clients,
For several years now, an ongoing debate around the taxation of carried interest received by investment fund managers has occupied professionals, lawmakers and other market participants. The major issue, which has been discussed in the United States, Israel and other jurisdictions around the world, is how to characterize the carried interest from a tax perspective or, more specifically, whether or not beneficial capital gains characterization and treatment is justifiable.
Earlier this month, the US Internal Revenue Service issued final regulations addressing the taxation of carried interest under Section 1061 of the US Internal Revenue Code of 1986 (the “Regulations“) which appear to have come as welcome news to fund managers in that they essentially limit the applicability of Section 1061 through the adoption of several exceptions. Section 1061 aims to limit the beneficial tax rate applicable to long-term capital gains stemming from the allocation to, or disposition by, persons, of partnership interests in a partnership that generates carried interest payments, and to which such persons provide investment management services, at times in consideration for the allocation of such partnership interests. Section 1061 extends the holding period required for the beneficial long term capital gains treatment to three years as opposed to the otherwise applicable one year holding period.
As noted above, the taxation of carried interest has been on the agenda in Israel as well, and there are preferential tax rates granted and applicable arrangements, albeit subject to meeting certain conditions.
On March 14, 2018, the Israel Tax Authority (the “ITA“) published two circulars addressing the taxation of carried interest of private equity and venture capital funds in connection with their investments in Israel (ITA Circular 9/2018 – Taxation of Venture Capital Funds and ITA Circular 10/2018 – Taxation of Private Equity Funds)(the “Circulars”). Among other things, the Circulars determine the following:
(i) Carried interest received by foreign participants (including a foreign seed investor entitled to up to 10% of the carried interest) is subject to Israeli tax at the rate of 15% on their share of any carried interest attributable to Israeli investments (while in some circumstances, the Israeli tax may be refunded, if not creditable in the residency country of the GP interest holders); and
(ii) Carried interest received by Israeli participants is subject to a reduced tax rate, which is calculated in accordance with a special arrangement between the Israeli Tax Authority and the Israeli Venture Capital Association dated 6 April, 2003 (the “IVA Arrangement“).
In accordance with the IVA Arrangement, the special tax rate applicable to Israeli participants will be a blended tax rate ranging between 25% and the marginal tax rate for individuals (currently 47%), depending on the profile of investors in the fund; the portion allocated to foreign investors and Israeli tax-exempt investors is calculated based on a rate of 25% while the portion allocated to all other investors is calculated at the marginal tax rate. The Circulars determine that this reduced tax rate is only applicable to individual interest holders, provided they hold such rights directly (including through a look-through vehicle). The reduced tax rate is subject to compliance with certain terms, including a holding period of two years. For a more thorough discussion of the Circulars, please refer to our previous client update.
With respect to value added tax (“VAT“), the position of the VAT Authority is that carried interest received by a general partner that manages the fund (and is registered as a “dealer” with the VAT Authority) is subject to VAT at a rate of 17% with respect to the portion allocable to Israeli investors, while the portion allocable to non-Israeli investor is subject to a zero-rate VAT. The issue is less clear with respect to carried interest received by a general partner that does not manage the fund or by other participants who do not take part in the management of the fund (in each case, assuming not registered as a “dealer” with the VAT Authority). The VAT Authority is currently examining what the applicable VAT in such cases should be. Rulings currently being issued by the VAT Authority to venture capital and private equity funds indicate, on this point, that if carried interest is received by such recipients, the Professional Department at the VAT Authority should be contacted for further guidance.
Despite the relatively recent publication of the Circulars, the taxation of private equity and venture capital funds in Israel is yet again under further examination, and the ITA is contemplating introducing new legislation in this respect. Such legislation may also change the manner in which carried interest payable to fund managers is taxed, and there is no certainty that the IVA Arrangement currently in place will continue to apply. That said, we do expect the publication of the Regulations and the rules therein to be considered by the ITA when moving forward with any proposed revisions on this topic.
We note that said tax treatment is relevant only to carried interest received from private equity and venture capital funds. Carried interest related to other investment funds should be examined separately on a case-by-case basis. It is noted that US taxpayers (which include US citizens and holders of Green Cards, even if not residing in the United States) should particularly be minded of their carried interest structuring as it has implications in both Israel and the United States.
Should you require any further information or clarification regarding the issues discussed in this client update, please do not hesitate to contact us. Our firm has extensive experience in working with investment funds on tax-efficient structuring of fund management entities and fund income and gains.
We will be happy assist for any questions and clarifications that may be required.