Since 2007 the US Congress has considered legislation numerous times that would subject investment fund managers to increased US federal income taxes on the share of investment partnership profits they are allocated in return for investment advisory services provided to such partnerships (carried interest). Why hasn't some form of carried interest legislation been passed to date? We believe the answer to this question is quite simple: The line drawing necessary to differentiate (and impose additional tax on) income attributable to investment management services provided by partners to US partnerships, without changing the favoured tax treatment of true equity investments in such partnerships, is just too difficult in light of the flexibility provided in US partnership tax rules, and in the current US political environment.
While there are a number of competing policy factors at play, we believe that two of such factors are the most significant.
The most compelling argument in favour of some type of additional tax on the carried interest is that, under current law, US investment fund managers pay lower taxes (at the same favoured rates as US taxable investors on their equity investments) on income they earn through the carried interest for investment management services than the taxes that are imposed on investment management services, or other services, earned outside of the investment fund context. As explained below, at first glance, there appears to be an apparent difference in tax rates without a significant difference in the services being provided.
The most compelling argument in favour of retaining the existing tax rate differential is that the rate preference encourages valuable economic activity by rewarding risk taking on the part of the service provider. For example, service providers outside the partnership context are generally compensated by fees reflecting a set percentage of assets under management. Although different arrangements can be entered into, service providers often will be paid this percentage whether the assets increase or decrease in value. Obviously, an increase in assets under management due to successful investment decisions will be rewarded with increased management fees (and vice versa). In the partnership context, a carried interest provides only upside rewards when the assets of the partnership appreciate and are realised (assuming the normal 2% management fee is for the payment of the general overhead of the investment manager). So a carried interest aligns the risk and reward incentives of the investment manager with those providing the equity capital being invested.
Congress might decide to come down on one side or the other regarding the policy decision to tax carried interest allocations in a particular manner, but the implementation of that decision into the current US partnership rules designed as incredibly flexible, has proven extremely difficult. As soon as one of the recent proposals to tax carried interest was introduced, tax lawyers began their game of chess to limit or ameliorate the proposal's effects by suggesting workarounds. The drafters responded by throwing the nets of the legislation wider and wider and potentially impacting a much broader range of participants using carried interests. Lobbyists and constituents began to influence the legislators stating that an exception should apply to their particular industry or arrangement and that risk taking should not be quelled in the current depressed economic environment. Sensing that there were difficult and insoluble choices to be made but keeping the proposals to a one-size-fits-all approach, the proposals morphed into a complex web of rules combined with a form of rough justice with only a portion of income earned from a carried interest treated as ordinary income and subject to employment tax, and the capital gain and other character of the remaining income unchanged (starting at 50% each and then moving to 75%/25% ordinary/capital gain after a phase-in period).
The legislation has been introduced a number of times because the estimates of revenue raised by the proposed changes is approaching $14.5 billion (June 8 2010), so it is not surprising that various forms of taxation of carried interests have been discussed and proposals introduced. While we believed that there was a considerable likelihood that Congress would change the taxation for carried interest in 2010 or 2011, recent elections in the US, putting the Republican party in control of the US House of Representatives, have reduced (or eliminated) the chances we will see carried interest legislation in the near future.
Present tax treatment of the carried interest.
The term carried interest is generally used to describe the share of investment fund profits that are specially allocated to the fund's manager in recognition of its investment management services. In the classic case of an investment fund that is organised as a limited partnership, the manager generally is allocated its carried interest – typically 20% of the fund's profits – as the general partner of the fund. A carried interest is a form of what is also referred to, under US partnership tax principles, as a profits interest, which is a right to share in the income, profits and realised appreciation of a partnership that does not reflect, as of the date of grant, a right to share in any of the then-value of the partnership.
In general, current safe harbours do not impose tax on the recipient of a carried interest where the recipient would not receive any proceeds if, immediately after the grant of such interest, the partnership sold its assets and liquidated.
Tax consequences of a carried interest
A carried interest, as a profits interest, is treated as a partnership interest for tax purposes. As a result, because a partnership is a pass-through entity for US federal income tax purposes, the holder of the carried interest will be allocated its share of the partnership's items of taxable income and loss, as if the items were realised directly by the partners, regardless of whether the partnership makes distributions to its partners.
