The huge sums generated by private equity fund managers by way of carried interest are in the spotlight once again, with Labour’s manifesto pledging to raise £565mn through changing how it is taxed: “Private equity is the only industry where performance related pay is treated as capital gains. Labour will close this loophole”.
Whether carried interest (or “carry”) ought to be characterised as capital or income has also been the focus of several High Court divorce judgments.
In that context, the question affects the extent to which carry should be shared on divorce – and, in contrast to the tax position, it has to date generally been treated as in the nature of income rather than as a gain.
Carry is paid to private equity fund managers where the fund’s performance exceeds a pre-determined rate of return for its investors, typically 8 per cent (the “hurdle rate”). Once that rate is reached, the partners are entitled to a fixed proportion of the fund’s profit, often around 20 per cent.
This remuneration tends to dwarf the management fees paid to the fund managers (typically 1-2 per cent of assets under management) and, unlike those fees, is currently taxed as a capital gain rather than as income.
While this reflects that the sums derive from the gains made on buying and selling investments, many regard it as a performance-related bonus paid by investors to the fund managers, and argue that it should be taxed accordingly.
By contrast, in financial litigation on divorce, fund managers tend to argue that carried interest (as opposed to co-investment) should be seen as more akin to income rather than as a gain on an investment.
This reflects the case-law that, on divorce, the value of investments generated during the marriage (which will normally include co-investments made during it) will generally be shared equally, even if they are currently illiquid or will not pay out for some time.
The underlying rationale is that it is marital funds that have been invested, meaning the proceeds should be shared whenever they become available (or bought out).
However, income earned after the breakdown of the marriage (that is carry) is not subject to sharing, as it is not considered the fruit of the marital partnership.
A bonus for effort
The first reported divorce case in which the nature of carried interest was considered was B v B [2013] EWHC 1232 (Fam) (in which the authors represented the wife).
It was agreed that the carried interest already received by the husband should be shared equally, but whilst the wife argued that carried interest entitlements from funds established during the marriage were akin to returns on an investment generated during the marriage, the husband argued that they were a performance related reward.
Mr Justice Coleridge (having considered each party’s “ingenious” arguments) accepted that carry “is in the nature of a bonus for effort earned for generating a super profit”, meaning the wife was not entitled to share in that portion of future carry payments reflecting the husband’s post-divorce work.
