Tapas and Tax Breaks, part 1: Spain's carried interest regime

Patricia:

Welcome everyone to the next in our series of Tax Lyrical podcasts. I am Patricia Allen, a tax partner in Ashurst's office in London, and I am delighted to be joined today by Javier Hernández Galante, who is going to tell us all about some of the changes that have been introduced recently in Spain with the introduction of a new regime for the taxation of carried interest for Spanish resident executives in private equity funds. So welcome Javier. Thank you so much for joining us today.

Javier:

Thank you, Patricia. It's a pleasure being part of this series.

Patricia:

Thank you. It's a complete pleasure to have you. Thank you very much indeed for taking the time to join us. So I think, first of all, this is a relatively recent regime. When did it actually come into force?

Javier:

Yes, it's true that it's relatively recent. It was approved at the end of the year 2022. So it should start entering into force for years 2023 and the following years. So it's something that has been in force only for the last two years.

Patricia:

So relatively recent that actually you've had the chance to see it actually in force, so that's quite interesting as well. Would you mind, Javier, just setting out for the listeners what the tax treatment for carried interest is under the new regime, and how that differs from the tax position under the regime that was in place previously?

Javier:

Yeah. So if we take what the situation was before, and using only one word was uncertainty, because although theoretically any remuneration obtained that is directly or indirectly linked with unemployment qualifies, for the Spanish tax purposes, as employment income subject to high tax rate, up to 50, depending on the region. Here in Spain, 50%. There were schemes identified and implemented in order to enhance the tax treatment of this remuneration, so the carried interest. Those schemes were based on the delivery of an asset, participation or interest in an entity to the executives or directors of the private equity house, with the intention of those individuals to obtain a capital gain at the end of the given period in time, and with the purpose of having that capital gain subject to a lower rate in Spain, now up to 30%, between 18 and 30% nowadays, that compared to the 50% maximum for employment income was definitely an attractive part of it.

But the Spanish tax authorities issued several rulings making clear that their understanding of the tax treatment of these type of remunerations was in any case employment income, and that gave rise to a relevant number of cases where the tax authorities challenged the application of the capital gain treatment and even court cases with dramatic consequences for the individuals and the companies paying the carried interest. So what is the novelty here? As I said, if in the past it was uncertainty, we are aiming to go to a more secure scenario. Now it is clearer than all those remunerations linked to, and I will explain later on the specific scope of the rule, but the carried interest will qualify in any case as employment income, but there is the possibility of applying a 50% rebate and only including in your tax return 50% of the total carried interest, if certain requirements are met.

Those requirements are in particular that the remuneration must be obtained by executives, managers, or employees of the private equity fund or private equity management company or a company of the group. And I will enter into that in a minute. The remuneration must allow a minimum return to be obtained by the capital investors in the fund, so the typical hurdle. The rights participation unit shares that give rise to this carried interest owned by the executives, managers or directors, have to be kept by these people for at least five years. And what is critical is that the right linked to those units or participation cannot derive, or the economic rights cannot derive, directly or indirectly from entities resident in what we call tax haven jurisdiction, non-cooperative jurisdictions. If those requirements are met, the 50% rebate applies and therefore we could reach a quite efficient tax treatment for the carried collected by Spanish [inaudible 00:05:56] individuals.

Patricia:

That certainly sounds like an improvement than the system that was in place before. Do you think we have complete certainty over the treatment under the regime now, or are there still elements that you think we need to get a little bit more certainty on going forward and need to be ironed out?

Javier:

At the time the rule was approved, and as I've said by December 2022, there were a lot of doubts. Those doubts, or some of them, have been verified by the tax authorities, but I would say that the main question marks in relation with this new regime were related first with the type of entities that generated the remuneration, or the economic rights to which the executive was entitled to. That was in relation with the holding period, the five-year holding period and what happened with payments that took place before the five-year period has elapsed, or what happens with payments done once the executive has left the company or the private equity. There are some doubts with the company on which the individual has the employment relation, if that needs to be with the fund itself, with the management company, or with a group company, and here maybe it makes sense to expand on it a bit.

