Carried interest losing its capital gains tax status isn’t a new threat to the private funds industry – the issue has been bubbling for at least a decade on both sides of the Atlantic. But lately there seems to be renewed political interest and momentum.
That’s perhaps most visible in the US, where carry is taxed at a 20 percent capital gains rate rather than as ordinary income, which carries a rate of up to 39.6 percent.
Once again this rate has become a US presidential election issue, with nearly every contender in the race for the White House coming out against carry’s tax status – perhaps one of the only issues they all agree on.
Republican candidate Donald Trump has been reported as saying, “The hedge fund guys are getting away with murder,” while Democratic candidate Hillary Clinton has – in both her current and previous bids for the White House – referred to carry’s tax designation as an offensive loophole unfairly benefitting the nation’s wealthiest citizens. Other candidates, too, have vowed to close the so-called loophole.
“In connection with the upcoming elections, this phrase ‘carried interest loophole’ has become a catchphrase for many of the candidates, and they have all come out and got on the bandwagon saying they will close the loophole,” says Matthew Saronson, a partner in the tax department at the law firm Debevoise & Plimpton. “If you look at what they are saying, 90 percent of their statements are really about hedge fund managers, which suggests that very few people appear to understand the way that carry works.”
Carried interest recipients are taxed on a look-through basis based on the type of income generated by the fund. Most hedge funds generate ordinary income and short-term gains, so the resulting carried interest is taxed at ordinary rates and does not benefit from the reduced rates applicable to long-term capital gains.
“From my perspective it’s not a loophole at all – it’s the way that partnership tax has worked from the beginning,” says Saronson. “For now, people are just sitting tight; there does seem to be a substantial risk that it will be switched to being taxed as ordinary income rather than looking through to the underlying income, but the big question is whether or not they can get it through Congress. The Obama administration has not managed to do so in eight years of trying.”
Alan Van Dyke, a partner in the tax and private funds team at Latham & Watkins, agrees. “People are constantly proposing legislation around this, but the odds of any of that becoming law in the near term are pretty slim,” he says. “Paul Ryan, the last head of the Ways and Means Committee of Congress [the chief tax-writing committee in the House of Representatives] specifically said that this is something where changes ought not to be made other than in the context of a major overhaul of the entire tax system. On a standalone basis, he said, it is not a change that should be made.” Ryan is now the Speaker of the House, its most powerful position.
Still, between the need to generate tax revenue and politicians eager to distance themselves from Wall Street, it’s an issue that is expected to keep popping up. As Mel Schwarz, legislative affairs partner in the US National Tax Office of global accounting firm Grant Thornton, told us way back in 2007, “The old joke is there’s nothing in the tax code that hasn’t been talked about for 10 years before they put it in. Once one of these things comes on the table, it’s very difficult to get it off the table. You can beat it back, but anytime they’re looking to raise revenue, it’s going to come back.”
One thing the Washington DC-based Private Equity Growth Capital Council is trying to do in the meantime is ensure politicians understand the asset class and how carry works.
“We are spending a lot of time on the educational front, to make sure new members of Congress are educated on carried interest, why it’s important, why it’s a longstanding practice, and why it’s beneficial to the economy,” says the lobbying group’s head of public affairs, James Maloney.
Across the pond
Until recently, the story was quite similar in the UK, in that raising the rate on carry has long been a talking point, with the House of Commons Treasury Committee notably looking into the issue in 2007. But in the summer of 2015, things started to change with the abolition of the so-called ‘base cost shift’.
Base cost shift enabled an investment manager to take advantage of a share of the capital invested by external investors in calculating the gain on its carried interest, in what was essentially a quirk in the UK tax rules on partnerships. But now, only actual investment by an individual participating in the carried interest can be taken into account when calculating the capital gain on the realisation of the underlying investments.
Then, new investment management rules were published that sought to define carried interest for the first time, and set out that unless gains to the GP fell within either carry or co-invest, they would be taxed as income.
