The Italian Government has at last put an end to the controversy around the characterisation of 'carried interest' for tax treatment purposes. By Law Decree no. 50 of 24 April 2017, which is to be brought into law by 23 June 2017, the long awaited rules permitting the taxation of carried interest as capital gains or dividends, rather than as employment income, will come into force.

In general terms "carried interest" is the reward granted to the managers of an entity or of an investment fund and linked to the performance of the investment made (in such entity) and it is an element of remuneration extremely widespread in the private equity sector.

The new rules apply to the income:

• generated (directly or indirectly) by the holding of shares, quotas and other financial instruments, bearing extraordinary remuneration rights and issued  by companies, entities and investment funds; and
• cashed by employees and directors of such companies, entities or funds or of other entities linked to such companies, entities or funds by a direct or indirect control or management relationship.

The application of the new rules is conditional on the satisfaction of the following three requirements:

1. the employees and managers holding such financial instruments must have invested (in the aggregate) at least 1% of the entire investment made by the fund;
2. the employees and managers' remuneration must accrue only after all other investors have cashed an amount equal to the capital invested plus a minimum return on it (as set out in the entity rules);
3. the employees and managers must retain their investment for a minimum holding period of 5 years (or until the exit from the investment by the fund).

The taxation of carried interest has been long debated in Italy, with tax authorities arguing that it should qualify as employment income due to the fact that it is paid in relation to the employment/directorship relationship, and thus subject to individual income tax at up to 43%, and private equity funds arguing that it represents a capital gain or dividend on non-qualified shareholdings taxable at 26%.

The new rules mean that from now carried interest will be taxed as a capital gain or dividend, at 26%, provided that the relevant requirements are met.

The terms and conditions of the incentives granted to employees and managers in the private equity field should now be reviewed and scrutinized to check whether they meet the above conditions and can thus benefit from the new rules.