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Grassley Seeks To Restore Balance In Carried Interest Debate

by Mike Godfrey,, Washington

13 July 2007

Senator Chuck Grassley, ranking Republican on the Senate Finance Committee, has disputed claims that an investigation into the 'carried interest' earned by some fund managers is an attempt by Congress to raise taxes and attack the investor class.

In his opening statement to the Committee's hearing on the subject of carried interest on Wednesday, Grassley stated that the ongoing enquiry is attempting to clarify the application of the tax code to certain limited partnerships, and was not motivated by "envy" of the large sums being earned by some fund managers.

"Contrary to the claims of some press reports, lobbyists, and politicians, our inquiry, and any proposal that it may produce, is not about raising taxes on capital income. It is not an attack on the investor class. It is about the definition of capital income versus labor income," he told the hearing.

The current partnership tax rules were introduced into the US tax code in 1954. Under these rules a partnership itself is not subject to tax, unlike a corporation. Instead, the income, and the character of that income flows through to its partners. If a partnership realizes ordinary income, then the partners are taxed on that income at ordinary tax rates, currently 35%. But if the partnership realizes capital gains, then the partners are taxed as capital gains at the much lower rate of 15%. This has led to calls from some that highly remunerated fund partners should be taxed at ordinary income tax rates in the interest of fairness.

Grassley went on to point out that during his tenure as Chairman and now ranking member of the Finance Committee, he has never overseen legislative measures with the sole intent of raising taxes, and he explained that the current investigation was more about closing loopholes than raising revenue.

"If the proposal was good policy, then I recommended it to our committee, whether it raised or lost revenue. For those who want to recklessly charge our deliberate, transparent policy inquiry as a tax increase exercise, I’d ask them a question. Which Finance Committee Chairman in the last generation cut the American People’s taxes more than I did?," he argued.

"So, this hearing and the committee’s inquiry is not about a revenue grab from private equity firms or hedge funds. Folks on both sides ought to roll up their sleeves, move away from partisan talking points, and join Chairman Baucus and me in finding the facts," Grassley added.

However, Grassley also argued that lawmakers must "not allow the carried interest tail to wag the capital gains dog".

"As a Republican who supports lower capital gains rates, I am concerned that to the extent we permit the dilution of the investment concept, we risk undermining the arguments we have made for the lower rates, and also making it more expensive to extend them," he remarked.

Responding to recent criticism, including from Treasury Secretary Henry Paulson, that their legislative proposals on the issue of limited partnerships are a narrowly targeted tax hike on a single industry, Grassley and committee chairman Max Baucus have said that their bill does not single out the issue of carried interest, but clarifies a 1987 law that requires corporate taxation of all publicly traded partnerships.

"Far from singling out one industry for punishment, we’re simply clarifying that private equity firms and similar businesses should not receive special treatment in the tax code," Baucus said last month, adding: "No one group of businesses should gain an edge over its competitors by claiming a tax status for which they do not qualify. Applying our tax laws fairly and according to precedent will make sure that American business continues to thrive and grow across all sectors.”

Testifying before the committee, Kate Mitchell, a National Venture Capital Association (NVCA) board member and managing director of Scale Venture Partners, asserted to the Senate Finance Committee that carried interest paid to venture capitalists has always been consistent with capital gains tax philosophy, and should continue to be recognized as such.

"As venture investors, our job is to identify and nurture promising companies," stated Mitchell. "Venture capital is about creating new companies that helped launch Google, Microsoft, Genentech, Starbucks, and eBay. While these companies are household names today, they were once just ideas put forth by entrepreneurs who had not grown a small business before."

Mitchell explained that venture capitalists typically receive two forms of compensation. The first is a guaranteed management fee which is used to pay for firm operations and salaries. This management fee is currently taxed at the ordinary income rate. The second is the carried interest paid to venture capitalists which typically amounts to 20% of a fund's total profit. Carried interest is only typically paid after all invested capital and all of the management fees have been returned to the limited partners, she said.

Mitchell argued that carried interest deserves to be taxed at capital gains rates because such gains are never guaranteed and are contingent upon successful company exits.

"We invest in companies for 5 to 10 years, often longer and rarely less," she told the hearing. "Many VC-backed companies fail. We dig many dry wells -- the cost of which is balanced by gains earned from our best investments. This balance is critical to support our entire portfolio of hopeful start-ups."

Wednesday's hearing was just the first in a series of hearings on the issue of carried interest.

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