Domenico Imparato (University of Hamburg, UC-Berkeley), Private Equity's Byzantine Tax Stand: An Untold and New Story of Carried Interest, 7 Brit. Tax Rev. __ (2024):

With the expansion of private equity’s footprint in the global economy has come scrutiny of its unique profit-sharing system, known as “carried interest”, which is perceived to enjoy favourable tax treatment.

The debate over whether to tax carried interest as a capital gain or as ordinary income reflects the tax industry’s complex interplay between finance, leverage, capital distribution, corporate structures and tax strategies. This article contributes to the ongoing discussion by proposing an empirical risk-based approach (ERB Approach) for the optimal taxation of carried interest. 

First, the article sheds light on the carried interest encompassing not only profits from realised gains when a buyout fund makes a corporate sale (exit), but also midstream income realised from the buyout fund’s balance sheet investments during its lifespan (for example, dividends, interest, buybacks)—referred to as Realised Performance Earnings and Realised Investment Earnings, respectively. 

Further, as carried interest—which resembles a call option in economic terms—exhibits a dual nature, the ERB Approach provides a novel model to “disaggregate” it into a capital component and a service income component (close to a success fee). The model is clear in that only the Realised Performance Earnings made at exit should be disaggregated, owing to legal and efficiency reasons, as it aims at striking a fair balance between tax on capital and income.

Editor's Note:  If you would like to receive a daily email with links to tax posts on TaxProf Blog, email me here.