Judgment in a case concerning an advance ruling on income tax

External investors in a private equity fund expect the manager of the fund to co-invest in the fund. The terms and conditions of such co-investments are often asymmetrical, meaning that the manager of the fund – or a company associated with the manager – receives a greater share of the profit relative to his or her share of invested capital, conditioned on the fund’s return exceeding a certain level. Such a profit distribution is regularly referred to by the English expression, “carried interest”.

An employee of a company that provides investment advice to the fund’s management company has been offered the opportunity to purchase shares that may entitle the holder to carried interest. The founders of the fund are the management company, known as the GP, which has unlimited liability in the fund, and the company ILP, which has limited liability. The founders’ co-investment in the fund has been made through ILP, which, under the fund agreement with the external investors, is entitled to carried interest from the fund.

The offer relates to the purchase of shares in the company Holding, which owns both GP and ILP. The employee intends to purchase the shares through a close corporation wholly owned by him, and his shares in that company will be qualifying shares. He applied for an advance ruling to clarify whether he will be taxed on carried interest paid out from the fund to ILP, or via a dividend from ILP to Holding, or alternatively from Holding to the closely held company, as employment income.

The Supreme Administrative Court found that the question in the case is whether the distribution of profit in the fund is to be disregarded for tax purposes and, if so, what tax effects this may have for the employee. It was noted that, generally, the distribution can only be disregarded if it entails an undue transfer of income or appears unreasonable and substantially motivated by reasons related to taxation. The distribution of profits between, on the one hand, GP and ILP and, on the other hand, the external investors was accepted as they are independent of one another. Furthermore, it was considered that the fact that ILP and GP had chosen not to have GP to undertake to invest in the fund, and thereby receive carried interest, could not be said to merit either the conclusion that an undue transfer of income has taken place from GP to ILP or that the profit distribution can be deemed motivated by reasons related to taxation. In summary, the Supreme Administrative Court notes that ILP is entitled to the special profit share and that this constitutes a return on the investment made by ILP in the fund. The income referred to in the application will therefore not have any tax implications for the employee.