Carried Interest Taxation

Part II of the JCT's report on the taxation of private equity deals with the specific tax rules faced by tax-exempt investors in private equity and hedge funds.  Understanding this section requires some background on the "debt-financed income" rules for tax-exempt investors.

As indicated by their name, tax-exempt organizations, such as pension plans and university endowments, do not pay tax on contributions and investment income.  However, special rules tax income earned by a trade or business conducted by such an organization and unrelated to its exempt purpose.  The theory of this exception to the tax exemption is that a tax-exempt organization would have an unfair competitive advantage over taxable entities in the same business, and the exemption shouldn't create such an advantage. 

Similarly, the tax code taxes investment income earned by a tax-exempt entity in proportion to the extent of any debt incurred by the organization to acquire the investment.  The theory behind this exception to the tax exemption is that the return to the extent is financed by debt, it is not the organization's capital and thus should not be tax free.

In the case of a partnership, each partner is considered to incur a proportionate part of any indebtedness incurred by the partnership.   Accordingly, if the partnership buys an investment asset with borrowed funds, a portion of the income from the asset will be considered debt-financed property to a tax-exempt partner in the partnership.

The debt-financed income rules do not apply to a foreign corporation.  Accordingly, if a foreign corporation borrows money to buy the stock of a US corporation and sells the stock for a gain, the foreign corporation generally would not be subject to Federal income tax on the gain.

With this background, consider an investment in a hedge fund.  Hedge funds use a significant amount of debt to manage their risk and returns, as well as to provide liquidity.  In addition, most hedge funds are taxable as partnerships.   So, if a tax-exempt investor invested in a US hedge fund, a portion of the investor's return would be taxable as debt-financed income. 

To address this issue, many hedge fund managers form offshore funds specifically designed to accomodate investments by tax-exempt investors.   These offshore entities choose to be taxable as corporations, so the fund "blocks" the imputation of debt financing to the tax-exempt investors.  As discussed above, the foreign corporation itself is not subject to the debt-financed income rules.   Any distributions from the foreign corporation to the investor would be dividends not subject to the unrelated business income tax.  Accordingly, by investing indirectly in  a foreign corporation, the tax exempt investor avoids tax on the capital gains earned by the offshore fund.

As reported on Friday, Representative Sander Levin (D-MI), a co-sponsor of the carried interest bill being debated in the House, has indicated that he will introduce legislation that would permit tax-exempt organization to invest directly in hedge funds without incurring unrelated business income tax, which would eliminate the need to form offshore blocker corporations to make such hedge fund investments.   This legislation would be welcome in the private equity community, because it would eliminate additonal transaction and operation costs normally incurred to set up the offshore funds.   

A lot of news to report surrounding the testimony in Congress yesterday:

• Russell Read, chief investment officer of CALPERS, testified his belief that the private equity legislation's impact of their returns would be negligible.  This testimony undermines claims by private equity  managers that changing the tax rate on managers would hurt retirees by reducing returns on pension investments in alternative investments.  The testimony is also consistent with our belief that it will be difficult for managers to pass on any tax increase to investors by changing the basic Two and Twenty economic structure.
• Representative Sander Levin (D-MI), a co-sponsor of the carried interest bill being debated in the House, has indicated that he will introduce legislation that would permit tax-exempt organization to invest directly in hedge funds without incurring "unrelated business income tax," which would eliminate the need to form offshore blocker corporations to make such hedge fund investments.
• Representative Levin also made it clear that hedge fund managers should pay the 2.9%  self-employment or FICA tax on "performance allocations," a structure very similar to carried interests held by private equity managers.  Experts disagree on the revenue impact of these taxes on the Medicare system that such taxes fund.
• Representative Rahm Emanuel (D-IL) stated that he will introduce legislation designed to eliminate the ability of hedge fund managers to defer taxes by setting up offshore entities that receive compensation from hedge funds.

Ove the weekend, we'll post a more thorough discussion of the hedge fund issues encountered by tax-exempt investors, and the JCT report's analysis of those issues.

