Private equity managers generally co-invest in the managed fund alongside fund investors. They also hold carried interest, which gives them an additional return to the extent the fund meets certain profitability requirements. Typically, both the co-investment and the carried interest elements are held in the form of units, shares or interests in the fund in question.
Whilst other EU countries such as France and the UK have rules in place addressing the tax treatment of carried interest, in Spain, only the Provincial (“Foral”) Territories of Guipúzcoa, Vizcaya, Álava and Navarra have approved rules regulating this matter and, at a national level, Spanish legislation has to date remained silent in this respect.
Against this background, on 1 December 2022 the Spanish Congress approved a Law promoting the start-ups ecosystem (known as the Start-Up Law), which sets out various different legal and tax measures that have the aim of attracting investment into Spanish start-ups. Included among these measures are new rules on the taxation of carried interest.
In this blog, we examine what’s next for private equity houses and executives in the light of this new legislation.
Carried interest: employment income and the new 50% reduction
According to the Start-Up Law, income obtained by private equity executives directly or indirectly from shares or rights, including variable fees, that grant special economic rights in certain closed-ended Alternative Investment Funds (AIFs) or in analogous entities, should be treated as employment income for Spanish tax purposes.
However, carried interest employment income taxation will be subject to a 50% reduction provided that certain requirements are met – these are discussed in further detail below. Considering that Madrid’s highest marginal employment income tax rate is currently 45%, the effective tax rate of a private equity executive would be around 22.5% if these conditions are met.
Conditions for 50% reduction
- AIF requirement: For the 50% reduction to be available, the relevant carried interest income must derive, directly or indirectly, from one of the following entities:
- Closed-ended AIFs as defined in Directive 2011/61/CE included in one of the following categories: (i) Spanish venture capital funds or Spanish venture capital companies; (ii) European venture capital funds; (iii) European social entrepreneurship funds; and (iv) European long-term investment funds; or
- Other entities analogous to the above – in determining whether an international private equity fund should be deemed “analogous”, the question arises of what comparability criteria the tax authorities are going to apply, as the Start-Up Law does not provide any guidance on this point;
- Employment requirement: The private equity executives receiving the carried interest must be directors, managers or employees of the AIF (or analogous entity) or of its management company or entities within its group;
- Hurdle requirement: The right to obtain carried interest distributions shall be subject to the third-party investors in the fund receiving a minimum return that is above the level of a hurdle defined in the fund regulations;
- Lock-up requirement: The shares or rights entitling the individual to carried interest distributions must be held continuously during at least a 5-year period. The Start-Up Law clarifies that this Lock-Up Requirement would need to be met, if applicable, by the entities holding those shares or rights; and
- Non-blacklisted jurisdiction requirement: The special economic rights must not derive, directly or indirectly, from an entity resident in non-cooperative jurisdiction or in a jurisdiction that has not entered into a mutual assistance procedure with Spain for the exchange of tax information.
When will the new Spanish carried interest regime enter into force?
The new carried interest regime will have effect from 1 January 2023.
Outlook and practical consequences
The approval of the Start-Up Law signals a significant shift in the taxation of carried interest in Spain and should, in our view, be seen broadly as good news for the sector in that it sheds light on how carried interest distributions should be treated going forward.
Spanish private equity taxpayers (and their advisors) will therefore need to revisit their existing structures in order to carefully assess whether they are compliant with the requirements set out by the Start-Up Law, and accordingly whether the carried interest income paid to their executives as from 1 January 2023 can benefit from the 50% reduction (meaning an effective tax rate of around 22.5% in Madrid).
In addition, considering the complexity and variety of private equity fund structures and the questions of interpretation that these new carried interest rules may raise, it will be key to remain up to speed any future tax ruling or guidance in this regard published by the Spanish tax authorities.
If you would like to discuss this development with us, please contact our Tax team or your usual Freshfields contact.