Tax distribution provisions were originally designed to help individual carried interest holders manage tax liabilities that arise by reference to their holding of carried interest but before their receipt of distributions. The issue is particularly relevant for US taxpaying carry holders due to the accrual basis of taxation for carried interest in the US, contrasting with the distribution basis prevalent in other jurisdictions. Over time, these provisions have evolved and become more complex, and a diverse array of practices have developed, sometimes producing outcomes beyond their original purpose. Considering the significant commercial implications of tax distributions, including their effect on fund returns and the dilution of clawback benefits for investors (plus, on the GP-side, the potential deferral and reduction of carry distributions for carry holders who do not receive tax distributions) this has sparked debate as to what is their appropriate application.
In addition to exploring these commercial considerations, this article examines the nuances of how tax distributions are taxed, the calculation of clawback obligations and the tax implications of a clawback, challenges in obtaining tax refunds, recent regulatory considerations around disclosure and tax distributions functioning as advance carry. The complexity inherent in these issues highlights the need for meticulous drafting of LPA provisions both at the main fund level and the level of the carried interest partnership. Such drafting must strike a delicate balance between accommodating the tax payment needs of carried interest holders and safeguarding the interests of the fund and its investors.
In a typical closed-ended private capital limited partnership fund, with a fund as a whole/European-style waterfall, distributions are paid first to investors until they have received back their invested capital along with a preferred return before carried interest distributions are made. Tax distributions are an exception to this rule and enable a GP to be able to make distributions out of partnership assets to the carried interest holders ahead of their entitlement in the commercial waterfall. Tax distributions are to enable recipients to pay tax they suffer in respect of their holding of carried interest before they receive carry distributions.
As most jurisdictions only tax carried interest on a distribution basis, on the assumptions that (i) the fund itself does not have a US tax liability due to its investment activity; and (ii) carry is not held in escrow, tax distributions are usually only required where there are US taxpaying carry holders, as the US charges tax on carried interest on something akin to an accruals basis.
Put simply, US taxpayers pay tax on carried interest on a deemed liquidation basis where each year, to determine the carry holders’ US tax liability, there is a deemed distribution through the commercial waterfall of both the income and gains realised in that year plus the cost of unrealised investments. As a result, in the case of a fund with a fund as a whole/European-style waterfall, tax usually falls due for US taxpaying carry holders considerably before the time at which the hurdle in the commercial waterfall is met and carry becomes payable to carry holders. This results in US carry holders suffering “dry” tax liabilities, and tax distributions are designed to provide them with the necessary funds to cover these. Tax distributions are treated as advance payments and are offset against future actual carried interest distributions from the fund (as further described below).
US tax liabilities arising before related UK tax liabilities in respect of carried interest has caused UK/US tax credit headaches for carry holders who are UK resident and US citizens. These crediting issues led to the introduction of the accruals basis election into the UK carried interest rules that allow an individual to irrevocably elect to pay UK tax on their carried interest in respect of a fund on a basis aligned with the US tax rules. While this election can be made by any carry holder, it is unlikely to be beneficial unless there is a corresponding US tax liability for the carry holder in relation to the fund in question.
A basic provision in a fund LPA would provide that a GP can make distributions to carried interest holders to enable them to discharge a tax liability arising from the holding of carried interest to the extent there are insufficient carry distributions in the relevant period to cover that tax liability. These tax distributions then operate to net against (and so reduce) carry distributions that would otherwise be made in accordance with the usual waterfall. The netting occurs on a gross basis, not an individual basis, meaning that even those carry holders who do not receive a tax distribution suffer a deferral as a result of tax distributions.
These fund LPA provisions should then track through to the carried interest limited partnership agreement ensuring that (i) tax distributions paid by the fund are on-distributed to those participants whose status gives rise to the entitlement to tax distributions at the fund level; and (ii) those same individuals (and not those who do not receive tax distributions) suffer the cost of the future netting.
The main distinction in drafting at the fund LPA level is whether there are tax distributions only to carry holders who have an actual tax liability or whether a tax liability is assumed for all carry holders.
We return to that fundamental question below, but there are other variations too including:
While the standard position in European funds is for tax distributions only to be payable to carry holders with an actual tax liability, in the US, it is usual to assume all carry holders have the same tax liability (even if they are not in fact taxable on an accruals basis). This practice was perhaps not intended to change much, on the basis that, for a US fund with only US carry recipients, all participants will have an actual tax liability.
However, with the geographic diversification of teams, a US tax distribution provision can nowadays result in material tax distributions to non-US carry holders who do not pay tax on carry on an accruals basis. For those recipients, while they will have a tax liability on the tax distribution, that tax would only be for a portion of that distribution (i.e. their applicable tax rate on the distribution), leaving them with net carry proceeds. If the tax distribution is effected by reference to the highest US marginal rate of any recipient (which is north of 50% for New York City residents), that can mean that tax distribution provisions can result in material advance carry distributions to certain team members.
For carry holders based in the US, tax distributions should not be taxable as they are the distribution of profits which have been taxed for US tax purposes. However, if a tax distribution recipient is resident outside the US, tax distributions themselves would normally be taxable.
