Jul 296 min read

Balancing Investment Incentives with Tax Equity : A Comparative Analysis of Carried Interest Taxation in the US and India

Updated: Sep 24

Written by Abhay Asagodu, the author is a law student currently Pursuing LLB from the University of Glasgow

Introduction

The taxation of carried interest, a critical element in the compensation structure of fund managers, presents a fascinating comparison between the United States and India. In the US, carried interest is treated as capital gains, providing significant tax advantages and encouraging investment and economic growth. This preferential treatment, however, exacerbates income inequality and leads to substantial revenue loss for the federal government. Conversely, India's approach, which also offers tax benefits by treating carried interest as capital gains, faces legal challenges and uncertainties, impacting financial planning for fund managers and investors. These differences in tax treatment reflect each country's economic priorities and tax philosophies, with the US focusing on incentivising investment and India balancing tax benefits with regulatory clarity. By examining both systems' strengths and weaknesses, this essay explores potential learnings and improvements each country can adopt to create more equitable and efficient tax policies that support economic growth while ensuring tax equity.

Taxation of Carried Interest in India

In India, the taxation of carried interest, or 'carry,' in the hands of fund managers has been historically viewed under both the Income Tax and Goods and Services Tax (GST) regimes. Carried interest represents a fund's profit share allocated to its fund manager, often viewed as 'being carried by the investors' since the manager receives a profit share disproportionate to their investment but proportionate to the fund's performance[i]. Traditionally, under Income Tax law, fund managers have treated their carry as capital gains from investments in specially designed securities, allowing them to benefit from lower capital gains tax rates[ii]. Under GST, income from carry has been considered income from securities, exempt from GST[iii].

The current tax treatment under Income Tax law, which classifies carry as capital gains, benefits fund managers by allowing them to pay lower taxes compared to regular income tax rates. This treatment also exempts the investors from bearing the GST burden on the carry paid to fund managers, which can be as high as one-fifth of the gross receipt[iv]. Such tax advantages encourage investment in venture capital and private equity, fostering economic growth and innovation.

However, this favourable tax treatment has faced criticism for being a loophole that allows fund managers to pay significantly lower taxes than they would on ordinary income. Critics argue that since fund managers typically invest negligible amounts compared to their returns, this income should be taxed as performance fees at normal income tax rates[v]. The recent ICICI Econet Internet and Technology Fund v. CCT case challenged this by characterizing carried interest as a performance fee, thus subjecting it to service tax[vi].

The varying interpretations and tax treatments have created uncertainty and potential for litigation, impacting the financial planning of fund managers and investors. The characterization of carried interest as a performance fee could significantly increase the tax liability for fund managers, affecting their net returns and potentially dissuading investment[vii]. The High Court ruling acknowledging the commercial arrangement and the principle of mutuality provided some clarity but did not settle the issue of GST on carried interest, leaving it unsettled[viii].

Taxation of Carried Interest in the US

Current Law: Explain the Tax Approach

Under US tax law, carried interest refers to the share of profits that general partners in private equity or hedge funds receive, typically 20% of the fund's profits. Unlike management fees, which are taxed as ordinary income, carried interest is treated as a capital gain and taxed at a lower rate. Carried interest is taxed when profits are realized, not when the right to future profits is initially granted. The character of the income is based on the underlying income; long-term capital gains are taxed at the long-term capital gains rate[ix].

The current tax treatment of carried interest has several strengths. Firstly, it aligns the incentives of general partners with those of limited partners, encouraging long-term investment and active fund management. Secondly, by taxing carried interest as capital gains, the policy promotes investment in businesses, potentially leading to economic growth and job creation. Additionally, lower tax rates on carried interest help maintain the US's competitive edge in attracting private equity and hedge fund managers.[x]

However, there are notable weaknesses in this approach. Critics argue that the current treatment allows high-income individuals to benefit from lower tax rates, contributing to income inequality. Since carried interest is effectively compensation for services rendered, it should arguably be taxed at the higher ordinary income rate. This is because carried interest represents compensation for services (fund management), it should be subject to higher ordinary income tax rates rather than the lower capital gains rates. This argument seeks to address perceived inequities in the tax treatment of different forms of income and has been a topic of significant policy debate and legislative proposals. Furthermore, the preferential treatment results in significant revenue loss for the federal government, which could otherwise be used for public services and infrastructure. The complexity of the tax rules surrounding carried interest has also led to tax planning strategies that transform management fees into carried interest, reducing tax liabilities beyond the law's original intent[xi].