What the law says is that the rights must be granted by one of the entities listed in the article that I will enter into now, obtained by people which are directors, managers, or employees of those entities, managing entities or entities within the group. When they refer to the group, do they refer to the group of the fund or the group of the management company? Our interpretation is that that refers only to the group of the management company. For example, for Spanish individuals that are executives in the Spanish subsidiary of the UK or the Luxembourg Management Company, those employees would be entitled to apply this regime. What are the funds or the type of entities that could generate the income? And that's a little bit limited by the law. The first one is Spanish venture capital funds or Spanish venture capital companies, as defined in the Spanish venture capital law. The second is European venture capital funds regulated in Regulation 345/2013 of the European Parliament. The third one is European Social Entrepreneurship funds, and the fourth one are European long-term investment funds.

And there is a final section, which is anyone that is analogous to the previous ones. There has been a lot of doubt on what are the funds that were under the scope of the rule, but in essence what I would say is that, it refers to private equity or venture capital funds or companies, either Spanish or resident in the European Union, or that was accepted by the Spanish authorities in a tax ruling, funds that are resident and managed by companies that are resident within the European Union or in a country that is not a tax haven jurisdiction.

Patricia:

So that's interesting. So it's covering not just Spanish entities, and it can cover other entities as well. Is that correct?

Javier:

That's 100% correct.

Patricia:

Yeah, that's interesting.

Javier:

The Spanish authorities have confirmed, and actually they refer to the Spanish venture capital company law where it is accepted that the Spanish venture capital companies could invest in certain non-Spanish funds, and those non-Spanish funds in which a Spanish venture capital company can invest would qualify as a rule for this treatment. But what is very important is to take into account that the tax authorities themselves say that there is no general rule in order to confirm whether a fund or an entity directly or automatically qualifies for the treatment. So it would be necessarily an analysis on a case-by-case basis.

Patricia:

Understood. And do you think is the perception that it covers not only private equity but also the special new regime could also apply to real estate or debt funds?

Javier:

In our opinion, it doesn't. And maybe this is an exclusion that there is no real rationale for it, but the rule refers to private equity of venture capital companies. The different definitions by cross-reference of different pieces of legislation, all of them require investment in equity of companies, and exclude typically real estate investment and debt, and fund investments. So I would say that funds involving the debt sector or real estate sector would not be within the scope of the special treatment.

Patricia:

Understood. And what happens, as you sometimes see, if the carried interest is actually paid to a management company and then that management company pays a bonus to the executive? Does that get the benefit of the regime as well?

Javier:

I would say that, although theoretically and according to the wording of the law, it is a little bit more strict. The truth is that the Spanish authorities have confirmed that it is allowed and will fall within the scope of the regime, a bonus paid to a Spanish resident individual linked to the carried interest obtained by the company entitled to the carried interest. What is relevant at that point is that the rest of the requirements are met, in particular the one referring to the non-participation and not relevance of companies within the payment structure resident in a tax haven jurisdiction.

Patricia:

Understood, understood. One of the requirements that you mentioned is that there is a minimum holding period of five years. Are there any exceptions to that minimum holding period? For instance, I suppose sometimes funds get wound up, somebody comes in and then the funds wind up. Is there any exceptions to the five year or is it a hard, fast rule?

Javier:

Interesting enough, the law itself includes exceptions. For example, obviously in the case of transfer, notice causa, obviously the individual cannot hold the interest on the shares of participation for more than five years, or up to the five years. But it has also been confirmed by the tax authorities that if the carried takes place before the five years and then the rights, the participation or the shares are redeemed or liquidated, that would only allow the individual to apply the 50% discount on the employment income. Maybe related with this also, the tax authority clarify what happens with payments that take place before the five years. So it is not necessary that all the payments take place at the end of the five years. There can be payments during the five-year period to the extent that the rights, interest or participations are kept for the five-year holding period, unless one of the two exceptions in the law apply, which is transfer due to notice causa or liquidation of the rights.

Patricia:

So that's actually quite flexible, isn't it? So long as you have the holding for five years, you can take money out a little bit earlier? So that's a sensible approach, isn't it, by the Spanish authorities? I think you mentioned that the executives needed to be employees. What happens if somebody has ceased employment and they get a payment? What happens under the regime for that sort of individual?

Javier:

Here we need to refer to maybe general rules under the personal income tax law, but in principle that would remain to be employment income, and to the extent it is possible to evidence that that remuneration corresponds to the management of the funds during the time or during the period where the individual was employee, executive or director of the managing company, the 50% rebate should apply. If that remuneration is obtained once he/she has left the company, but it's not related, or it cannot be evidenced that it's related with that management activity, it will not be entitled to the 50% discount.