In the UK, assuming the income-based carried interest (IBCI) rules are not in point (including where the carried interest is an employment related security), tax distributions should be taxed as carry with income tax treatment only to the extent the distribution is accompanied by allocations of underlying income by the fund partnership.
Turning to carry which is potentially within the IBCI rules, HMRC’s view is that tax distributions are not ”realisation model” carry distributions and so cannot benefit from the enhanced conditional exemption from IBCI if made after four years from the commencement of a fund. That means, according to HMRC, tax distributions made after the initial four years of a fund will likely be IBCI. We understand that is not a position adopted by all taxpayers, some of whom take a more purposive interpretation to the meaning of “realisation model”.
On the plus side, HMRC do accept that the existence of a tax distribution does not taint future post-hurdle carry payments and prevent them being realisation model/safe harbour carried interest provided the tax distribution was (i) for the amount of the tax due only; (ii) paid from the fund to the executive; and (iii) paid for no other purpose than to cover the outstanding tax charge. While these three conditions cannot be found in the legislation they should give food for thought for those using tax distributions on a less precise basis.
The making of tax distributions has a number of commercial consequences that should be borne in mind. These include:
Clawback is the obligation of the carried interest partner, at the end of the life of the fund, to repay carry distributions if, over the life of the fund, the carried interest holder receives more than the agreed share of the investors’ overall profits. Overdistribution can occur (for example) due to an early home run followed by a loss, or indeed due to tax distributions or other advance carry distributions.
The standard provision is that a clawback obligation on a carry recipient is net of any tax paid or payable by the carried interest holder in respect of prior distributions. Like with tax distribution provisions, clawback provisions will need to be tracked through into carry documentation (including shadow award documentation) and it is usual for investors to both require this and to obtain an undertaking from the GP to enforce these provisions. You also see these enforcement obligations sometimes backed by a parent company guarantee or an escrow arrangement.
However, like with tax distributions, in determining the terms of a carry clawback provision, there is both a fundamental question, and other questions, to answer.
The fundamental question is whether tax distributions are excluded entirely from the clawback obligation, with the other questions including:
In US standard LPAs, which provide for tax distributions to all carry participants irrespective of their actual status, it is not uncommon to see excluded from the clawback obligation tax distributions which have been made or which the GP could have made. This position developed on the basis that all such distributions were used to pay tax and that there was not an easy way to get that tax back. However, as noted above, this first assumption may no longer be the case.
A carried interest clawback usually occurs several years after both the carried interest distribution and the time that any related tax was payable. There is usually no basis for participants to recover tax they have paid relating to carried interest which is subsequently clawed back. A tax benefit that might arise in this situation is that the amount clawed back and returned to the partnership by the carry holder could result in base cost in the partnership for the contributor which could give rise to a capital loss on the ultimate winding up of the fund. That might result in a tax related benefit for the carry holder in due course, but it is not a tax refund and is a benefit the timing and amount of which it is difficult to determine.
It might be hoped that it would be possible to allocate a loss at fund level to the carry holders in a clawback situation to allow an earlier enjoyment of a tax benefit in connection with the clawback. However, (i) that assumes there is a loss to allocate; and (ii) in the UK at least, due to the vagaries of the UK carried interest rules, a loss can only be allocated effectively for UK tax purposes in respect of carried interest where the transaction giving rise to a loss does not give rise to any proceeds for distribution to carry holders. That means that such losses will only arise on losses on FX forwards, complete write offs and/or negligible value claims. Even where a loss can be allocated, these can only generally be set off against capital gains (not income) and usually cannot be carried back.
Interestingly, in the UK, if the carried interest is structured as a phantom entitlement and paid as a bonus to an employee a refund of income tax (but not NICs) may be available in a clawback scenario. This will be the case if the satisfaction of a clawback counts as negative earnings for employment tax purposes in which case it may be set off against other income subject to certain limits.
The limited circumstances in which a tax refund will be available in a clawback scenario and the uncertainties of any tax benefits accruing from a clawback understandably push managers to seek to limit “benefit crediting” obligations in a clawback scenario.
While the SEC private fund adviser rules have recently been struck out by a US court, they had included certain disclosure obligations in relation to clawbacks. Justifying the proposed inclusion of these disclosure rules (instead of their original proposal to not allow clawbacks to be reduced on account of tax liabilities), the SEC noted:
“For example, many fund agreements only require advisers to restore the excess performance-based compensation (less taxes) to the fund, without requiring them to provide investors with any information regarding the adviser’s related determinations and calculations, such as whether a clawback was triggered and the aggregate amount of the clawback. Without adequate disclosure, investors are unable to understand and assess the magnitude and scope of the clawback, as well as its impact on fund performance and investor returns. Further, not all investors may be able to ask questions successfully or seek more information about a clawback on a voluntary basis from their private fund’s adviser. We believe that disclosure will achieve the rule’s policy goal of protecting investors, while preventing unintended consequences that may have resulted from a flat prohibition.”
While the private fund adviser rules have been struck out, this development shows that carry clawback is an area of regulatory focus.
