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VC/PE Industry Apprehensive Over Probable Increase in Carried Interest

08 June, 2010

The US Senate is this week debating the “The American Jobs and Closing Tax Loopholes Act of 2010” (the “Loopholes Bill”) which in the Loopholes section of the bill proposes the removal of the ‘capital gains tax’ status from carried interest earned by General Partners (fund managers) of venture capital and private equity funds.  This is will have a definite impact on the VC/PE industry including the Indian VC/PE industry.  

 

This is because many leading VC/PE funds invest in India related investments out of their global fund, ie. not through a separate India fund, and the General Partners are partners in the global fund.  While such funds may invest through a Mauritius or other tax efficient special purpose vehicle, the “mother ship” fund and the General Partner are often US entities (usually incorporated in Delaware) and therefore the immediate tax impact on the General Partners of such funds.  Also, tax authorities globally are becoming more aggressive and it is possible that other jurisdictions, including India, may follow the US and tax general partners in a similar fashion. 

 

Currently, the carried interest earned by the General Partner (GP) is treated as capital gains and therefore taxed under US tax laws at a rate of 15%.  The proposed bill, however, seeks to re-classify carried interest as ordinary income, which is taxed at a rate of 35%  – more than double the current rate of tax. 

 

Despite hectic lobbying by the VC/PE industry, including by the National Venture Capital Association which sought carve-outs for the VC industry in particular (because the bill lumps VC, PE and hedge funds into the same bucket), the bill passed the US House of Representatives last week and will be debated in the US Senate this week.

 

The bill has garnered much attention because proponents of the bill state that the current “loophole” allows General Partners to pay a lower tax rate than essential service workers such as policeman and teachers. The VC lobby’s counter argument is that venture capital (as opposed to private equity) invests in early stage ventures, encourages innovation, creates jobs and that the proposed tax will have a chilling effect on venture capital. However, given the current US economic climate, the populist arguments seem to be prevailing over the VC/PE industry arguments. 

 

In a spirit of self-introspection, some leading VC commentators have agreed that there is a potential loophole that needs to be closed. This is because the current scenario taxes General Partners as though they actually supplied the financial capital of the fund (GPs normally contribute 1%) and are therefore eligible for capital gains treatment rather than being taxed as managers receiving compensation for services rendered (and are therefore liable to pay ordinary income tax rates).

There are several consequences of the passage of the Loopholes Bill for the Indian VC/PE industry.  Those fund managers/GPs who are GPs with global funds will have to work twice as hard for the same carry if their tax rates double in comparison to their peers who are structured through Indian GP entities. Perhaps some GPs may leave these funds and join funds/GP structures which are located in a more tax favorable jurisdiction.  Some global funds may exit India if their India based GPs leave the fund.The argument that has been posited by opponents of the bill is that the tax will have a chilling effect on the VC/PE industry as it makes it a less attractive industry to work in.

 

Carried Interest Structures:

VC/PE funds are typically structured as pass-through entities, ie. income and losses are not attributed to the fund itself but passed through to the fund’s partners.  In venture capital and private equity funds, carried interest or carry is a share of profits that is attributable to the General Partner of the fund as compensation above and beyond the management fee. 

In a typical fund structure, profits generated by the fund are ordinarily divided between the Limited Partners (investors who subscribe to interests in the fund) and the General Partner (individuals who organize an entity and act as general partner to the fund) according to a formula which provides the General Partner with a share of the profits – usually the ratio is such that 80% of the profits go to the Limited Partners and 20% of the profits go to the General Partner.  This structure is typical for both US funds investing in India and funds which have raised separate India funds.

Indian funds are typically structured using trust structures which attempt in some fashion to follow international limited partnership fund structures.  For current tax purposes in India, only Venture Capital Funds (“VCFs”) registered with the Securities Exchange Board of India are accorded a tax pass through status and only if such VCFs invest in certain specified sectors (i.e. biotechnology; information technology relating to software and hardware development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceuticals sector; dairy; production of bio-fuels, and hotels/convention centers).

 

Typically, the carried interest for Indian General Partners is treated as capital gains (15 to 20%) and the actual rate depends on whether the unlisted shares are held on long term or short term basis.  As in the US examples above, Indian fund managers/GPs are currently being taxed as if they contributed the capital as investors rather than as remuneration for fund management services.

 

Possible Restructuring of Funds:

Some commentators in the VC/PE industry are preparing for the passage of the US bill and are examining alternative fund structures. In one scenario that has been posited, the Limited Partners loan the General Partners 20% of the fund’s capital and the General Partners then invest this into the fund.  Proponents of this structure argue that any profits accruing to the General Partner are then properly characterized as a capital gain.   Other alternative scenarios involve US funds moving offshore (India may be a beneficiary of such move) to jurisdictions which offer more favorable capital gains treatment and/or carried interest being paid as a fee rather than as a percentage of profits.  Such alternate structures are, however, still in the hypothetical phase.

(By Shantanu Surpure, Managing Attorney, Sand Hill Counsel;  Assisted by Varun Shah and Rashi Saraf, Associates, Sand Hill Counsel)

 


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VC/PE Industry Apprehensive Over Probable Increase in Carried Interest

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