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Study Queries Revenue Effect Of Tax Hike On Private Equity

by Mike Godfrey, Tax-News.com, Washington

23 August 2007


An academic study has concluded that plans by the US Congress to tax carried interest earned by private equity fund partners at higher rates of tax would lead to a negligible rise in tax revenues for the Treasury.

The paper by Michael Knoll, a law professor at the University of Pennsylvania in Philadelphia, which was published online by the Social Science Research Network, calculated that moves to change the way private equity partners are taxed would boost revenues by, at most, $3.2 billion annually.

Professor Knoll's essay revealed that between $12 billion and $17 billion in carried interest is granted by private equity firms every year. Legislation proposed by senior House Democrats is seeking to tax this as ordinary income at 35%, instead of at the long-term capital gains tax rate of 15%, in the interest of maintaining a level playing field in the tax system between the wealthy, lower, and middle-income taxpayers. However, according to Knoll, even if such legislation is enacted, private equity and venture capital firms will simply restructure certain aspects of their business to effectively cancel out the tax increase.

Knoll wrote that this could be done, for example, by funds charging higher fees to their clients who in turn could legitimately deduct them for tax purposes, thereby negating the tax hike and producing little or nothing for the government in the way of revenues. Buyout firms could also shift the burden of the tax increase onto their portfolio companies, in the form of a contingent fee in exchange for assistance in restructuring the business, which could then be deducted as a normal business expense, he speculated.

The government has not yet released a revenue estimate for the House bill that would tax carried interest at ordinary income rates, and the paper is perhaps the first credible examination the potential revenue effects of Congressional proposals on the tax treatment of carried interest.

However, moves are also afoot in the Senate to change the tax treatment of certain partnerships, which go beyond the issues examined by Professor Knoll. Proposed legislation by Senate Finance Committee Chairman Max Baucus and ranking Republican Chuck Grassley primarily focuses on preventing publicly traded limited partnerships from benefiting from a corporate tax exemption unavailable to most other types of company. However, legislation due to be introduced by Finance Committee member Charles Schumer (D - NY), would tax as ordinary income the carried interest earned by all types of investment partnerships.

A comprehensive report in our Intelligence Report series examining tax-sheltering arrangements for investors, including Venture Capital, Forest Finance, Film Finance, is available in the Lowtax Library at http://www.lowtaxlibrary.com/asp/subs_reports.asp and a description of the report can be seen at http://www.lowtaxlibrary.com/asp/description_report5.asp

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