Tax Update | August 2020
Carried Interest Taxation – IRS Proposed Regulations
It is quite common in the investments funds (“Funds”) arena that US residents and/or Israelis holding US citizenship, in their capacity as core investors and/or service providers, hold economic rights for carried interest and/or partnership interests in general partners that allow for participation in carried interest payable upon realization of portfolio companies and/or other securities of the Funds. Pursuant to Section 1061 of the United States Internal Revenue Code, a provision included as part of a broader enactment of tax changes from late 2017 commonly known as the Tax Cuts and Jobs Act, the income derived from carried interest can be classified for US tax purposes as long-term capital gains which can be subject to reduce rates of tax in the US. In Israel, no such regulations exist and generally the income can be treated as income generated from trade or business and therefore the rate of tax could be up to the highest tax bracket in Israel (i.e., 50%) applicable to employment income. However, for Funds that obtain a tax ruling from the Israeli Tax Authority, the carried interest would be subject to reduce rate of tax of 28% assuming all investors of the Fund are non-Israeli residents and subject to compliance with certain conditions set forth in such tax rulings. It should be noted that currently the State of Israel is revisiting the rules of taxation on carried interest and it is expected that regulations shall be enacted and rules shall be clarified with respect to benefitting from the reduced rate of tax in Israel.
The United States Internal Revenue Service (“IRS”) and the United States Department of the Treasury (“DoT”) published proposed regulations on July 31, 2020 (the “Proposed Regulations”) regarding the tax treatment of partnership interests referred to as carried interest, which are held in connection with the performance of services. The Proposed Regulations were issued under Section 1061.
Under Section 1061, holders’ eligibility for preferential long-term capital gains rates was limited in certain respects, and specifically, a longer holding period requirement of greater than three years was imposed in contrast to the default period of more than one year. However, under the Proposed Regulations, there are two look-through rules that may apply to a carried interest recipient even when the recipient owned the partnership interest for more than three years, whereby gains from a sale of the interest may be recharacterized as a short-term capital gain.
One look-through rule examines if 80% or more of the fair market value of the assets of the applicable partnership consist of capital assets with a holding period of three years or less. If yes, then even if the taxpayer owns the partnership interest for more than three years, the Proposed Regulations will recharacterize a portion of the gain from the sale of the partnership interest as short-term capital gains.
A second look-through rule included in the Proposed Regulations provides that the IRS may look through certain tiered partnership arrangements to determine if a lower-tier partnership interest has been held for less than three years, even when the individual carried interest recipient has held an upper-tier partnership interest for more than three years. If such an arrangement exists and the holding period in the carry vehicles is less than three years, a portion of the gain upon sale will be taxed at short-term capital gains rates.
Partnership Rights Held by a Corporation
Generally, Section 1061 does not apply to a partnership interest that is owned directly or indirectly by a corporation. However, the Proposed Regulations have clarified if the carried interest is held through an S corporation or a passive foreign investment company (“PFIC”) with respect to which the shareholder has a qualified electing fund election, then the rules of Section 1061 will apply and such application will have retroactive effect. With respect to S corporations, such rules apply to taxable years beginning after December 31, 2017, and for PFICs, the rules will be effective on the date the Proposed Regulations are published in the Federal Register.
In the preamble to the Proposed Regulations, the IRS and DOT acknowledge that taxpayers may attempt to waive their right to gains that would be subject to Section 1061, and utilize arrangements whereby gains that are out of the scope of Section 1061 such as dividends (see next section), are allocated instead. Although the Proposed Regulations themselves do not specifically address these and other similar arrangements, the aforementioned preamble provides that the preexisting anti-abuse provisions in the Internal Revenue Code are always applicable and states that such arrangements may not be respected.
Dividends, Real Estate and other Sources of Income not Subject to Recharacterization
The Proposed Regulations confirmed that a more technical read of Section 1061 is appropriate and that gains from certain sources of income are excluded from potential recharacterization as short-term capital gains. These sources of income include: dividends, gains from dispositions of depreciable property and real estate used in a trade or business, certain options and contracts marked to market on an annual basis and certain straddle positions. The specific allowance for dividends provides that carried interest recipients may wait out the required three-year holding period requirement with in-kind distributions.
Further to the issuance of the Proposed Regulations, we recommend that holders of carried interest review and reanalyze the tax considerations applicable to their carried interest rights to make sure that such rights would be under Section 1061 and continue to enjoy from the long-term capital gains treatment.
For further information regarding this update, please contact Adv. Oren Biran, Partner, Head of Tax Practice, at firstname.lastname@example.org or 03-6074547.