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'Carried Interests, Part 1' Hearing

Tax Alert

Authors: Joan C. Arnold, Steven D. Bortnick and Todd B. Reinstein

7/13/2007

On July 11, the Senate Finance Committee convened a hearing in which panelists and senators discussed how carried interests should be taxed. A carried interest is generally defined as the income private fund managers obtain from a portion of gains on investments made with others’ money. The issue that has been the center of attention (as well as two legislative proposals) is that a carried interest typically is taxed at the 15 percent capital gain rate, rather than the 35 percent rate applicable to compensation income.

We have previously discussed the legislative proposals affecting carried interests [see our June 25 Tax Update and our June 21 Tax Update.] The following provides a brief summary of the hearing discussions. The panelists included Eric Solomon, U.S. Treasury Assistant Secretary for Tax Policy, Peter Orszag, Director of the Congressional Budget Office, Andrew Donohue, Director of the SEC’s Division of Investment Management, Kate D. Mitchell, Managing Director of Scale Venture Partners, and Marc P. Gergen, a professor at the University of Texas, Austin School of Law.

In his opening statement, Chairman Baucus indicated that he had not reached a conclusion regarding the appropriate tax treatment of a carried interest, saying that “[t]he purpose of these hearings is to explore the economics and understand the arguments” for and against changing existing tax treatment. Through discussion, Senator Baucus hoped to reach a solution that will “ensure fair treatment under the tax code” while not vitiating the entrepreneurial motives of individual taxpayers, which Senator Baucus calls “the mother of invention” that drives the economy. Senator Baucus’s opening statement also called for discussion regarding a proposed Senate bill that would impose corporate taxes on publicly traded partnerships that derive revenue from services relating to investment or asset management. Almost all of the hearing, however, focused on carried interests and whether the current partnership taxation rules that cover carried interests should be changed.

Senator Grassley, the ranking Republican on the Finance Committee, perceived one of the hearing’s primary purposes to be clarification of the definition of capital gain. This clarification would follow from ascertaining the difference, if any, between carried interests and other forms of capital gain. A clear, reasoned definition of capital gain would maintain the integrity of the existing tax preference for returns on investment. Senator Grassley foresees a fight in Congress for the continuation of current capital gains rates of 15 percent beyond their sunset in 2010, and failure to address the carried interest issue may result in a public backlash against this favored tax treatment.

Mr. Solomon favored continuation of the existing tax treatment for carried interests. He believes the treatment is a clear protocol that taxpayers can easily understand when planning transactions and the IRS can easily implement when administering the tax code. Additionally, the economy as a whole benefits from the incentive to “pool[ ] capital, ideas and skills in a manner that promotes entrepreneurship and risk-taking.” Mr. Solomon analogized a fund manager’s contribution to a private equity partnership to an investing partner’s contribution to the partnership instead of seeing a disparity between the two. There is a substantial risk that both parties will lose their investment of resources in the enterprise. Mr. Solomon stated that “[t]he incentives provided by this structure contribute to innovation and risk-taking.”

According to Mr. Solomon, imposing ordinary income taxes on the carried interest contradicts established tax rules that have operated well for many years. Additionally, the complexities of interpreting and applying the proposed changes in the tax treatment are fruitful grounds for increased litigation. Mr. Solomon also was not in favor of taxing the receipt of a partnership interest in profits by using the predicted value of a carried interest when received by a service partner. He believes that the speculation inherent in valuing the interest would result in litigation and create uncertainty.

The pattern of questioning during the question and answer session indicated that most senators are reluctant to change the existing tax treatment of carried interests in light of the potential for damage to the U.S. economy by shifting capital investment away from the U.S. to other countries with more favorable tax laws. Senators Kerry and Schumer, from Massachusetts and New York respectively, indicated that significant private equity funds operate within their states and these entities provide benefits to their economies that they want to maintain. Through favorable questioning by Senator Hatch, Ms. Mitchell of Scale Venture Partners explained the risks inherent in venture capital that warrant favorable tax treatment and the benefits it has provided the U.S. economy by furthering companies such as Google and Microsoft.

Even senators who advocated raising taxes on carried interests posited alternatives that would limit the raise. Senator Wyden of Oregon advocated a change in tax policy first proffered in 1986 that would eliminate the capital gains preference entirely, but would also lower marginal rates. Other senators did not join this proposal.

For more information on this topic, please contact Joan C. Arnold, Steven D. Bortnick or Todd B. Reinstein.

This article is informational only and should not be construed as legal advice or legal opinion on specific facts.