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US Congress Takes Another Look At Carried Interest

by Mike Godfrey, Tax-News.com, Washington

07 September 2007


The United States Congress has held its latest round of hearings on the tax treatment of carried interest, as lawmakers seek to justify their proposals to increase the amount of tax paid by private equity partners and hedge fund managers.

In the House of Representatives on Thursday, the Ways and Means Committee held three panels to assess whether the US tax code is "fair and equitable" for working US families, especially in the light of recent tax reforms enacted under the Bush administration, which Democrats on the committee contend favour the wealthy over low and middle income wage earners.

The third of these panels concerned the vexed question of the tax treatment of income, or carried interest, earned by limited partners, principally in the private equity industry. The debate is focusing on whether, in the case of private equity partners, their earnings should be treated as investment income and taxed at the capital gains tax rate of 15%, or ordinary income taxed at 35%.

The consensus of the panel, which consisted mainly of academics and tax experts, seemed to be slanted in favor of the latter opinion. In written testimony, Peter R. Orszag, Director, Congressional Budget Office, stated that most economists would agree that at least some part of carried interest is performance based rather than a return on financial capital invested, and therefore should be taxed accordingly.

"That perspective would suggest taxing at least some component of the carried interest as ordinary income, as most other performance-based compensation is currently treated, regardless of the nature of the underlying investments generating the profits of the fund," Orszag testified.

Eugene Steuerle, Co-Director, Urban-Brookings Tax Policy Center, and Former Deputy Assistant Secretary of the Treasury for Tax Analysis in the Reagan Administration said that Congress could take an important step towards solving the problem of carried interest "by amending Section 702(b) to provide that a partner’s distributive share shall be treated as ordinary income when it is compensation for services rendered by the partner to the partnership." He also stated that Section 1402 a should be amended to make this income subject to the self-employment tax.

Mark Gregen, Professor of Law at The University of Texas School of Law, claimed that there was "widespread agreement" among tax professors and economists that "the status quo is an untenable position as a matter of tax policy".

Meanwhile, over in the Senate, the Finance Committee held its third meeting on the issue of carried interest, which explored claims that a tax hike on carried interest would be passed on to the pension companies that invest in private equity funds, and ultimately to the pensioners themselves.

Finance Committee Chairman Max Baucus observed that observed that in July 2006, American pension plans held $350 billion in alternative investments, including private equity and hedge funds. "That is a lot of money," he noted. However, at this time, defined benefit pension plans had more than $5 trillion in assets, meaning that less than 7% of their pension assets were held in alternative investments. In 2006, about 10% of hedge fund capital came from US pension plans.

"This data says to me that hedge funds and private equity funds may need pension funds more than pension funds need private equity or hedge funds," Baucus stated. "And that means that hedge funds and private equity funds may not have the economic power simply to pass along increased costs to pension funds."

However, tax experts believe that at least some of the tax hike on carried interest will be passed on to pensioners, although it is unclear to what extent the measure would erode investments.

"In short, the proposed tax changes, if they can effectively be enforced, would be progressive but also would reduce returns to investors, including pension funds, somewhat," testified Dr. Alan J. Auerbach, Professor of Law and Economics, University of California at Berkeley.

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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