Now, rules that are intended to come into force on April 6, but which are still in consultation, propose all carried interest to be treated as income-based unless a fund satisfies a statutorily defined average holding period for its investments. This is part of an effort to define whether funds are ‘investing’ or ‘trading’, with the starting point that a fund that invests in unlisted equity with an investment horizon of five years is probably investing, while a hedge fund with a frequent turnover of assets is probably trading. If a fund is investing, then the carried interest performance fees can be taxed as capital gains by the fund manager, at 28 percent, rather than 45 percent.
Once the average holding period is calculated, the proportion of the return eligible for taxation as capital gains will be set out in the rules.
“We finally had a legislative definition of what carry is, and that’s in many ways helpful,” says David Irvine, a tax partner in the London office of law firm Weil Gotshal & Manges. “Broadly, where amounts arise from profit-related returns, and are subject to significant risk, then they should, prima facie, fall within the new carried interest definition.”
He adds, “But, based on the latest legislative proposals, we are about to further complicate this and will find ourselves in a world where carry will be automatically treated as management fee income if certain fairly arbitrary holding period requirements, calculated based on average investment holding periods across a fund’s life, are not satisfied. So, we will have all of the historic record-keeping requirements for tracking where everything is coming from, plus new requirements to track the details of investment holding periods in order to work out what falls within the narrow boundaries of what can be treated as carry and how that carry is taxed.”
The British Private Equity and Venture Capital Association has expressed its apprehension over the proposals’ potential impact: “We are very concerned that the approach taken will, at best, result in significant uncertainty as to the ultimate tax treatment of carried interest returns across the industry, with the result that the UK could become a significantly less attractive jurisdiction for the establishment and operation for fund management businesses.”
Other concerns have been raised by experts. Darren Docker, a tax partner at PwC specializing in funds, says: “The curious thing about what we have now is that, while different parts of the alternative assets market have lobbied Her Majesty’s Revenue & Customs to have slightly more advantageous holding periods, it still comes down to the question of the longer I hold something, the better my tax position is likely to be. So we are starting to get concerned investors talking about conflicts of interest, because you might start seeing behaviour that is not necessarily what the managers would have done if you had taken tax out of the equation.”
Until the exact scope of the legislation is finalized, which will be after it has passed through parliament, and likely sometime after it becomes effective in April, there is little that funds can do to mitigate the effects. Longer term, as the impact on different types of funds become clearer, we could see some structures doing away with limited partnerships that were only there to increase the chance of performance-linked rewards being taxed as capital gains, and some performance allocation or growth share corporate structures may revert to simply having a performance fee.
Ceinwen Rees, a senior UK tax associate at Debevoise, concludes: “All funds should be thinking about their average holding period and looking at their documentation to work out what they have at the moment. For funds not in existence yet there are some things that can be done, depending on what the sponsor has done previously. If you are looking at successor funds you are limited in what you can do because there are very wide anti-avoidance rules, but for brand new funds to the market there are structuring changes that can be made, but it is difficult to be explicit about them until the rules are in their final form.”
Carried interest taxation in Asia
The Hong Kong Inland Revenue Department (IRD) does not currently tax carried interest in the hands of individual recipients, but there is still ambiguity. In the last couple of years when the IRD has reviewed the Hong Kong management or advisory entity’s profits tax return – the equivalent of the corporation tax return in the UK – it has selected some private equity management or advisory businesses based in Hong Kong for audit. As part of the audit process it has, in some cases, been effectively trying to apply a transfer pricing analysis to some portion of the carried interest, and to say the Hong Kong portion should have been reported as income of the Hong Kong advisory entity in its profits tax return.
“There may be red-flag factors that the IRD has seen as triggers for an audit,” says one Asia-based private equity tax lawyer, who did not want to be named, “such as firms not bringing as much management fee onshore as they might, or carried interest arrangements where the carried interest is effectively used by the management company to pay bonuses. But as far as we understand it, those aren’t common to all of the investigations that have happened.”
pfm understands that industry bodies, including the Hong Kong Private Equity & Venture Capital Association, are working with the IRD to come up with some kind of agreement as to the consistent treatment of carried interest going forward, but the issue is currently very sensitive and being addressed behind closed doors.
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