Don’t call it a loophole

A new, new tax compromise makes carried interest even more legit.

In May, US lawmakers decided that carried interest deserved to be 25 percent “extra-ordinary”. Now that number has increased to 35 percent if the GP is naughty and 45 percent if the GP is nice.

An amendment from Senator Max Baucus makes the already eyebrow-raising HR 4213 even more of a hybrid curiosity. Whereas the US House version last month declared that 75 percent of carried interest should be taxed at the higher ordinary income rate, the Senate version calls for 65 percent of carry to be characterised as ordinary income. In addition, if the GP holds an investment for seven years or more (as decent, non-stripper-flippers do), that figure steps down to 55 percent.

The good news for the private fund market is that lawmakers clearly agree that carried interest is indeed a mix between ordinary income and capital gains. Now the discussion is simply around what the right blend is.

The name of the bill in question is “The American Jobs and Closing Tax Loopholes Act of 2010”. So presumably GPs “getting away” with paying capital gains on carried interest was an egregious loophole that Congress is now seeking to close. But I still don’t get it – if carry-as-capital-gains is unfair, why allow some GPs to enjoy 45 percent of this filthy lucre at the lower tax rate?

The introduction of a hybrid rate is an admission by lawmakers that current carry tax is in fact not a loophole but merely a revenue opportunity they never seriously considered until now. In fact, a code whereby GPs who hold investments for seven year or more enjoy favourable treatment on their carry shows Congressional faith in incentives for long-term investment.

The most recent amendment also begs a question – if GPs get a lower rate for holding an “asset” for seven years or more, what is an “asset”? Carry is typically calculated based on the performance of a fund as a whole, with the performance of many different investments weighed against each other. Was this taken into consideration by Baucus and staff? Does this mean that fund managers who wait seven years before they begin paying out estimated carry from the fund in question get the 55 percent ordinary income treatment? Or does it mean that each portfolio investment within a fund would have a separate tax treatment applied to it based on whether it was held for less than or more than seven years, and those different tax treatments would then have to be blended on a pro-rata basis into the tax treatment of the aggregated carry?

And if so, can the human mind even handle such a calculation? Mine can’t.