Assume, for example, that a private equity fund organised as a partnership recognises a long-term capital gain on a sale of a portfolio investment that has been held for more than a year. If the fund's general partner is allocated a carried interest reflecting 20% of that gain, the general partner, if an individual, would be eligible for the lower US tax rates that apply to long-term capital gains, versus ordinary income. For 2011 (absent legislative adjustments), rates applicable to ordinary income are scheduled to increase to a maximum of 39.6% and capital gain rates are scheduled to increase to 20%.
Capital gains
Subject to some special rules for certain assets, the sale of a partnership interest, including a carried interest should be treated as a capital asset (and long term gain if held for more than one year) for US federal income tax purposes.
Income allocated to limited partners of a partnership (including limited partners in a fund general partner organised as a limited partnership) as a share of the income of the partnership (as opposed to a guaranteed payment for services, unrelated to profits) generally is not subject to US employment tax even when the partnership's profits are attributable to a business. US employment taxes include social security taxes and Medicare contribution taxes, as well as state and local employment taxes.
US taxpayers are subject to various limitations on deductions for investment expenses, such as management fees that are paid by an investment fund or its partners. In contrast, because a carried interest is treated as an allocation of profits to the general partner, with a smaller amount of profits remaining to be allocated to the other partners, the reduction in other partner's profits caused by a carried interest is not treated as the payment of a deductible expense (and thus is not subject to limitations on such deductions).
Proposed changes
All of the proposals have reflected the same underlying approach. Rather than treating the grant of the carried interest as triggering compensation income, the proposals would change the character of taxable income allocated to a partner holding a carried interest received in connection with investment services.
The Obama administration, in its budget proposals for 2010 and 2011, has suggested proposals that would have a similar effect to the Congressional proposals, but that would apply to all profit interests in partnerships, regardless of whether the profit interests were received in connection with investment management services.
To date, none of the Congressional proposals have taken this expansive approach. However, as discussed below, the most recent Congressional proposals as drafted may encompass many partnerships beyond what are commonly thought of as investment funds, and many partners whose services do not resemble the typical services performed by investment fund managers.
The proposals that have been considered by Congress during 2010 all have some common features. Under the proposals, various adverse tax consequences apply to a partner that holds an investment services partnership interest in a partnership. As described below, the proposals define an investment services partnership interest very broadly and, as a result, many partnerships that are not thought of as investment funds, and many partnership interests that do not constitute carried interests, could be covered.
Investment services partnership interest
An investment services partnership interest (ISPI) is a partnership interest that is granted to a partner that, as of the date of grant, has performed, or is reasonably expected to perform, certain services for specified assets of the partnership. These services include: advising as to the advisability of investing in, purchasing, or selling any specified asset; managing, acquiring, or disposing of any specified asset; arranging financing for acquiring specified assets, and; any activity in support of any of the foregoing services. Specified assets, in turn, include securities very broadly defined (including stock and debt instruments), real estate held for rental or investment, interests in partnerships (even when such partnership interests don't otherwise constitute securities, such as interests in a closely held operating business operating as a partnership), commodities, and options or derivative contracts for any such assets. The proposals pick up, as specified assets, assets owned by other entities (including corporations and partnerships) in which the partnership holds an interest.
There is no requirement that an ISPI be held by an individual. The proposal also could pick up partnerships that do not look at all like traditional investment funds such as an operating partnership that has operating subsidiaries or holds investment assets are part of its working capital. A partnership interest held by the chief executive or financial officer of an operating partnership might be treated as an ISPI, because of the officer's responsibility for the partnership's financial assets, while a partnership interest held by officers responsible for marketing or manufacturing activity would not be an ISPI.
Consequences of holding an ISPI
The consequences of holding an ISPI would include the following:
- Taxable income allocated to that partner from the partnership would be recharacterised, in that partner's hands, as ordinary income, regardless of whether the partnership's underlying taxable income includes long-term capital gains or qualified dividends otherwise eligible for lower tax rates;
- Recharacterised income would be subject to employment taxes, on the same basis as other compensation income;
- Tax losses allocated to the partner from the ISPI could only be used to offset taxable income from investment services partnership interests;
- If an ISPI is disposed of (including in various transactions that otherwise would be tax-free under US federal income tax law), gains from the sale would be recharacterised as ordinary income, and not capital gains, and subject to employment tax, and losses from the sale would be taken into account only to offset other income from ISPIs.
From the point of view of other partners in a partnership, the proposals would not change the character or amount of taxable income or loss allocated to partners, other than partners holding an ISPI. As a result, for example, the limited partners of an investment fund would continue to be allocated less taxable income, rather than being allocated an item of deduction reflecting an allocation of profits to a general partner pursuant to a carried interest.
