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New administrative practice from the Danish Tax Agency is expected to expand the scope of taxation of carried interest, implying that investments in portfolio companies owned by a private equity or venture capital fund may now also be covered. This new practice could potentially have a significant impact on the taxation of both existing and future co-investments and incentive programs in Danish portfolio companies owned by a private equity or venture fund.
In Denmark, carried interest is taxed in the same tax bracket as ordinary salary income, where a so-called “excess return” on investments in a fund (both directly or indirectly via a company) is taxed at up to 56% for direct investments and 22% for indirect investments.
The rules were introduced in 2009 and were intended to tax “private equity fund partners” who received an abnormal return on their co-investments in the fund as personal income (up to 56%) rather than returns on shares (up to 42%). The rationale for reclassifying equity income into personal income was that the abnormal return – referred to as excess return – represented remuneration for the private equity partner’s work in the fund and with the fund’s investments, and not a return on an investment in the fund as an investor.
The rules for taxation of carried interest are found in section 16 I of the Danish Tax Assessment Act, according to which the following conditions must be met for the taxation to occur:
Until now, the rules has, according to common understanding, only covered investments via a fund where the manager of the fund co-invests and thereby receives an excess return on the investment at fund level. For example, the manager’s investment may correspond to 2% of capital, while the return to the manager may be up to, 20% of the total return on the investment.
However, two new binding rulings from the Danish Tax Agency are seen to expand the scope of Section 16 I of the Tax Assessment Act.
These binding rulings are SKM2025.46.SR and SKM2025.47.SR, where the Danish Tax Agency finds that investments directly in an underlying portfolio company of a fund may also be covered by the rules on taxation of carried interest.
The cases concern a transaction in which the Danish sellers had sold two companies to a private equity fund. As part of the agreement for the sale, the sellers were to reinvest in the private equity fund’s buyer company by subscribing for shares directly in the buyer company, and part of the sales price was settled by issuing a promissory note to the seller.
The question before the National Tax Board was whether the return on these subscribed shares could be taxed under the rules on carried interest.
The rulings contains several elements, but the following key conclusions from SKM2025.47.SR should be highlighted: i) the participation capital does not include ordinary debt instruments, and ii) an investment through the fund includes direct investment (and reinvestment) in underlying portfolio companies the fund invests in.
The excess return is the return that exceeds a standard return on the total participant capital. The seller was of the opinion that the debt instrument should be considered part of the reinvestment in the buyer company and therefore also part of the participation capital, which, however, in the opinion of the Danish Tax Agency, would require that the debt instrument entitled to a return in connection with a later exit. It had been agreed that the debt instrument would be redeemed at an exit with the agreed interest rate, but the redemption was independent of the return that an exit would entail.
Previously, the Danish Tax Agency has dealt with so-called PPLs (Profit Participating Loans), which were considered by the Danish Tax Agency as participating capital. This had an impact on the calculation of the excess return that the sellers were taxed on as carried interest.
Secondly, it was the Danish Tax Agency’s opinion that the sellers’ re-investment in an underlying portfolio company owned by the fund – and not directly in the fund – constitutes an investment made through the fund when the sellers’ investment is made in accordance with the contractual basis for the fund. It is not clear from this case whether the contractual basis for the sellers’ investment is or is not in accordance with the contractual basis of the fund, but the Danish Tax Agency concludes that the sellers have not demonstrated the latter.
The Danish Tax Agency then concludes that the sellers’ investment outside the fund directly in an underlying company in the fund’s investment structure is an investment via a capital fund, and that the sellers’ return on their reinvestment is therefore covered by the rules on carried interest.
It is difficult to predict the future impact of these two new binding rulings as they are based specific circumstances and arguments, noting that the Danish Tax Agency conclusion is based on the seller’s inability to demonstrate the contracturual basis of their investment, including whether the new administrative practice may have an impact on investments made by employees under an incentive program in a Danish portfolio company.
However, it is our assessment that these binding rulings will be followed up by further rulings, as we are aware that there are already cases regarding the scope of carried interest taxation pending before the National Tax Tribunal.
The tax department at Gorrissen Federspiel has considerable experience both with the establishment/structuring of investment structures and incentive programs, as well as handling tax cases (both dialogue with the Danish Tax Agency and appearing before the courts) if an existing structure or an existing incentive program is subject to tax audits.