Patricia:

And that's actually quite a sensible approach as well, isn't it? I think you also said that the regime only applied provided that in effect the economic return doesn't come directly or indirectly from an entity that is resident in a jurisdiction that Spain regards as a tax haven. That's interesting. What happens if the fund itself is all established in good jurisdictions but happens to invest via a blacklisted country, does that cause a problem?

Javier:

That should be two different points here to be considered. One is whether the fund itself qualifies for the treatment, and the second one is whether the employee is entitled to the discount. So if we first go for the first question, whether the fund would qualify. If, in our opinion, to the extent that the venture capital legislation in Spain allows a given percentage for the Spanish venture capital company to invest in vehicles that do not qualify as Spanish venture capital, and the maximum is 40%, so 40% of the total investment can be done in assets that do not qualify as venture capital companies. Do we think that there is room for the fund, Spanish or not, to invest in entities that would not qualify by themselves, but to the extent that within that threshold should not taint the whole structure?

So the answer in principle is, the fund could invest in companies that are resident in or are managed from a tax haven jurisdiction, to the extent it is in any case below the 40%, and maybe here we would take a prudent approach and maybe have a lower percentage or weight in the total portfolio of the fund, and that requires added analysis and ongoing analysis of the weight of those investments. The second point, and the second analysis, would be based on the individual and whether the individual would be entitled to the 50% discount, considering that part of the funds are generated in a tax haven jurisdiction. Here, our approach is that to the extent the structure implemented by the fund in order to channel the carried interest is not tainted by a company located in a tax haven jurisdiction, it should be allowed that the fund invests in tax haven jurisdiction companies. So the answer to your question, Patricia, is yes, it is possible, but it should be subject to a detailed analysis and continuous control of the weight of those investments.

Patricia:

That's really interesting, isn't it? So we're saying the fund itself might be able to invest in some tax haven jurisdictions so long as the carried itself does not come from those jurisdictions.

Javier:

Correct.

Patricia:

If you see there is a problem, Javier, do people restructure? If they see that there's a problem in the fund, do people try and restructure around that to try and get themselves into the regime?

Javier:

We are seeing that, because obviously, and you are very, very familiar with all the structures for carry, typically those include companies residing in Cayman, Jersey, Guernsey, which are tax haven jurisdictions for Spanish tax purposes. So typically the carried for Spanish executives in these types of vehicles had always been channelled through these jurisdictions. So we have seen a number of them considering the possibility to restructure that in order not to have the money flowing through tax haven jurisdictions. The problem here is, sometimes it's not efficient to have complete different structures for the Spanish investor, for the Spanish executives, and any other executive within the private equity house, and therefore sometimes it has been discarded because of this practical reason.

The second one is, we have seen the tax authorities through tax rules, because we have not seen yet tax audits on this because it is so, so recent. But on those tax rulings when, for example, their structuring was based on having the exactly same structure for the channel of the carried using the same Jersey, Guernsey companies, but then having a lax [inaudible 00:21:26] that was the one entitled to make the payment, formal payment, of the carried interest to the Spanish executives, typically on behalf of that Guernsey company or acting as a payment agent that has not been accepted by the tax authorities. And in addition to that, not only they have said that the structure does not qualify, but they warned that, depending on the factual background, there is a risk of the tax inspection, considering that such a structure can be abusive or a sum transaction just to avoid the real structure channelling the carried interest.

So if restructuring is going to be done in order to have the Spanish executives benefiting from this tax regime, a real restructuring has to be done, with the carried channel through then typically the UK or Luxembourg. I would say those are the two main jurisdictions where we can see new structures for the carried. But just having a formal, cosmetic change in a way that the carried is paid by a EU or UK entity instead of having the payment directly from a tax haven, that creates risks for the future.

Patricia:

Again, that's super interesting, isn't it? You really want to be thinking about this when you're structuring the fund at the beginning, don't you? Getting everything in order on day one. It's very interesting. The regime sounds like a very good regime. Can I just ask, are there any other benefits, apart from the regime, if you're a Spanish executive getting carried interest? Are there any other features of the Spanish tax system that are beneficial?

Javier:

The answer is no, and this is what is very, very important here. The individual will need to choose whether to apply any other benefit that is considered in the Spanish legislation, for example, the discount 30% rebate in case of irregular employment income. Irregular meaning that income with a generation period longer than two years, or for example, certain exemptions that may apply on work done abroad, because if, doing the numbers, those other regimes or benefits can be applied, you will need to renounce to the application of the 50% rebate, typically for carried interest and taking into account the amounts that we typically would be considering in carried interest, I would say that it would be always more beneficial to apply this 50% rebate than going for any other tax benefit. But what is clear is that once you apply this one, you are not entitled to apply any other one.

