Carried interest: employement or capital income?

The recent answer to the tax ruling no. 407 of 24 September 2020 offers an opportunity to return to the issue (still with uncertain borders) of the qualification of incomes deriving from participations with reinforced patrimonial rights (the so-called carried interest) attributed to key managers in application of incentive plans (see our previous article).

Incomes from carried interest (usually given to high-qualified employees) have always been difficult to qualify, because of their hybrid nature that stands between a capital investment and the remuneration for the activity carried out. In fact, the preeminence of one or the other nature determines the correct qualifications as capital or employment income[1].

As known, the percipient is generally interested in seeing those incomes qualified as financial because of their more favorable tax regime (for example, the tax rate applied is 26% instead of the ordinary tax rates of the personal income tax brackets).

Through time, the Tax Administration, since the Circular no. 25/2017, has listed a series of indexes (not particularly elastic) to identify the nature of these incomes. These indexes have been further specified in the abovementioned tax ruling answer.

In this case, the Italian Tax Agency has denied the qualification as capital income proposed by the applicant (an asset management company). The Tax Agency considered that the incomes from participations in a fund (set up by the applicant itself) attributed to the managers of the asset management company did not have the nature of return on capital investment (with the consequent participation in the business risk). On the contrary, the Tax office considered these incomes as the variable part of the manager remuneration (for this reason, to be added to their employment income). This conclusion, whether shared or not, was based on a series of evaluations and/or factual circumstances that characterized the incentive plan and that is useful to take into account.

Firstly, the Tax Agency considered that the amount of the investments undertaken by the managers (in reality substantial, as stated by the applicant and also demonstrated by the need for the latter to recourse to forms of financing to sustain the subscription) was not large enough to indicate an alignment of the managers’ interests with the ones of the ordinary fund investors.

Secondly, the Tax Administration identified a several circumstances. As indexes of the employment nature of these incomes. In particular:

• (i) the circumstance that the ordinary remuneration of the abovementioned managers consisted exclusively of a fixed part (lacking a variable part that made them participate in the performance of the fund);
• (ii) the presence of some statements in the minutes of the meetings of the company board, where it is declared that the reward system is to be identified in the attribution of the abovementioned carried interest, considerable as a form of incentive (that, from the Tax Office’s point of view, would represent – and replace – the variable part of the remuneration);
• (iii) the provision of bad and good leaver clauses which, even if they didn’t provide the loss of enhanced patrimonial rights upon termination of the employment relation (an index used several times by the Agency to qualify that incomes as from employment), lead to a decrease in the carried interests in consequence of the moment of termination of the relationship between the managers and the applicant.

It should be noted that the Revenue Agency is rather restrictive in admitting the qualification of the carried interests as capital incomes (although, in this case, the nature of financial investment is evident as demonstrated by the size of the disbursement made by the managers[2]). For this reason, it remains fundamental to carry out a careful analysis and structuring of the entire incentive plan (from the relevant regulations, to the wording to be used in approval resolutions and agreements with managers) in order to avoid that such income is qualified[3] as from employment (with application of the higher tax rate and, consequently, the risk of frustrating the appeal of the incentive itself).

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[1] The article 60 of Law Decree no. 50/2017 provides a legal presumption following which incomes from carried interest, if met some specific requirements, are qualified as capital incomes. Nevertheless, the issue regarding the correct qualification remains for the remaining cases (actually most of them) where those requirements are not met.

[2] This element, in different case (i.d. Tax ruling answer no. 473/2020), has instead made the Agency to qualify the income deriving from participative financial instruments (attributed to directors) as capital income.

[3] Perhaps a posteriori, during a verification and/or an assessment, with negative effects on the direct beneficiaries and also on the employer and tax-substitute company.

Author: dott. Paolo Visconti

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