Carried interest, or “carry,” is the share of a fund’s profit paid to its general partner as compensation for managing the fund, on top of — not instead of — the annual management fee, payable only once limited partners have their capital back and the fund has cleared the preferred return the fund’s own documents set.
Nothing in the Income Tax Act is defined as “carried interest” the way s. 38(a) defines the taxable capital gain, or the way a dedicated section sets the lifetime capital gains exemption. A Canadian PE or VC fund is almost always structured as a limited partnership, and a partnership itself pays no tax — under Income Tax Act s. 96(1), each partner computes “the amount of the income of the partnership for a taxation year from any source… were the income of the taxpayer from that source,” which is what preserves the character of the underlying gain. A carry allocated out of the fund’s capital gains is therefore generally taxed to the GP as a capital gain in its own hands, subject to the same one-half inclusion under s. 38(a) as any other capital gain, rather than as fully-taxable business or employment income.
That treatment has a guardrail. Income Tax Act s. 103(1) lets the allocation be overridden “where the principal reason for the agreement may reasonably be considered to be the reduction or postponement of the tax” that would otherwise be payable — each partner’s share is then deemed to be “the amount that is reasonable having regard to all the circumstances.” A carry has to reflect a genuine, at-risk share of partnership profit, set out in the fund’s own limited partnership agreement, to hold its capital-gains characterization rather than being recharacterized as a disguised fee for services.
A fund raises $150 million in commitments. Its own LPA sets an 8% annual preferred return to LPs before any carry is paid. On exit, the fund returns $240 million in total proceeds: LPs first receive their $150 million of capital back, then the 8% preferred return accrued over the fund’s roughly six-year weighted average hold, which in this fund comes to $46 million — leaving $44 million of profit above the preferred return. The GP’s carry vehicle is allocated its contractually agreed share of that $44 million as a partnership allocation retaining capital-gains character under s. 96(1), provided the allocation reflects a genuine profit share rather than a fee the s. 103(1) reasonableness test would recharacterize.
See also: Capital call · Capital commitment · Cutting the turnaround time on quarterly LP reports.
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