Carried interest tax debate re-kindled

According to recent reports, Skatteverket, the Swedish tax authority, has launched a tax investigation into eight large Swedish private equity firms. The investigation is to focus on the tax treatment of profit from carried interest, which Skatteverket now claims should be taxed as normal income, not as capital gains. Although the names of the firms involved have not been disclosed, it has been reported that Nordic Capital, EQT, IK Investment Partners and Altor Equity Partners are among those being investigated.

While this issue has been the subject of much debate in the US, where it has been described as "perhaps the most preposterous tax break in the entire federal code", it has attracted less attention on this side of the Atlantic. In Sweden, the market has always considered carried interest as capital gains and the tax authority has not previously contested or audited this area. However, a change in the interpretation of the law could bump the tax rate applied to carry from 25% to 55%. Furthermore, the tax authority would be able to back-date the claim for a period of up to five years, meaning professionals at these private equity firms could face combined tax claims worth several billion Swedish kronor.

Speaking to unquote", David Aversten, head of the private equity practice at the Swedish law firm Delphi, said: "Private equity-backed companies have seen growth and success and investors in private equity funds have received returns on their investments far higher than in other investment classes such as stock markets. To reward that success by imposing income tax on carried interest is not very productive for Sweden as a nation."

One worrying issue with the investigation is that most firms in the private equity and venture capital industry utilise similar fund structures and a carried interest model. As Aversten highlights: "If the tax authority's position regarding carried interest prevails, it would be a hard blow against the Swedish private equity industry. The long term effect could be that we would have no – or very few – Swedish-based private equity houses in the future. That would be a great loss for Sweden and Swedish companies."

Anecdotal reports suggest the justification behind Skatteverket's new interpretation is that only employees are able to invest in funds on terms that allow access to carried interest, meaning that profits from carry are as a direct result from employment.

There are a number of counter-arguments to this, including the fact that GP employees are often required to invest (and therefore risk) their own capital in the funds and are entitled to receive carried interest, as defined in the LPA, as a capital gain from their investment. Additionally, in most cases, carried interest is paid on the fund as a whole and is not restricted to the projects on which an individual professional has worked directly.

Another fundamental issue to consider is that a fund will not produce carried interest unless it has performed strongly, paying back all fees and exceeding the performance hurdle. It is therefore debatable whether such a return on the considerable risk these professionals take should be taxed as income.

It remains to be seen what the outcome will be and the investigation is likely to last several years. One question that remains to be answered is whether the situation in Sweden will act as a catalyst for other European tax authorities to review their stance on this highly debated and controversial issue.

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