A rising tax tide

Private equity lobbyists seemingly lost the carried interest battle as the US House of Representatives passed a bill that would tax 75 percent of carried interest as ordinary income. But they were surely cheered (at least a bit) just one week later when the US Senate voted it down.

Senators Baucus (left), Grassley: carry crusaders

 

It’s a familiar chain of events that has repeated itself in various forms over the past three years – prominent legislators like Charles Grassley, the most senior Republican on the Senate Finance Committee, propose a bill that would raise carry tax and each time ending with the Senate squashing any proposed tax change to carried interest designation.

In the most recent developments at press time, senators nixed raising tax on carried interest in a 45 to 52 vote against the American Jobs and Closing Tax Loopholes Act of 2010. The Senate needs 60 votes to pass legislation. Not a single Republican voted to pass the bill, while 11 Democrats and one independent voted against it. Three senators did not vote.

According to a source familiar with the process, however, this vote does not mean a tax raise on carried interest is off the table. Montana Democrat Max Baucus plans to introduce another amendment addressing carried interest, according to a source: “This is part of the negotiation process”.

Senator Baucus, the Democratic chairman of the Senate Finance Committee, proposed on 7 June an amendment that would decrease the percentage of carried interest characterised as ordinary income to 65 percent from the House of Representatives proposal of 75 percent.

The new proposal, if enacted, would still mean that only 35 percent of carried interest would continue to be taxed as capital gains, which enjoys a low 15 percent tax rate. Ordinary income in the US is taxed as high as a 39 percent rate.

The Senate proposal, however, seems designed to encourage long-term holds. The amendment decreases the amount of carried interest that is characterised as ordinary income to 55 percent for the sale of investments held for seven years or more.

The US House of Representatives on 28 May voted in favour of HR 4213, called The American Jobs and Closing Tax Loopholes Act of 2010. That bill raised eyebrows because it for the first time proposed a hybrid treatment of carry, with 75 percent characterised as ordinary income and 25 percent as capital gains.

The tax increase would apply to profits earned after 1 January, 2011 and would phase in over three years. Private equity and venture capital lobbyists are unsurprisingly disappointed.

“The House of Representatives failed to recognise the serious economic consequences of their actions,” says Mark Heesen, president of the National Venture Capital Association. “To those House members who consistently express interest in bringing more venture capital investment to their districts and states, I can tell you unequivocally that this is how not to attract investment.”

Law firms are increasingly hearing about the provision from anxious GPs.

“You essentially have a double whammy. If you hold the interest, you are going to be subject to taxes and that would depress the value of the business. If you’re selling the business as a whole, that will also be ordinary income,” says James Nix, a New York-based partner at Dechert.

On the other side of the Atlantic, private equity practitioners domiciled in the UK are waiting to see what will emerge from the new coalition government’s emergency budget announcement on the 22 June with regards to the treatment of capital gains tax. The coalition has previously stated it will “seek ways of taxing non-business capital gains at rates similar or close to those applied to income, with generous exemptions for entrepreneurial business activities”.

The British Private Equity and Venture Capital Association has written to its members suggesting their portfolio companies contact their local Members of Parliament to lobby against damaging rises in CGT. The BVCA drafted a sample letter for portfolio companies – seen by Private Equity International – which stresses, “Raising capital gains to the level of income tax would jeopardise our ability to attract investment and grow our business.”