The economic effects of the current tax treatment of carried interest are multifaceted. Favourable tax treatment likely boosts investment in start-ups and innovation, encouraging fund managers to take on the risks associated with new ventures. However, this approach may distort market dynamics by encouraging funds to structure compensation to exploit tax benefits, potentially leading to inefficient capital allocation. Additionally, the disparity in tax treatment contributes to broader economic inequality, benefiting high-income individuals in private equity and hedge funds disproportionately, thereby exacerbating wealth gaps[xii].

Comparative Analysis and Learnings

The US's treatment of carried interest as capital gains encourages investment and economic growth by providing significant tax advantages to fund managers. This favourable tax treatment aligns the incentives of fund managers with those of investors, fostering long-term investment and active fund management. However, this approach has significant drawbacks. It exacerbates income inequality, as high-income individuals benefit from lower tax rates compared to ordinary income. Moreover, it results in substantial revenue loss for the federal government, which could otherwise be used for public services and infrastructure.

India's approach, while offering similar tax benefits, is more complex and has faced legal challenges that create uncertainty and potential for increased tax liabilities. Historically, carried interest has been treated as capital gains, allowing fund managers to benefit from lower tax rates and exempting income from carry under GST. This dual benefit encourages investment in venture capital and private equity, promoting economic growth and innovation. However, recent legal cases, such as ICICI Econet Internet and Technology Fund v. CCT, have challenged this classification, arguing that carried interest should be taxed as performance fees. This has led to potential litigation and uncertainty, impacting financial planning for fund managers and investors.

Another critique of the US approach is that it may inadvertently encourage short-termism in investment strategies. While the intention is to promote long-term investments, the significant tax advantages might lead fund managers to focus on realizing short-term gains to capitalize on the lower tax rates, thereby undermining the goal of sustainable long-term growth. This potential misalignment between tax policy and investment behavior could result in inefficient capital allocation and volatile market dynamics, ultimately affecting the stability and health of the broader economy.

Both countries can learn from each other to improve their tax policies. The US might consider India's efforts to reclassify carried interest as performance fees to address fairness and revenue concerns. Such a reclassification would ensure that fund managers' compensation for services is taxed as ordinary income rates, thereby increasing federal revenue and promoting tax equity. Additionally, it would mitigate the issue of income inequality by ensuring that high-income earners pay a fair share of taxes.

Conversely, India could streamline its tax policies to reduce uncertainty and create a more stable investment environment. By adopting a clear and unified approach to the taxation of carried interest, India can balance the need to encourage investment with ensuring tax equity. Simplifying the tax treatment and providing clear guidelines would help avoid litigation and make the tax system more predictable for fund managers and investors.

The US focuses on incentivizing investment and maintaining a competitive advantage in attracting private equity and hedge fund managers. In contrast, India grapples with balancing tax benefits with regulatory clarity and ensuring that fund managers' compensation is taxed appropriately.

Conclusion

A critical re-evaluation of carried interest taxation in both the US and India can foster more equitable and efficient tax systems. For the US, reclassifying carried interest as performance fees would ensure that the fund manager’s compensation is taxed as ordinary income, increasing federal revenue and promoting tax equity. This change would also reduce income inequality by ensuring that high-income individuals pay their fair share. In India, streamlining tax policies to reduce uncertainty and adopting a unified approach would encourage investment while ensuring fair taxation. A probable alternative solution can be taxing carried interest as ordinary income, with graduated rates based on investment duration, ensures fairness. Longer-term investments could qualify for lower rates, promoting stability and discouraging short-term speculation. International coordination and stakeholder consultation are crucial for effective implementation and balanced tax practices. Clear guidelines and simplified tax treatment would make the system more predictable, fostering sustainable economic growth and innovation. Combining these reforms would help both countries balance investment incentives with equitable tax practices.