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U.S. House approves ‘carried interest’ tax, hedge fund managers get six-month reprieve

Tuesday, June 01, 2010
Opalesque Industry Update – The U.S. House of Representatives approved on Friday a $113bn tax extenders package that aims, among other things, to end tax breaks for investments executives, including hedge funds, private equity and venture capitalists. But the move gives hedge funds enough room to find ways to mitigate the effects of the proposed tax measure before the Senate tackles the bill next month, media reports said.

Lobbyists were able to delay the implementation of the new tax measure until Jan. 1, 2011, reported Business Week.

Under the proposed tax, the government will impose higher tax on carried interest - or the share of the profit that fund managers are paid, from its current 15%. Indeed, performance fees are currently treated as capital gains.

Victor Fleischer, the University of Colorado professor whose paper on the subject helped prompt Congress to act, said that carried interest should not qualify as capital gains because fund managers risk mostly other people’s money rather than their own, said New York Times. The carried interest tax issue had been stalled in the Senate over the past three years.

The measure was part of a broader $113bn package approved by the House in two votes, said IMarketnews.com. The package that was passed would extend about a dozen tax cuts that expired at the end of last year, expand unemployment benefits, and provide a 19 month extension of current Medicare payments for doctors.

The legislation will have to wait until Congress returns on June 7 from a recess, as the Senate was not expected to approve the bill before then, said Reuters.

The tax would hit hedge fund managers’ 20% performance fee, also known as carried interest. The bill proposes to treat part of this performance fee as ordinary income instead of capital gains.

Until 2013, 50% of the profits would be treated as ordinary income. The bill would eventually subject 75% of the income to ordinary tax rates of more than 40%, and 25% to capital gains tax (15%).

This change is expected to raise more than $17bn in tax revenue over the next decade.

Lobby groups not giving up fight
Although fund managers suffered a setback with the passage of the House version, groups opposed to the bill are given ample time to look for ways to ease the impact of the new tax measure. Lobby groups also have enough time to press their arguments.

Lobbyists against the measure said they have not yet lost the fight. They are expected to persuade senators to phase the imposition of the tax increase in several years and to propose a lower percentage of carried interest tax, said New York Times.

One of the group opposed to the tax, Private Equity Council, said that with other lobbyists, they would try to convince the Senate to scale back a provision in the bill affecting what they call the “enterprise tax,” - which requires the founders of hedge funds to pay ordinary income tax rates on proceeds they received from selling their firms.

Heated debate over carried interest tax
A commentator wrote that while there is nothing wrong with hedge fund and private equity managers collecting 20% of the profits they make, “there is something strange about the way the government taxes these revenue streams.” He said that instead on focusing on “closing the carried interest loophole,” Congress should try to close the loophole in the way hedge funds are managed. “Hedge fund managers aren't evil, they're just playing by a different set of rules. This is a loophole worth closing.”

Last week, two lawyers from the opposing sides in the debate on the carried interest tax took turns defending their positions on CNBC Monday. While one described Congress as being “a bunch of drunken sailors who will tax anything” for proposing the carried interest tax; the other said the bill aims to restore some integrity into the tax code, as he dismissed the opposition as “ridiculous.

Dumlao, Gravrand


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