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Carlyle Boss Defends US Private Equity Taxation

by Mike Godfrey,, Washington

02 August 2007

Raising taxes on the private equity investment industry could reduce investment in companies, lower returns for pension funds and other investors and hurt the competitiveness of US capital markets, according to a senior figure from the industry.

“There will be deals that won’t be done, entrepreneurs who won’t get funded and turn-arounds that won’t be undertaken,” Bruce E. Rosenblum, managing director of The Carlyle Group and chairman of the Private Equity Council told Congress as lawmakers consider new legislation that aims to reduce the apparent tax advantages enjoyed by private equity firms and their partners compared with other corporate forms.

In testimony before the Senate Finance Committee, which held its second hearing on the issue of 'carried interest' on July 31, Rosenblum said the Private Equity Council opposes two bills that would significantly raise taxes on private equity investment firms because they would undermine an industry that has made a major contribution to the American economy.

Legislation currently progressing through the House of Representatives would tax profits earned by private equity firms on long-term investments at the regular income rate of 35% instead of the long-term capital gains rate of 15%. Meanwhile, Senators are considering a bill which would impose a 35% corporate income tax on private equity partnerships that decide to go public.

In his opening statement at the hearing, Senate Finance Committee Chairman Max Baucus said that there is little difference between a large private equity firm and a Wall Street investment bank and that it was hard to argue that private equity firms should receive more favorable tax treatment.

"Both offer merger and acquisition services. Both provide mezzanine financing for transactions. Both offer a wide array of investment strategies for their clients. But only one claims that the income from an active business is passive and is subject to capital gain treatment," Baucus stated.

However, Rosenblum warned lawmakers to "proceed very carefully" before changing a form of ownership he said has been a "major and positive force in strengthening US competitiveness, giving struggling or failing businesses a new lease on life, and pumping critically needed capital into the economy."

Rosenblum claimed that private equity investment firms between 1991 and 2006 returned more than $430 billion in profits to their investors, nearly half of which are public and private pension funds, university endowments and charitable foundations.

Changing the tax structure would make US private equity investment firms less competitive with their foreign counterparts and foreign governments that are amassing large investment funds, Rosenblum said. He added that a large tax increase could prompt the next generation of private equity investors to set up their shops outside the United States, diverting investment capital from US businesses to foreign competitors.

Critics are wrong to suggest that private equity investment firms benefit from tax loopholes, Rosenblum argues, because taxes on private equity firms are based on their ownership interests in long-term investments – their portfolio companies – that appreciate in value. He pointed out that PE firms are taxed at the same rate and in the same manner as any other partnership – including those that invest in real estate, oil and gas, start-up enterprises and family businesses – that owns an asset that increases in value over time and later is sold for a profit.

“The tax treatment of this ownership structure is well settled by case law and administrative rulings of the Internal Revenue Service. It is anything but a loophole.” Rosenblum said.

Countering an argument made by tax increase advocates, Rosenblum said that there is a clear distinction between owners who take entrepreneurial risks to grow businesses over time and employees who are paid based on their performance.

Rosenblum quoted a new PEC-funded study by David A. Weisbach, Walter J. Blum professor at the University of Chicago Law School. In the study, “The Tax Treatment of Carried Interests in Private Equity Partnerships,” Weisbach said: “The tax law makes a fundamental distinction between an employee performing services and an entrepreneur creating or increasing the value of its business. There is little question that a sponsor of a private equity fund is more like an entrepreneur than an employee. The sponsor is the driving force, the individual with the ideas and the skill to make a project happen. The sponsor is the general partner of the fund with exclusive control over the fund’s activity. …[T]he sponsor bears all of the fund’s residual risk.”

Contrary to critics, private equity firms take on substantial risks, including risks to their capital, Rosenblum testified. The firms’ partners contribute significant risk capital to their funds and they can lose all or some of it, just like their limited partners. Private equity firms, large or small, also face the real risk that after investing in and working with their portfolio companies for years – six years is the current average – they will have nothing to show for their efforts if things go bad. In that situation, they also could face significant legal and financial liabilities, he said.

Rosenblum added that capital gains treatment has never been tied to the proportion of capital contributed to the venture. The founder of a technology company may put very little capital into the business and over the years raise billions of dollars in equity financing from third parties. Still, the founder will receive capital gains treatment on the sale of his or her 50% stock ownership, even if he or she has provided only 5% of the capital, Rosenblum said.

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