The first part of the JCT Report on the tax treatment of carried interests deals with the primary issues addressed by the legislation currently proposed in Congress, mainly whether carried interests should be taxable as compensation income and whether publicly traded private equity partnerships should be taxable as corporations. 

With respect to the first issue, the report catalogs the arguments on both sides of the issue.  The primary points discussed in the report are as follows:

1. Carried interest distributions should be ordinary income because they represent compensation for services rendered by the individuals whose professional skill generates capital income for fund investors. 
2. Carried interest distributions should be taxable by reference to the character of the fund's income, because they represent a sharing of the fund investors' favorable tax treatment between the investors and the manager.  In this regard, the fisc is in the same position as if the investors paid deductible compensation to the manager, because the investors would deduct the compensation against ordinary income and the fund manager would have an equal amount of ordinary income.  The net would be the capital gain taxable at preferential rates to the investors.  The fallacy with this argument is that it assumes that all investors are taxable at the same rates and can fully deduct the compensation deductions, which is not the case.  For example, an individual investor would probably not get the full benefit of a compensation deduction, because of the distinctions between trade or business (deductible under Code section 162) and investment (deductible under section 212) expenses.
3. A carried interest represents a combination of compensation for services and income from the underlying investments (this point reflects Professor Fleischer's argument discussed previously).
4. A carried interest represents capital gain income because the manager earns it by taking a risk on fund performance.  However, the policy for reduced tax rates for capital gains really has nothing to do with taking risks, but more the disposition of a capital asset.  On the other hand, the fund clearly owns a capital asset, and under traditional views of partnership tax, the fund manager, as a partner in the partnership, is considered to own the same assets as the fund.
5. A carried interest is analogous to an entrepreneur's "sweat equity," which is taxable as a capital gain upon exit from the partnership.  We believe that this point is the strongest policy argument for maintaining the existing regime for the taxation of carried interest.  We don't see why the manager of an investment activity (the private equity fund) can't take sweat equity on the front end and get the same treatment as the entrepreneur who starts the business in which the private equity fund invests. 
6. The existing rules should remain in place because raising the effective tax rate on carried interests would change the economics between the investors and the manager, reducing the effective rate of return to the investors.  We believe that this argument is a red herring, affected by the market for capital independent of the tax consequences.
7. The existing rules should remain in place because treating carried interest income as compensation for services would introduce additional complexity to the tax rules, which could creat inefficiences and distortions in the economy.  On the other hand, the perception that similarly situated taxpayers are taxed at disparate rates on the compensation for services might increase noncompliance by taxpayers who viewed that disparity as unfair.

With respect to the taxation of publicly traded fund manager partnerships is whether a business that derives its income from asset management and advisory services should be treated as a passive investment partnership that is exempt from taxation of a corporation.  (For a background of the publicly traded partnership rules, see here.)  While the legislation clearly exempts carried interests, the report speculates that Congress didn't focus on these types of partnerships, because only a few types of businesses had organized as publicly traded partnership (like the Boston Celtics). 

Tomorrow, we'll report on the second part of the JCT Report, detailing the use of foreign private equity entities by tax exempt investors (universities, pension plans, etc.) to avoid the taxation of returns to those investors because of the use of leverage by the funds.

The Joint Committee on Taxation this morning issued two new reports on the taxation of carried interests.  The first report analyzes the compensatory aspects of carried interests.  The second report analyzes the tax rules applicable to carried interests earned by offshore entitites.  We'll dig into these reports and post more tonight or in the morning.

As we get ready for the Ways and Means Hearings next month, we thought that we would look at some of the issues raised regarding the current carried interest legislation proposals.  Over the next few days, we'll analyze the following issues:

• Does a carried interest represent services income or an investment in a capital asset?
• Will either of the proposals raise revenues for the fisc?
• Will either of the proposals dampen the market for private equity investment?
• Will either of the proposals change the basic "Two and Twenty" deal between private equity managers and investors?
• Is a publicly traded private equity firm taxable as a partnership an erosion of the corporate tax base?

Check back over the next week or so as we begin to analyze the arguments for and against the legislative proposals.