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Tags: Loopholes | Investment | Fund | tax

Loopholes Hard to Find in Investment Fund Tax Battle

Friday, 28 May 2010 05:21 PM EDT

Lawmakers have given the investment fund industry an uphill task to try to find any loopholes in a proposal to raise taxes on the profits made on investments.

While lawyers have been working around-the-clock advising private equity clients on the impact, there aren't obvious ideas left that would avoid or skirt the tax.

The threat that Washington would raise taxes on the "carried interest" dollars executives earn has been looming for years but escalated in recent months and days as the government faced increasing pressure to raise money.

The proposed tax, currently in a White-House backed jobs bill pending a vote, has become even more contentious by including a proposal that taxes also be raised if the companies themselves are sold.

Carried interest is typically the 20-percent slice that private equity executives take from the profit made on their funds. The amounts can be huge if the funds perform well and have made many managers very wealthy. Still, it is only payable after a fund generates a profit — or performance hurdle — usually 8 percent.

The bill threatens a rise in the tax, most of which would be charged at the ordinary income level of roughly 35 percent, rather than at the capital gains level of 15 percent. And top tax brackets and capital gains rates are also heading higher by several percentage points next year.

The industry has become increasingly resigned to a tax hike and has been trying to work out how to live with it. Finding loopholes isn't easy.

"I don't think there are easy ways to game this bill," said Victor Fleischer, a professor at the University of Colorado whose paper on the topic has been influential among lawmakers backing the tax change. "If there was an easy way to do it, they wouldn't be fighting it so fiercely."

The proposed tax is so controversial because it will not only hit the private equity and hedge fund industries, but the venture capital and real estate sectors as well, which have been lobbying hard against the tax, arguing it will hit a nascent recovery.

"It is clearly, if it got enacted as it stood, a bitter pill to swallow" for the venture capital and private equity industries, said Josh Lerner, a Harvard Business School professor specializing in private equity.

Taxing carried interest at the higher rate has been batted around for years, allowing ample time for lawmakers to spot ways people might try to get around the system. The bill currently being proposed outlaws some obvious loopholes, lawyers say.

"Various ideas using offshore corporations or borrowing money from (investors) have been addressed and don't work under the version of the legislation as it is now," one lawyer who declined to be named said.

For example, profits a private equity executive made from borrowing money to make a direct investment in a fund would be treated as ordinary income, lawyers say.

Moving funds or registering firms offshore is fraught with difficulties, lawyers say, although "it is conceivable something will work someday," one said.

A steep deterrent to coming up with too creative a method to bypass the new regime is a 40 percent penalty for skirting the law -- on the high side of related penalties.

"Once the penalty is that high it's extremely intimidating," said Terence Cuff, an attorney at Loeb & Loeb whose clients include partnerships that would be impacted. "Quite frankly, people are worried you could end up accidentally doing something that could incur" the penalty, Cuff said.

The looming threat might theoretically encourage some funds to exit investments ahead of the new law's enactment to avoid the tax.

Still, Edward Smith, Tax Partner at tax services firm BDO Seidman's Private Equity Practice, said exiting investments was about the right numbers and the liquidity.

"The tax (tail) shouldn't wag the dog," he added.

The threatened hike comes at a difficult time for many firms, which have had returns hurt by the credit crisis and have only just started to be able to sell investments and make new ones again. That means they are unlikely to try increasing fees or argue for a larger cut of the profits pie.

Major structural changes are also unlikely in fund agreements, at least in the short to medium term, lawyers say.

However, some issues that may be addressed in funds currently being raised or about to be raised are the amount of capital that private equity executives put in by co-investing as opposed to investing in the fund itself, and management fee waivers.

Private equity firms sometimes grant investors a waiver of their management fee — typically charged at 1-2 percent of investments — in exchange for being able to use that capital as their own investment income in the fund. The benefit for the investor is recouping their fee, while the fund manager gets extra incentive to make the fund perform well.

However, profits on that would be charged at the higher level too, making it a less attractive proposition.

Funds which are currently being raised, or about to be raised "may not use the management-fee-waiver anymore, or may use it less," said Bruce Ettelson, the head of law firm Kirkland & Ellis' Private Funds Group.

© 2024 Thomson/Reuters. All rights reserved.

Lawmakers have given the investment fund industry an uphill task to try to find any loopholes in a proposal to raise taxes on the profits made on investments. While lawyers have been working around-the-clock advising private equity clients on the impact, there aren't...
Friday, 28 May 2010 05:21 PM
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