Alpha - September 2007 - (Page 88)

Unhedged Commentary The Taxman Cometh By Viva Hammer he taxation of alternative-investment managers may be one of the biggest tax issues of the upcoming presidential election. Congress seized on the subject early this year and within a few months released two bills that, if passed into law, would shut down two tax benefits the hedge fund and private equity industries enjoy. Although cynics have attributed the legislation to the federal government’s desperate search for revenue, the movement is actually being spurred by tax wonks concerned about fundamental policy issues like equity and efﬁciency. At the eye of the storm is the pay package that fund managers get for doing their jobs — typically an annual management fee of 1 to 2 percent of a fund’s capital, plus 20 percent of any proﬁts (“carried interest”). The management fee is treated as labor income and taxed Washington at the highest marginal rates. In legislators have contrast, carried interest gets an exceedingly sweet deal. their sights set Most funds are structured as tax partnerships, which are nonon the privileged taxable entities; all income and tax status of hedge losses ﬂow through to the partners, including fund managers. Partners funds and their pay tax not when they receive carried interest but rather when fund managers. investments are monetized. The character of the income varies with the underlying assets. For hedge funds about one ﬁfth of the proﬁts, on average, are long-term capital gains; for private equity funds, it’s about half. With long-term gains currently taxed at 15 percent and the highest marginal rate on ordinary income at 35 percent, it’s not surprising that legislators are looking for ways to close the gap. In late June, Michigan Representative Sandy Levin, a Democrat, introduced a bill to tax carried interest as ordinary income. The bill, which was cosponsored by 21 Democrats, including House Ways and Means Committee chairman Charles Rangel, is targeted at the alternativeinvestment industry. It does not touch carried interest associated with other sectors, like oil and gas. Hedge funds would be able to get around the bill relatively easily, however. For example, the partnership could be financed mostly with nonrecourse debt, and the managers then buy their equity interests cheaply instead of receiving them as compensation for their services. T The Levin bill came just days after Senate Finance Committee chairman Max Baucus, a Democrat from Montana, teamed up with Iowa Senator Chuck Grassley, a Republican and ranking minority member of the committee, to introduce legislation that would hit a narrower target: nontaxable publicly traded partnerships, or PTPs. Although partnerships that trade publicly are typically taxed as corporations, those that derive at least 90 percent of their income from interest, dividends, capital gains, rents and naturalresource-related activities are not taxed at all. These, of course, are exactly the types of income that an alternative investment ﬁrm normally generates, a fact that became clear to Finance Committee staffers when Fortress Investment Group and Blackstone Group ﬁled for IPOs earlier this year. The Baucus and Grassley bill prevents partnerships from qualifying as PTPs if they derive any of their income from investment adviser or asset management services. Entities like Fortress and Blackstone that were already public or had filed for an IPO before the bill was introduced, however, get a free pass for ﬁve years. The initial reaction to the Levin and PTP bills was stunned silence and disbelief. As one hedge fund manager told me this summer, “I had Washington on my ‘To Do’ list last year, but things got so busy.” It would be wise for the hedge fund industry, which is largely unaccustomed to the machinery of politics, to make time for Washington. Yes, some big players have hired lobbyists and coalitions have been formed, but these efforts may not be enough to stop the momentum building on Capitol Hill. House Ways and Means Committee chairman Rangel says that he intends to push for reform of the alternative minimum tax this fall, which he would pay for in part with a tax increase on carried interest. New York Senator Chuck Schumer, a Democrat, will likely introduce legislation that increases taxes on carried interest for all partnerships, not just for investment managers. Several Democratic presidential candidates, including Hillary Clinton, John Edwards and Barack Obama, support raising the tax on carried interest. Although it’s unlikely that such a seismic change will happen in a hurry, I learned during my years working at the U.S. Treasury that once a revenue-raising tax idea is out of the bag, there’s no getting it back in again. Viva Hammer is a tax partner in the New York ofﬁce of law ﬁrm Crowell & Moring. She recently joined the ﬁrm from the Ofﬁce of Tax Policy at the Department of the Treasury. 88 • INSTITUTIONAL INVESTOR’S ALPHA • SEPTEMBER 2007

Table of Contents Feed for the Digital Edition of Alpha - September 2007

Contents Letter from the Editor Longs & Shorts Pension Corner: Keeping the Faith The Good Guys: Going Public Interview: Barry Bausano - A Delicate Balance Cover Story: Cruel, Cruel Summer Profile: Phil Cooper - Alternative Flight Plan Strategies: Marshall Wace - TOPS in Its Field Profile: Fortis Investments - Banking on Alternatives Research Center: Top Equity Trading Firms Alpha Bytes: Desktop Duel Unhedged: Commentary - The Taxman Cometh

Alpha - September 2007

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