Italy: Issues New Tax Guidance On Carried Interest

The Italian tax authorities have released their official guidelines (Circular no. 25/E of 16 October 2017 – the "Circular") on the new tax regime applicable to extra proceeds ("Carried Interest") deriving from securities with special economic rights (diritti patrimoniali rafforzati) held by managers and employees of investment funds ("Funds") and companies, recently introduced by art. 60 of Law Decree no. 50 of 24 April 2017 (the "CI Regime").

The CI Regime clarifies when fund managers' or employees' Carried Interest would be treated as financial income for Italian tax purposes (taxed up to 26% save for exceptions), rather than as employment income (generally taxed at marginal rates up to 43%).This clarity is to be welcomed as it not only provides a thorough and detailed analysis of the CI Regime (applicable from 24 April 2017), but it also finally provides some general and comprehensive clarification on the Italian tax treatment of Carried Interest that does not fall within this regime.

The CI Regime: overview

By adding clarity to the tax treatment of incentive schemes for Funds' and companies' managers, the new rules aim at further boosting the Italian private equity and private debt sectors and narrowing the gap with EU competitors (such as France and Germany). In this respect, the CI Regime has an international reach as it applies: (i) on one side, to securities issued by entities and Funds incorporated/set up in Italy or in "white list" jurisdictions (i.e. those allowing an adequate exchange of information with Italy) and (ii) on the other, to Italian and non-Italian resident managers and employees.

As we lack a definition of Carried Interest and securities with special economic rights for these purposes, these are identified through some thresholds specifically provided by the law. In this respect, the Circular not only sheds more light on the scope of the new rules, but also confirms the Italian tax authorities' growing understanding of the private equity and private debt sectors.

The CI Regime: thresholds

The CI Regime only applies to managers and employees of Funds and companies holding securities with special economic rights ("Managers"), provided that all the following conditions are met:

1. the actual investment made by all Managers equals at least 1% of the overall investment carried out by the relevant Fund / company;
2. Carried Interest is subordinated to the repayment to all the Fund investors or shareholders of their contributions first, plus a "hurdle rate" (i.e. the performance set by the fund rules / by laws, etc.);
3. a five-year holding period requirement is met by the relevant Manager.

With regards to the first condition ("1% investment"), the Circular clarifies that with regard to Funds:

  • Managers' 1% overall investment is represented by the amounts they have actually contributed (as capital) to the Fund, reasonably assessed at the end of the relevant subscription period (pursuant to the Fund rules), including management fees. Thus, Managers have to bear an actual investment risk;
  • Managers' 1% investment also includes: (i) securities other than those with special economic rights and (ii) securities (with or without special economic rights) attributed to Managers as fringe benefits and taxed in their hands accordingly (as employment or self-employment income);
  • Managers' 1% investment can be carried out through dedicated companies or trusts (holding securities with special economic rights);
  • the overall investment made by the relevant Fund is to be determined with reference to the amounts the latter has effectively received from investors (e.g. "drawdowns") and invested accordingly, net of third party loans;
  • once the 1% threshold is exceeded, further transfers of the same securities with special economic rights to non-Managers (e.g. upon succession) would not impact such threshold (save for abuse of law).

As for the second condition ("subordination"), the Circular clarified that:

  • the CI Regime still applies to Carried Interest if Managers receive capital reimbursement and hurdle rate pari passu with all the other Fund investors or shareholders;
  • the CI Regime would also apply to the Carried Interest deriving from sales of securities in case the above condition is met..

As for the third condition ("holding period"), the Circular confirmed that Managers' interest should be aligned with investors' interest. Accordingly, the five year holding period:

  • reasonably starts from the date of subscription;
  • applies to all securities held by Managers (with or without special economic rights) concurring to reach the 1% investment threshold;
  • is not interrupted in case of "change of control" (or in case of a Manager's demise);
  • can also be completed after the Carried Interest (benefiting from the CI Regime) is effectively received by Managers (otherwise a recapture of taxable income may apply).

Securities falling outside the CI Regime

The Circular goes further than the scope of the CI Regime by also addressing the case of securities with special economic rights falling outside these rules (because any of the aforementioned conditions are not met). Indeed, this makes the Circular the first official document from the Italian tax authorities providing a complete analysis of Carried Interest taxation in Italy (previously, the tax authorities only issued a few partial clarifications).

First of all, the Circular confirms that, outside the CI Regime, Carried Interest is not per se treated as the employment income of a Manager for tax purposes.

Moreover, it clarifies that Carried Interest could continue to be treated as financial income provided that it is not actually used to remunerate an employment / self-employment activity carried out by the Manager. For such purposes, the Circular requires a case-by-case assessment aimed at identifying that, amongst other things:

  • Managers' interests are aligned with investors' interests;
  • Managers bear an actual investment risk;
  • Managers will hold title to such securities with special economic rights should their relationship with the Fund or company be terminated;
  • securities with special economic rights are not reserved to Managers;
  • there are no good/bad leaver clauses, unless the same are mitigated by other circumstances (e.g. the foregoing)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Giorgio Vaselli
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