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Senate Tax Writers Target Hedge And Private Equity Funds

by Mike Godfrey, Tax-News.com, Washington

18 June 2007

Senators Max Baucus (D-Mont.) and Chuck Grassley (R-Iowa), Chairman and Ranking Republican Member of the Senate Finance Committee, have introduced legislation that would tax as corporations all publicly traded partnerships that directly or indirectly derive income from investment adviser or asset management services.

The initiative is aimed at private equity and hedge funds, which derive most of their income directly or indirectly from investment adviser or asset management services, but which then pay investment taxes at 15% rather than income tax at rates of up to 35%.

“The nature of investment vehicles is changing right before our eyes, and the tax code must keep up with the times,” stated Baucus. “Creative new structures for investment vehicles may blur the lines for the tax treatment of income. We must make the law clear and apply the law fairly, or risk the erosion of our corporate tax base. If a publicly traded partnership makes its money by providing financial services, that active business should be taxed as a corporation. ”

“Right now, some businesses are crossing the line between reasonably lowering their tax burden and pretending to be something they’re not to avoid most, if not all, corporate taxes,” announced Grassley. “A hallmark of corporate status is access to the capital markets. It’s unfair to allow a publicly traded company to act like a corporation but not pay corporate tax, contrary to the intent of the tax code. We don’t have a workable tax code if we don’t have structural integrity. If left unaddressed, the tax concerns presented by the public offerings of investment managers, like private equity and hedge fund management firms, could fundamentally erode the corporate tax base. That would leave other individuals and business taxpayers with a greater share of the nation’s tax burden.”

Corporations and their shareholders are subject to two levels of tax. Corporations pay taxes, and shareholders pay taxes on distributions received from the corporations. In contrast, partnerships and their partners are subject to only one level of tax. Partners are taxed on their distributive shares of income.

Baucus and Grassley have pointed out that Congress became concerned as far back as 1987 that some partnerships with interests traded on public exchanges were essentially operating as corporations, but avoiding corporate tax. Congress feared that such publicly traded partnerships would erode the corporate tax base and gain an unfair advantage over companies operating as corporations. In response to these concerns, Congress updated the law to generally tax publicly traded partnerships as corporations. An exception to that general rule exempts publicly traded partnerships from corporate taxation if they can demonstrate that at least 90% of their income is passive – for instance, from dividends, interest, or royalties rather than the provision of services. But today, new structuring of investment vehicles may make it possible for partnerships to argue that their income is passive, when it is actually produced by actively providing financial services.

With the new legislation, Baucus and Grassley said they are seeking to further clarify the law, both to appropriately preserve the corporate tax base and to assure that such publicly traded partnerships do not gain an unfair advantage over established financial services corporations. The Senators also believe that recent and proposed public offerings of private equity and hedge fund management firms are inconsistent with the intent of the existing rules regarding publicly traded partnerships.

In addition to filing this legislation, Baucus and Grassley have written to Treasury Secretary Paulson, asking for Treasury’s views on this issue, and enquiring as to what plans Treasury and the Internal Revenue Service have to issue guidance and enforce Congressional intent.

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