| Summary: | <p>Carried interest is a proportion of the investment return that private equity fund partnerships allocate to the fund’s manager. In the United States and the United Kingdom, carried interest is treated as a capital gain for tax purposes. Many view treating carried interest as a capital gain as unfair, arguing that carried interest (or at least some portion thereof) should instead be treated as earnings from employment. Others vigorously defend the status quo. Both sides of the debate have put forward flawed arguments that obscure a satisfying solution to the carried interest puzzle.</p>
<p>The tax treatment of capital gains is advantageous in two key respects: reduced tax rates and deferred timing of taxation. A number of justifications have been put forward for offering these two tax preferences to capital gains. This paper examines the extent to which these justifications also apply to carried interest. The applicability of these reasons to carried interest would strengthen the argument to maintain the status quo of taxing carried interest as a capital gain. Conversely, the status quo is not defensible if these reasons fail to apply.</p>
<p>The analysis of this paper suggests that taxing carried interest at preferential rates is not supported by the reasons for taxing capital gains at preferential rates. However, taxing carried interest under the realisation principle is defensible, supported by the same valuation concerns that justify taxing capital gains upon realisation. As a result, two proposals to change the tax treatment of carried interest stand out as sensible solutions to the carried interest puzzle. The first is to tax carried interest as ordinary income upon realisation. The second, the cost-of-capital approach, puts the fund manager in the position of financial capital supplier and, therefore, a legitimate recipient of preferential capital gains treatment.</p>
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