Explanation of Term and Definition: Carried
The term Carried (especially in the form “Carried Interest”) is used in various legal systems, primarily in the areas of corporate, tax, and capital markets law. It describes a performance-based component of remuneration that is granted to investment managers, fund initiators, or management companies. Carried Interest is of particular legal and economic significance in connection with private equity, venture capital, or other alternative investment funds.
Legal Nature of the Carried Interest
Contractual Principles
Carried Interest typically arises through a written agreement within the framework of management agreements, fund agreements, or shareholder agreements. These contractual arrangements determine the amount, conditions, and modalities of the distribution. As a rule, Carried Interest does not represent a fixed claim for remuneration, but rather a performance-based, variable participation in realized investment success (e.g., profit, surplus, capital gain).
Participation in Sale Proceeds
Essentially, the Carried Interest is defined as a percentage share for fund initiators or managers in the value increases, which is granted after the return of contributed capital and, if applicable, after prior preferred payouts to investors (“hurdle rate”). The contractual parties set out corresponding calculation parameters in the fund documentation (limited partnership agreement, partnership agreement).
Classification under Company Law
Remuneration via Carried Interest is closely tied to the role of management or certain shareholders (e.g., general partner of a limited partnership). Under company law, Carried Interest recipients are often personally liable partners or hold a special role as “managing members” within investment structures. The legal permissibility of such arrangements is subject to the relevant provisions of company law and must be transparently governed in the partnership or shareholder agreement.
Rights and Obligations of the Participants
Carried Interest not only comes with entitlements to profit distributions, but also often involves participation duties, liability risks, and, under certain circumstances, duties of information and accountability.
Tax Treatment
Legal Elements and Classification as Type of Income
The Carried Interest may be classified for tax purposes in various ways. In many countries, the share in the fund’s profit or in value increases is treated as income from self-employment, investment income, or another category of income. Decisive factors for tax assessment are the structure of the participation as well as the amount of payment received.
Germany: Tax Classification
In German tax law, the treatment of Carried Interest is complex and depends on the individual case. If the participant is considered a co-entrepreneur (e.g., limited partner), income from Carried Interest can be classified as income from a commercial enterprise under § 15 of the Income Tax Act (EStG). If the elements of co-entrepreneurship are not present, classification as other income may be considered. The tax authorities and case law particularly address the distinction between employment income and capital-related participation.
International Taxation
Internationally, Carried Interest is taxed differently. While some countries allow for preferential tax treatment as capital gains, others seek to subject Carried Interest to regular income tax rates. There is an extensive discussion regarding the so-called “performance fee” and its equal tax treatment with other forms of income.
Cost Allocation and Timing of Taxation
In tax practice, the question of when Carried Interest is received and the resulting tax implications is of significant importance. Since Carried Interest often only arises after several years, its tax allocation can be challenging. Additional questions arise regarding the allocation of operating expenses and personnel taxation.
Regulatory Framework and Legal Policy
Statutory and Regulatory Principles
The legal structure of Carried Interest is seldom explicitly regulated by law, but rather arises from a combination of contract, company, and tax law provisions. Investment law regulations such as AIFMD (Alternative Investment Fund Managers Directive) at EU level or the KAGB (Capital Investment Code) in Germany impose additional requirements regarding transparency and disclosure of remuneration structures.
Legal Policy Discussions
Especially in the context of tax advantages, Carried Interest remains the subject of legal policy debates. Critics argue that participants may benefit from low tax rates through classification as capital gains, even though the economic substance is often remuneration for performance.
Transparency Obligations and Investor Protection
Increasingly, transparency obligations are being introduced through regulation, such as requirements to disclose management fees to investors. The aim of these regulations is to reduce potential conflicts of interest and to strengthen investor protection.
Practical Relevance and Outlook
Carried Interest is a central remuneration element in the field of alternative investments. Its legal treatment depends on a variety of factors, including contractual structuring, involvement of organizational members, and tax classification. Due to the international diversity of legal concepts and regulations, the treatment of Carried Interest continues to be a subject of current legal discussion and legislative processes.
Future Developments
In view of national and international reform efforts, it remains to be seen how legislators and courts will respond to new market developments. In particular, special tax regulations and regulatory requirements could significantly shape the legal situation regarding Carried Interest in the coming years.
Summary: Carried Interest is a legally complex term that entails numerous aspects of company, contract, and tax law. Both nationally and internationally, the treatment of Carried Interest is subject to significant changes, especially regarding its classification as income, remuneration, and the resulting tax consequences. A comprehensive understanding of the legal foundations, tax treatment, and regulatory framework is therefore essential for the legally compliant structuring and execution of Carried Interest agreements.
Frequently Asked Questions
What rights and obligations are associated with Carried Interest from a legal perspective?
