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.