Patricia:

That's also interesting. I suppose in a funny way, at least those other potential routes might be helpful if you find that you're falling foul of the minimum holding period, or you don't think you're going to be able to restructure your fund, it is good to hear that actually Spain has got other potential routes. But as you say, clearly the new regime with the 50% deduction is the cleaner and probably gives the most favourable result. What do you think is going to be the impact of the new regime for Spain? Have you seen people moving to Spain? What have you seen as being the consequences?

Javier:

I would expect that would be the main commercial impact. So from the legal side or legal standpoint, the main implication would be, as I said, the reduction of the uncertainty. So that clarifies how these remunerations have to be treated. If you can check all the boxes, you will be entitled to a 50% discount, and that is obviously attractive. So we will know the rules of the game from the very beginning, and as you said, at the time of the structuring of the fund. From a maybe more commercial, social impact, I fully agree with you. I would say that this should attract, together with other positive features of Spain, not the least the sun and the food, can attract executives, partners of private equity houses to Spain. If we haven't seen a big number of those in the last two years, maybe it's due to maybe the typical understanding of Spain as a country where there is a high level of legal uncertainty.

It is possible that maybe you can give your opinion Now here on this point, and I see that for other completely different structures, but Spain competing with the Netherlands or Luxembourg or the UK is usually seen as a country where there is legal uncertainty and well, this is the rule now, but who knows what the rule could be in the future? I think that this or such interpretation of the Spanish legislation is not 100% fair, and we should convince people that this treatment has arrived to a stay. So I think that this will stay for at least a relevant number of years, which makes it typically attractive for non-Spanish executives in private equity houses to move here, maybe together with the legislation that we have for expatriates, what we call here the Beckham Law, which is also attractive for non-resident Spain individuals moving their residency to Spain.

Patricia:

It's really interesting the point you make, Javier, about the uncertainty, because of course that is one of the issues that we are facing actually in the UK at the moment, in that many, many years, the UK was a very stable environment. I know over the last couple of years there's been, as you know, there are changes being introduced to the carried interest regime in the UK, and you cannot underestimate the impact that uncertainty has on a people's desire to be in the country, and for business. People like to know they're in a stable regime where they think they're walking into something and it's not going to change.

So that is an interesting point you make, and I think we are seeing that a little bit at the minute in the UK as well. Just the last thing I was just going to ask about, and maybe you're slightly touching on it there, is, quite often you'll see executives who, as well as having a carried interest, they will be making a co-investment into a fund. So actually, they'll be putting in their own money and co-investing alongside the third party investors, and taking returns in the same way that those investors are. How are those sorts of returns taxed in Spain?

Javier:

That is completely different, and maybe that allows me to connect with the original introduction. The uncertainty on the treatment of the carried interest was originated because, even if those schemes that I have described trying to make the executive obtain a capital gain through the acquisition of participations or interest in the vehicle, the main issue there was that high remunerations were linked to very low investments, and typically under completely different terms and conditions compared to those of the other investors in the fund. And that is what created the risk, in my opinion, for co-investment. And as you said, assuming terms and conditions are the same, that the investor puts skin in the game, risking his or her own money with the same returns expected as those of the other investors, I think that that can qualify as a capital gain. Because it's a real investment, and running the risk of a pure equity investor compared to the risks and expected returns of a private equity carried interest. So this is completely different and I think that it can still apply the capital gain treatment.

Patricia:

But again, that's another really, really good result. Thank you. Javier, that's just been a really, really interesting... It's really clear to me that the new regime in Spain is super attractive, and frankly as I sit and look out the window here at the rather grey weather in London, I have to say that this new regime, when added together with the weather, the food, and absolutely lovely people, I have to say that Spain is looking top of the list for me at the moment. But look, thank you very much for your time today, Javier. We really, really appreciate you chatting with us, and I hope everybody listening has enjoyed this and find it informative, and we'll be back soon with the next instalment.

Javier:

It has been a real pleasure, Patricia, sharing these minutes with you.

Patricia:

Thank you so much.

Javier:

Thank you very much.

Patricia:

Thank you again for listening. That brings us to the end of this episode, but I hope you will join us again for part 2 of Tapas and Tax breaks where I will be exploring with Javier the so called beckham law in Spain and the benefits that regime can offer and indeed how it interacts with the carried interest regime we have been discussing today.