Carried Interest (The capital gains from funds)

April 24, 2024

INTRODUCTION

This issue is centered around Carried Interest (The capital gains from funds), and we look at how taxes are dramatically different for a Venture Capitalist sitting in India (Geeta) vs one who sits in the US (Chandrima).

First, let’s understand a thing or two about funds and carried interest. Generally, VCs get funding from other sources and they get compensated based on what return the fund makes. This return is called carried interest. And typically, rather than being paid as ordinary compensation, the fund managers will own another stock (class B stock) while the investors own class A stock. So in an example where the fund makes 300% and the VC is entitled to 20%, they’ll peg it as if it’s a payout of class B shares. This is their carried interest and it is their capital gains. From a taxation standpoint, Carried Interest is considered long term capital gains as long as the 3 year holding period is met.

From Chandrima’s Perspective

Now let’s look at Chandrima: a US resident from Boston, a VC fund operator, basketball enthusiast, and mother of one. Chandrima is about to start a fund in India and she will own Carry in the Indian fund.

Problem

As a US citizen and resident with a fund in India, paying worldwide taxes is inevitable, but we can still mitigate the burden and make it easier for her to take her capital gains outside India. If she passes the holding period of 3 years, the gains are considered long term and for US tax purposes, she will be taxed at 23.8%.

Solution

Chandrima consulted with us before she started the fund, and here’s what we advised her:

First thing she has to remember is that she needs to bring her funds from the US to buy her class B shares. She shouldn’t transfer money from her NRO account from India because the moment she does that, the transferred money becomes non-repatriable. For example, if she puts in Rs 1 lac of her own money and that becomes 30 Million, then that money will be stuck in India (FEMA rules make it hard to get the money out all in one go, and Chandrima would be entitled to take out only 1 Million every year). Addressing FEMA, it’s best to bring funds from outside India to invest in the fund.

Secondly, if she makes this investment, it’s better than she doesn’t do it in her own hands but rather through an LLC that she sets up in the US. This is so that the LLC owns the carried interest rather than Chandrima, the advantage being that the LLC can access the gains, but Chandrima as an individual and as an NRI, would not be able to take out the money out of India (FEMA, again) except at the $1MM per year. In the form of an LLC, the investment is considered an institutional investor so different rules apply and there are no limits to how much can be taken out of the country.

Chandrima talked about started a local basketball league for under-privileged children, so we advised her that if she is inclined towards doing some charity work, then creating a charity could also serve as a vehicle to transfer money or save on taxes.

From Geeta’s Perspective:

Contrast Chandrima’s situation with Geeta’s. Geeta is also going to start a fund, but hers will be in the US and Geeta is from Bangalore. Geeta is a seasoned VC in India, but this will be her first fund in the US.

Problem

Geeta will also paying taxes on worldwide income because she’s a resident of India and her fund will be in the US.Carried Interest (which are capital gains) in India up until March 31st 2022 was taxed at 28.5%. After April 1st 2022, one is eligible for a tax at 23.92% tax.

So Geeta, as compared to Chandrima, pays 5% extra in tax because she lives in India (despite the fact that the fund she owns is in the US). The way this could have been structured is that when the carry itself was invested in the US, Geeta could have made sure that the carry was funded out of funds in the US (to avoid the gains coming back to India under FEMA rules). If Geeta were to send funds from India towards this US fund, and the gain happens (i.e. the fund does exceedingly well) and it’s worth many millions, she would be forced to bring that currency back into India. Ideally, most people want the ability to keep that currency anywhere in the world, so for this reason Geeta should think about where the funds for her US-based fund come from. Geeta has two children who are in their early twenties, and it’s likely that they might end up living abroad.

Solution

To reduce her tax burden on carried interest, she can create a charitable trust, before or right when she starts her fund (when the value is low), to give any portion of her carry towards this trust. Or, she can create an irrevocable trust with her kids as the beneficiaries. More often than not, many VCs from the US with funds in India have children who will want to go to the US at some point and so having the children as beneficiaries is a good option. One can even choose a distribution of carry between a charitable trust and an irrevocable trust.

EXPLANATION

In Chandrima’s case, the actual taxation from the gains i’s considered an Indian gain so there’s no escaping the India tax of 28.5% (versus the 23.8% in the US), but the good thing is that any tax paid in India can be declared in the US for credit. These credits will come through in the form of a K1 form which she can show in her personal tax returns in the US. In the US, Chandrima’s tax rate would have been only 20% (had the fund been in the US) and so she will pay in India (28.5%) is a lot higher but her US taxes get offset by the credits in India. Over and above this, she will have to pay 3.8% in the US. Note that this ratew of 28.5% has now dropped to 23.92% following the rules laid out in the Finance Act 2022 effective all transactions after April 1, 2022.

Chandrima may also have a state tax burden in the US so she should really consider where she wants to set up the LLC. She’s from Boston (state of Massachusetts), so her total worldwide taxes could easily be north of 30%.

The last thing Chandrima can do to reduce tax exposure, if she has relatives in India she trusts, is that she can create a trust where her relatives are holding the interest on her behalf rather than her holding the carry. In this case, the tax gets confined to India. These can later be gifted to Chandrima.

In Geeta’s case, instead of owning all 100 shares of class B stock, Geeta could choose to own 50 and give 25 to the charitable trust and 25 invested in an irrevocable trust. If she does do this, and her fund does really well, then both the charitable trust as well as the irrevocable trust will be exempt from any kind of India tax exposure. Only the gains of Geeta’s 50 shares will be exposed to India taxes.

Contact Ventura Pranas, for such customised solutions to complicated tax-related issues.