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Senate Bill Calls for Tax on Publicly Traded Carry Partnerships

Tax Alert

Authors: Joan C. Arnold, Steven D. Bortnick and Benjamin M. Hussa

6/21/2007

On June 14, Senators Max Baucus (D-Mont.) and Chuck Grassley (R-Iowa) introduced a Bill that calls for all publicly traded partnerships that derive income from investment advisory or asset management services to be taxed as if they were corporations. While the proposal is narrowly focused in that it only will affect publicly traded partnerships, some of the language used by Senators Baucus and Grassley in introducing the Bill may be cause for concern even for those investment partnerships with no plans to go public.

Background on the 'Blackstone Bill'

It is little secret that the pending IPOs of the Blackstone Group and a handful of other investment partnerships contributed to the hurried arrival of the Bill. Blackstone is even mentioned by name in a public letter from Senators Baucus and Grassley to Treasury Secretary Paulson asking for Paulson’s views on the Bill.

Currently, most partnerships pay no income tax at the entity level. Profits that flow through to partners generally are taxed to the partners. To the extent that those profits come from capital gain and qualified dividend income, individual partners are taxed at the preferential 15 percent long-term capital gains rate. As most private equity and venture capital fund sponsors take their carry in the form of a share of partnership profits, this carried interest generally is taxed at this preferred rate. To the contrary, the management fee and hedge fund carry (which is typically an incentive fee that is deferred) is taxed at the rate of 35 percent. Publicly traded partnerships are currently subject to a 35 percent entity-level tax, just as if they were corporations. Congress’ rationale for originally enacting this rule in the 1980s was, in large part, to avoid giving publicly traded partnerships unfair competitive advantage over publicly traded corporations.

Blackstone’s IPO was designed to take advantage of an exception to the general rule that a publicly traded partnership must be taxed as a corporation. This specific exception currently allows a publicly traded partnership to escape being taxed as a corporation if more than 90 percent of the publicly traded partnership’s gross income is “qualifying income,” which includes interest, dividends and gain from the sale of capital assets. This exception is consistent with Congress’ original intent of preventing unfair competition with publicly traded corporations – only publicly traded partnerships with substantial active businesses would be subject to tax as corporations, while publicly traded partnerships merely collecting passive income could escape the tax.

The character of Blackstone’s income would allow it to utilize this “qualifying income” exception and, once public, still avoid tax as a corporation. The authors of the Bill, however, view Blackstone’s business, despite the character of its income, as the active provision of financial advisory and asset management services. In their view, allowing Blackstone to avoid entity level tax would give it a competitive advantage against the big financial services corporations that already pay corporate tax.

Accordingly, the Bill would not permit publicly traded partnerships earning any direct or indirect investment advisory or asset management income to utilize the “qualifying income” exception. There would be no way for Blackstone and other publicly traded partnerships to avoid being taxed as a corporation (as the vehicle would earn management fees indirectly through its corporate subsidiary.)

Effect of the Bill

If the Bill passes, it will have a significant effect on Blackstone, Fortress and the small handful of other investment partnerships that are public or plan to make a public offering. By taxing these publicly traded partnerships as corporations, investors’ after-tax returns will drop substantially. Instead of their partners paying a single level of tax of 15 percent on passthrough income, the partnership itself will pay 35 percent tax, followed by the partners paying another 15 percent tax on distributions. Soon after the Bill was announced, Fortresses’ shares fell sharply as investors worried about the effect paying corporate level taxes would have on their returns (although shares have since rebounded). Media outlets, including the Wall Street Journal, New York Times and others, have given the bill coverage, with dramatic titles such as “Private equity: End of the golden age?”1 and “Tax Plan Adds to the Pressure on Buyout Firms.”2

However, for investment partnerships other than Blackstone, Fortress and the small handful of others who are or plan to be public, this Bill should have no effect. The National Venture Capital Association, in a short press release in response to the Bill, perhaps captured the effect of the Bill best in saying:

“[t]he Bill proposed today by Senators Baucus and Grassley is directed at publicly traded partnerships. As almost no venture capital firms are publicly held, this proposed legislation does not impact our business.” 3

Finally, note that even Blackstone, Fortress and any others that were trading or had filed a registration statement with the SEC in anticipation of an IPO by June 14 would get some relief under the Bill. The new rules calling for their taxation as corporations would not apply to these early filers until years beginning after June 14, 2012.

Pepper Perspective on the Bigger Issue – Taxing the Carried Interest

In recent months, there has been tension and speculation in the private equity community about possible Congressional efforts to tax fund managers’ profit shares at ordinary income rates. Congressional staffers have met with Victor Fleischer, an associate professor at the University of Illinois College of Law who has written about how and why fund managers should be taxed at ordinary income rates on their distributive shares. Mainstream media including the Times and the Wall Street Journal have focused on the issue as well.

The public statements made by Senators Baucus and Grassley in connection with the publicly traded partnership Bill do nothing to quell any speculation about taxing carried interests at ordinary income rates. Senator Baucus’ introductory statement included his sentiment that private equity and hedge funds claim “all of their income from asset management and investment advisory services is passive. But objective observers would say that this income actually arises from active businesses.” Senator Grassley’s statement contained a similar idea that “virtually all of their income is derived from providing asset management and financial advisory services[,]” while funds “structur[e] service fees in a way that purports to characterize those fees as passive-type income.” The Senators’ letter to Secretary Paulson quotes one fund’s public filing, which states that “[w]e believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting, or trading securities. We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provisions of services.” If the two Senators feel strongly that profit allocations to fund managers are really fees for services, we may see an effort to tax these allocations as services income, which is generally subject to ordinary income rates.

Practically speaking, figuring out a way to tax a carried interest at ordinary income rates presents a much more difficult problem than the one addressed by the new publicly traded partnership Bill. The publicly traded partnership issue was a discrete issue that required a narrow legislative fix. Taxing flow-through capital gains as something other than capital gains would be much more problematic. It would require identifying under exactly what circumstances capital gains must be recharacterized – that is, when is capital gain not really capital gain but rather services income? This is an issue for more than just investment fund partnerships. Any potential legislation could affect a large array of partnerships in different industries and of various sizes. It is hard to tell what the result will be in the near future. However, there is a concern that the definitions provided in the publicly traded partnership bill could be used as the basis for attack on similar partnerships that are not privately traded.

Endnotes

1 Fortune /CNNMoney.com, June 18, 2007.

2 Wall Street Journal, June 16, 2007.

3 PR Newswire, June 14, 2007.

Joan C. Arnold, Steven D. Bortnick and Benjamin M. Hussa

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