Carried Interest particularly establishes, from both company law and often tax law perspectives, a special legal status for the beneficiaries (usually fund managers or co-initiating partners). While typical investors (Limited Partners, e.g. in limited partnerships) generally receive interest-bearing profit entitlements on their capital contribution, Carried Interest consists of an additional, profit-dependent remuneration claim that is, as a rule, explicitly regulated in the fund’s documentation. This means that the beneficiary only receives payment claims once all prior obligations have been settled, especially the repayment of contributed capital (Return of Capital) and the preferred minimum return (Preferred Return) to investors. The detailed provisions of this model are usually stipulated in the partnership agreement or in an annex to it. The rights associated with Carried Interest typically include participation in surpluses beyond a precisely defined threshold, while among the obligations confidentiality, loyalty obligations, and a duty of diligent management are particularly notable. Furthermore, depending on the specifics of the agreement, repayment obligations (so-called clawback clauses) may arise if it turns out retrospectively that the beneficiary received excessive distributions.
How is Carried Interest generally structured under German law?
The legal structuring of Carried Interest in Germany is mainly done within partnership agreements of the respective investment structure, often designed as a GmbH & Co. KG or comparable model. From a legal perspective, a separate participation (so-called carry participation) in the fund is usually created for the holder of Carried Interest, which is to be distinguished from the regular investor participations. The fund documentation – especially the partnership agreement or the corresponding participation agreement – regulates in detail the amount, the time of the payout, the basis of assessment, as well as any agreed hurdles (hurdle rate) and clawback claims. The partners are regularly contractually obliged to adhere to conflict of interest clauses and good leaver/bad leaver rules, and extensive disclosure obligations often exist. Under civil law, the carry participation constitutes a legal claim arising from the partnership that only comes into existence under certain conditions (e.g., successful exit, achievement of the “hurdle”).
What tax implications are relevant for Carried Interest?
From a tax perspective, Carried Interest is a complex topic, since its classification largely depends on the legal structure of the fund and the individual circumstances of the beneficiaries. Under German tax law, it must be assessed case by case whether the carry constitutes income from employment (§ 19 EStG), from self-employment (§ 18 EStG), from commercial business (§ 15 EStG), or from capital investment (§ 20 EStG). Usually, the manager entitled to carry is treated as a co-entrepreneur (co-entrepreneur status under § 15 Sec. 1 No. 2 EStG), which means the Carried Interest received is taxed as commercial income. In deviation from this, depending on the contractual design, taxation as income from capital investment is also possible, especially if there is no co-entrepreneurial initiative and no entrepreneurial risk. The tax treatment is also subject to ongoing changes in case law and administrative instructions, so continuous advice is recommended. Special issues may also arise in an international context, for instance, with cross-border fund structures or double taxation agreements.
What legal risks exist if Carried Interest is not properly structured?
A lack of proper legal structuring of Carried Interest can entail significant risks. If the entitlement criteria and modalities of distribution are not clearly and legally securely regulated in the partnership agreement or participation framework, there is a risk, among other things, of disputes among partners regarding entitlement to payout and the respective amounts. In particular, problems may arise in the absence of or unclear clawback provisions if distributions are made based on profits that are later revised. Unclear agreements also increase tax risks, such as the danger of unexpectedly high progressive taxation due to a different classification of income by the tax authorities. Furthermore, there is a risk that regulatory obligations – such as information or reporting duties under the KAGB (Capital Investment Code) – are not met properly, potentially triggering regulatory measures.
What regulatory requirements apply to Carried Interest?
Carried Interest is subject to the regulatory requirements of the Capital Investment Code (KAGB) and other relevant financial market regulations within investment structures, especially when the relevant fund falls under the KAGB and thus qualifies as an investment fund. Of particular importance here are the provisions regarding transparency, investor information, and conflicts of interest. Fund managers are obliged to document appropriate measures to prevent and disclose conflicts of interest and must clearly and unambiguously disclose possible “performance fees” (such as carry) in the sales prospectus and the key investor information. Additionally, aspects of employee participation and remuneration requirements under the KAGB itself (particularly §§ 37 ff. KAGB) must be taken into account. For cross-border funds, EU law requirements, for example from the AIFM Directive (Alternative Investment Fund Managers Directive), may also become relevant.
How can a claim for Carried Interest be asserted under civil law?
If a beneficiary believes they are entitled to Carried Interest and the company refuses to pay, they can generally assert their claim in court in accordance with the general rules of civil law (§§ 280 ff. BGB). The prerequisite is the maturity of the claim according to the partnership/shareholder agreement and proof that all contractual preconditions for receiving the carry have been met. It is common for the partnership agreement to include arbitration or mediation clauses, meaning an out-of-court procedure may have to be undertaken first. Only if such mechanisms fail is litigation available. In court, the interpretation of the contractual provisions, the timing of fund distributions, and any recovery claims (clawback) are closely examined. A contestable shareholders’ meeting can also play a role if resolutions regarding carry are disputed. Preservation of evidence and compliance with statutes of limitations are particularly important here.
What particularities apply regarding the transferability of Carried Interest?
The transferability of Carried Interest is mostly significantly restricted by contractual and company law regulations, in order to ensure control over the carry holder, since entitlement is regularly tied to the personal performance of the beneficiary. Partnership agreements often require the consent of the other partners for a transfer of the carry interest. Legally, the transfer process often involves an assignment (cession) or a transfer of the respective partnership shares. Transfer without consent can generally be agreed to be invalid. Additional stumbling blocks may arise for employment or regulatory reasons, for example, when Carried Interest is linked to employment with the company or special provisions in investment law. It is also essential to examine whether the transfer would unlock hidden reserves and thereby trigger tax consequences.