Exception for qualified capital interests
The various adverse tax consequences that apply to an ISPI do not apply if the ISPI is a qualified capital interest. A qualified capital interest, in general terms, is a partnership interest that has been purchased from the partnership for fair market value and that shares in profits and losses of the partnership in the same manner as a partnership interest held by partners that do not hold ISPI (that is, partners that do not provide investment services to the partnership). A broad exception applies if all partners in a partnership share in profits and losses in accordance with contributed capital; in that circumstance, none of the partnership interests are treated as ISPIs.
Loans, advances, guarantees
For purposes of the exception for qualified capital interests, an ISPI is not treated as acquired by contribution of capital by a service providing partner to the extent of any loan or other advance made or guaranteed, directly or indirectly, by any other partner or the partnership. This applies even where the loan is on commercially reasonable terms, is fully recourse and is secured by other assets. The breadth of this provision is intended to prevent work-arounds, where in essence investment fund investors retain their traditional economic interest (through direct or indirect creditor status), leaving behind the equivalent of the traditional carried interest (without any change in tax treatment) for the investment fund manager. However, this same breadth has raised concerns about fairness (why shouldn't investment fund managers be able to preserve the tax treatment of investments made with true debt) and concerns about unintended consequences For example, where loans are made outside the traditional investment fund context, among joint venture participants.
Increased penalties for non-compliance
The proposals double the rate at which penalties may be imposed if a partner doesn't properly pay taxes attributable to an ISPI, from the 20% penalty rate that would otherwise apply to a 40% penalty rate. In addition, higher standards would have to be met to establish reasonable cause for taking a position that the proposals don't apply. The strengthened reasonable cause exception does not apply unless: the relevant facts affecting the tax treatment of the item are adequately disclosed; there is or was substantial authority for the tax treatment; and the taxpayer reasonably believed that the tax treatment was more likely than not the proper treatment.
Anti-abuse rules
The provision also recharacterises as ordinary income the income or gain for certain other interests, including interests in entities other than partnerships that are held by a person who performs, directly or indirectly, investment management services for the entity.
Proposed blended tax rate
To address the argument that the proposals are overly broad, the proposals introduced in 2010 suggest a rough justice blended tax rate which recharacterises ISPI income only on the basis of broad percentages. In the most recent proposals, for taxable years to which the provision applies that begin before January 1 2013, the applicable percentage is 50%. For taxable years beginning after December 31,2012, the applicable percentage is 75%.
Proposal concerns
Many argue that the current proposals will have difficulty in being passed by the US Congress because they cover too broad a range of both partners affected and partnership activities to be politically acceptable. Space limits our ability to thoroughly address all of the issues raised under the proposals, so we are just mentioning a few. While corporations are not subject to different tax rates between their ordinary and capital gain income, they still need to segregate such income for other purposes that do have tax consequences. One of the most widely reported issues is that the proposals may have unintended negative consequences for corporate joint ventures. Another concern is that ISPI status would taint partnership interests held by an investment fund manager, resulting in extra tax if the manager sells his or her business (including the carried interest) at a gain. Unlike other operating businesses, where gains attributable to good will and going concern value generally are treated as capital gains and subject to tax at favorable rates, the proposals would impose extra tax on this gain.
In addition, the rules continue to provide for disparate treatment between service providers depending on the entities and arrangements for paying such persons. Accordingly, extensive planning opportunities will still exist if the proposals are passed in their current form with only undefined anti-abuse rules as a check.
In the early stages of the proposals, tax practitioners noted that loans, certain passive foreign investment corporations, and other mechanisms using the flexible partnership rules could be used to limit (or eliminate) the negative consequences of these rules. The proposals responded with more and more complex rules to address these workarounds. The result is a web of rules so difficult to understand, navigate and administer that they will likely be opposed from almost all corners.
Throw in the towel
Our best prediction is that, at least for the foreseeable future, the US Congress will throw in the towel on taxing carried interest legislation because of the inability to pass narrowly crafted provisions that is not susceptible to restructuring or elimination of the character recharacterisations. The wider the proposals throw their net, the more taxpayers will cry out for relief. The attempt to placate various constituencies with the blended rates approach to date has received a less than stellar reception. Accordingly, at least in the near future, we believe we are in for more of the same.
Bill Zimmerman (wzimmerman@morganlewis.com) & Richard Zarin (rzarin@morganlewis.com).