For the first time, the Basque Country and Navarre have enacted regulations on the Personal Income Tax treatment of carried interest. But it is currently unclear whether the new regimes, which reduce the tax burden on qualified carried interest income, can apply to carried interest paid by entities located outside the Basque Country and Navarre.
Regions enact new regimes
Among the 17 administrative regions of Spain, the three territories (Bizkaia, Alava and Gipuzkoa) that form the Basque Country region, and the region of Navarre have the prerogative to enact their own income tax laws, including Personal Income Tax (“PIT”) laws (within certain constitutional limits).
Both of these regions have, for the first time, enacted new regulations providing for a specific tax treatment of certain carried interest income earned by individuals acting as private equity investment managers (“Managers”) who are resident for tax purposes in one of the territories or regions.
This is a significant development. The new rules include tax incentives which reduce the tax burden on qualified carried interest income and provide legal certainty on the applicable tax treatment (as it was unclear whether carried interest is to be taxed as investment income or as regular income).
Reduced tax burden
Pursuant to the newly approved regimes, carried interest earned by Managers is taxed at a PIT rate of 25%, and not at the 42.5% to 48% general maximum PIT rates applicable in other territories.
In Bizkaia and Alava, qualified carried interest earned by Managers is deemed to be employment income for PIT purposes, but 50% of its total, uncapped, amount is exempt from tax, thus resulting in an effective maximum tax rate on qualified carried interest income of 24.5%.
Gipuzkoa and Navarre have opted for a different approach and re-characterize qualified carried interest income earned by Managers as deemed dividends, taxed at a maximum PIT rate of 25%.
In order for the income to qualify for this special carried interest tax treatment, the following requirements must be met:
- The remuneration of the Managers must be set out in the investment vehicle’s by-laws, which must also make reference to the minimum guaranteed IRR for the private equity investors.
- The Managers’ (direct or indirect) stake in the target entity must be held for a minimum period of 5 years.
- The application of the special tax regime must be notified to the relevant tax authorities.
In addition, as it refers to Managers resident for tax purposes in Gipuzkoa and Navarre, Managers entitled to qualified carried interest income must jointly hold at least 1% of target’s equity.
Since the new rules solely apply to those Managers resident for tax purposes in the Basque Country or Navarre, there is a clear incentive for Managers to move to those territories. The new rules may also incentivise the establishment of private equity entities there.
Some uncertainties remain in respect of the scope of the new regimes. In particular, the regulations could be interpreted to only cover carried interest obtained by Managers of private equity entities that are located in the same territories, i.e. Basque Country and Navarre, and therefore exclude carried interest paid by entities established elsewhere in Spain, or in any other jurisdiction.
The Basque and Navarre tax authorities are expected to issue guidelines on the scope of the new regimes. It is hoped that these will provide the clarity and comfort required by taxpayers and private equity management entities.