Norwegian tax authorities had taxed key managers as if they had earned the carried interest personally as employment income. In a landmark judgment the Norwegian Supreme Court has ruled in favour of the taxpayers in the Herkules case, accepting their claim that carried interest profit share should not be taxed as employment income but instead should be taxable at the level of the individuals’ personal companies.

The Supreme Court has thereby overruled the Court of Appeals, which had concluded that the carried interest profit share was linked to services provided by employees and therefore should be treated as taxable income for those employees. This means that the carried interest should be taxed at 28% at the hands of the personal companies rather than at 47.8% at the hands of key managers and without triggering employer’s social security contribution at 14.1%.

Background

The Herkules case concerned a private equity fund established under a Jersey LLP structure.  The services of key individuals were provided to the fund through a management agreement with Herkules Capital, a Norwegian company which employed those individuals.  Both Herkules Capital and the General Partner of the fund were owned 60% by personal companies owned by those key individuals, and 40% by the private equity sponsor.  All profits generated by the fund were split on a fixed basis, with up to 8% of invested capital being paid to ordinary investors and any excess profits being split 80/20 with the General Partner (the ‘carried interest’).

The Court of Appeals had considered the strong links between the ownership of the General Partner and the working obligations of the key employees, and the fact that the carried interest arrangement was clearly intended as an incentivisation tool.  Therefore, the Court ruled that the portion of the carried interest received by the employees’ personal companies should be treated as employment income for the employees and taxed accordingly.  Herkules Capital was also held liable for employer’s social security contributions on the same amount. In addition, the Court imposed penalty tax and a penalty contribution of 30% and the taxpayers were required to pay the State’s legal costs.

Read our article on the ruling in the Court of Appeals in the CELIA April newsletter.

Supreme Court ruling

The Supreme Court has considered the arrangements in a different light, emphasizing that the General Partner was a real company with a separate board of directors that had made its own separate decisions, based on careful consideration of the advice provided by Herkules Capital. The fund profit, and thereby the carried interest, was a result not only of the services provided by these specific employees, but was generated also by services provided by other employees in the organization, by value creation in the businesses the fund had invested in and by general market development. The Supreme Court also noted that the employees were the driving force behind the establishment of the fund, and they had a legitimate business aim of creating an efficient organization and attracting investors. The carried interest should therefore be treated as income derived from ownership of the fund rather than as income from employment or work.

It should be noted that the taxpayers originally (and in their tax returns) had treated the carried interest as earned by their personal companies as profit on shares, and thereby exempt from tax altogether. This view was not maintained before the Supreme Court. Instead the taxpayers accepted that the carried interest should be treated as taxable business income at the level of the personal companies.

Comment

The tax situation now for Norwegian-based fund managers seems to be similar to the situation for Swedish-based fund managers, after Nordic Capital AB last year ultimately won a tax case with facts similar to the Herkules case.

The judgement was not only a significant victory for the taxpayers concerned but it is also viewed as being vital to the competiveness of the Norwegian private equity fund industry.