Arguably, this reflects the reality that carried interest is a bonus for effort paid by investors from their gains, rather than a gain realised by fund managers on their own investments.
It therefore seems a disconnect exists between the Treasury treating carried interest as a capital gain and the divorce courts treating it as income.
Wells sharing
Meanwhile, the divorce courts have to grapple with one issue that the Treasury does not: valuation.
While tax only bites after the carried interest has been received, which may be many years after a divorce has been finalised, the division of a carried interest entitlement on divorce typically takes place before receipt, as carried interest tends to become payable in the latter years of a fund’s life.
The likely payouts cannot be estimated with any precision; while a broad estimate based on past performance or market averages can be calculated, the returns will be heavily dependent on the particular investments and the economic circumstances in which they come to be sold.
In some cases, this will lead a court to adopt a “Wells sharing” approach (named for the case in which it was first suggested), in which the division of an illiquid and/or unquantifiable asset is mandated at the date of a court order but which only actually takes place when the investment or carry is realised – potentially many years after the divorce.
While this has the benefit of fairness, it necessitates an ongoing financial relationship between the parties, which conflicts with the court’s duty to consider terminating the parties’ financial obligations to each other as soon as “just and reasonable”.
The alternative to Wells sharing is to use the best estimates of future value that are available and apply the relevant percentage to provide for the payment of a fixed sum.
This can create tough choices for recipients (usually wives). Should they seek a share of future receipts, risking that they may fail to materialise and therefore delaying their receipt of funds, or should they seek a fixed sum now, knowing it may significantly undervalue future receipts? In our experience, husbands usually prefer to pay out a fixed lump sum (perhaps reflecting their confidence in the future success).
Which approach is ultimately taken will depend on a number of factors including the reliability of the valuation, how long it will likely be until the fund pays out, whether the wife needs immediate funds and whether there are particular reasons to avoid an ongoing financial nexus between the parties.
In B v B, Mr Justice Coleridge prioritised fairness, providing for the carried interest to be shared on receipt, notwithstanding that this could result in payments being made many years into the future.
