Fund managers can rest easy for the moment. Intent on passing the alternative minimum tax (AMT) patch, and in light of the Senate’s insistence that the patch should be passed without adding revenue raisers to offset the cost, the House passed a modified version of H.R. 3996. The Act, signed by the president on December 26, 2007, excludes the proposed carried interest legislation, including the provisions that would tax partnership income related to a carried interest as ordinary income from the performance of services. While comforting for the moment, we are already seeing statements from legislators that they intend to look for revenue raisers to offset the cost of the AMT patch.
We have been reporting on this proposed legislation from the standpoint of U.S. managers who would see the tax on their carry more than double if the legislation is passed. (See our Tax Alerts for June 21, “Strategies and Hybrid Instruments: A Practitioner’s Perspective;” June 25, “House Democrats Introduce Bill to Tax Carry at 35 Percent;” September, “Does H.R. 3501 Signal the End of UBTI Blockers?” and October, “Proposal Targets Offshore Deferred Compensation and Carried Interests”). This article focuses on the potential consequences (perhaps unintended) to foreign investment managers.
Individuals who are neither resident in, nor citizens of, the U.S. (i.e., nonresident aliens or NRAs) are taxed in the U.S. under two distinct set of rules. U.S. source investment income, such as dividend income, is taxed at a flat rate of 30 percent. This rate may be reduced by applicable tax treaties. The tax is collected by means of withholding. No deductions are available to offset the income. The individual need not file a U.S. income tax return if all income has been properly withheld, unless the individual is seeking a refund of over-withheld taxes. Except in limited circumstances, capital gains and “portfolio interest” of such persons are not subject to U.S. tax.
NRAs engaged in business in the U.S. (including those who perform services in the U.S.) are subject to tax in the U.S. in the same manner as U.S. residents on income from the income that is effectively connected to such U.S. trade or business. Such income is taxed at graduated rates up to 35 percent, although a portion of this may be collected in advance through withholding at the rate of 30 percent. Subject to various limitations, expenses incurred for the creation of such income are allowed as a deduction against such income. Moreover, the individual must file a U.S. tax return, whether or not the individual actually has any income.
A U.S. trade or business conducted by a partnership is attributed to its partners, and NRAs who are members of partnerships that have income that is effectively connected income are subject to withholding on such income by the partnership.
Income from the carry generally is comprised of interest, dividends and capital gains. Accordingly, under current law, assuming that the fund is not engaged in a trade or business in the U.S. other than managing its investments, a foreign investment manager would expect that his or her share of income from the carry would either be exempt from U.S. tax (in the case of capital gains, portfolio interest and foreign source dividends and interest) and subject to withholding tax only on U.S. source dividend income. If the legislation passes in the form originally introduced in H.R. 3996, however, the manager may be in for a rude surprise.
H.R. 3996 initially proposed rules that would treat net income with respect to a partnership interest as ordinary income from the performance of services if the interest is held by a person who provides (directly or indirectly) a substantial quantity of certain investment advisory services with respect to the assets of the partnership. To prevent avoidance of the rule, gain on the sale of such a partnership interest also would be converted into ordinary income from the performance of services, as would certain other income from certain interests in the partnership.
Income from the performance of personal services performed in the U.S. is treated as U.S. source effectively connected income. Accordingly, absent some exception, if the legislation is enacted as proposed in the original version of H.R. 3996, income with respect to the carried interest would be treated as effectively connected to a trade or business in the U.S. to the extent services were provided in the U.S. This raises questions as to how these provisions should be applied to NRAs. The income is only deemed to be income from the performance of personal services. In reality, it consists of investment income.
However, as the legislation provides that the income would be recharacterized for all purposes of the Internal Revenue Code, presumably, it would be necessary to determine the number of days that the manager worked in the U.S. compared to the number of days he or she worked outside the U.S. Unless another method of apportionment better reflects the portion of effectively connected income, this percentage of the income from the carry would be U.S. source and effectively connected to the U.S. trade or business of providing investment services.
A significant open question is how the proposed rule would apply where (as is typical) the carry in the form of a partnership interest in the fund is itself held by a partnership in which the investment managers are partners. Assume that a Fund A, a private equity fund formed as a Cayman Islands exempted limited partnership, has one general partner (GP) and a number of limited partners. GP is itself a Cayman Islands exempted limited partnership with a corporate general partner, one U.S. individual limited partner (A) and one English individual limited partner (B). A and B provide investment advisory services with respect to the assets of Fund A. All of A’s time working for Fund A is spent in the U.S. and all of B’s time (which is the same as A’s) working for Fund A is spent in the U.K. GP is entitled to a 20 percent carried interest in the form of a partnership profits interest, and a separate entity serves as the manager of Fund A. See the illustration below. Fund A recognizes $1,000 of capital gain income, $200 of which is allocated to GP, and ultimately $100 of which is allocated to each of A and B.
If, as we believe should be the case, the proposed legislation is intended only to recharacterize the partnership net income in the hands of those persons who provide investment advisory services, then A will recognize $100 of U.S. source personal services income (subject to tax at ordinary income rates and self employment taxes). B would recognize $100 of foreign source personal services income which, because of its foreign source, would not be effectively connected to a U.S. trade or business, and would not be subject to tax in the U.S.
However, if as a result of the recharacterization of the capital gain income as income from the performance of personal services, A and B are deemed to provide such services on behalf of GP, then, the GP partnership is engaged in a trade or business, and each of its partners (including the limited partners) is treated as so engaged. Therefore, A and B each would recognize $50 of U.S. source and $50 foreign source personal services income. With respect to B, the U.S. source income would be effectively connected to a U.S. trade or business, and, absent some exemption, B would be subject to tax in the U.S. at graduated rates up to 35 percent , and would be required to file a U.S. income tax return.
For a potential exemption, we’d look to the U.S. – U.K. tax treaty. Income tax treaties typically provide that a resident of one country who performs services in another country may be taxed in the country in which the services were provided. Under the income tax treaty between the U.S. and the U.K., personal services performed by a partnership typically may be taxed in the country in which the services were performed only if the person has a fixed base or permanent establishment regularly available to him or her. The IRS has ruled, and the Treasury Technical Explanation to the U.S. – U.K. income tax treaty confirms, that any fixed base or permanent establishment of the partnership is attributed to its partners, and that even partners who never set foot in the U.S. may be subject to tax here as a result of services provided by partners who do work from a permanent establishment of the partnership.
A permanent establishment generally is an office, fixed place of business or place of management. The term also includes a person (other than an independent agent) who has and habitually exercises authority to conclude binding contracts on behalf of the partnership. Accordingly, if the proposed legislation is read as treating investment managers who share in the carry as performing services on behalf of the carry vehicle, and a U.S. person can (and habitually does) conclude contracts on behalf of that vehicle, B, in the example above, would be subject to tax in the U.S. whether or not he ever comes to the U.S.
Although the proposed legislation is far from clear, we believe that the intent was to convert the income in the hands of investment managers. It should not be read to then cause the carry vehicle to be deemed to be engaged in a trade or business in the U.S. We hope that Congress will clarify this if the proposed legislation is reintroduced in 2008. Unfortunately, various revisions to the proposed legislation culminating in the original version of H.R. 3996 indicate a general tendency to take an expansive approach to converting investment income into remuneration for services.
Additionally, even in the narrow reading of the proposed legislation, an NRA investment manager who actually visits the U.S. to investigate investment opportunities or make investments in the U.S. would be treated as engaged in a trade or business here. Such managers who are residents of treaty countries may be able to avoid taxation if they can show that they do not have a fixed base or permanent establishment in the U.S. available to them.
Neither the proposed legislation nor the report accompanying the original version of H.R. 3996 made any mention at all about the impact of the legislation on nonresident investment managers. Moreover, during the Congressional hearings, this was not discussed. It certainly appears that nonresident investment managers were not the targets of the proposed legislation, and the resulting logical extension of the fiction created by these rules, as discussed above, may be entirely unintentional. However, this would be little comfort if the legislation is reintroduced in the same form next year. Additionally, it would be quite unfortunate if Congress takes an expansive view that investment managers who share in carry through a partnership carry vehicle be treated as performing services on behalf of such carry vehicle. We will continue to follow this issue closely.
Joan C. Arnold and Steven D. Bortnick