Legal Special: Carried interest tax reform

There can be few issues that unite figures as diverse as Donald Trump and the accountants at HM Revenue & Customs (HMRC), but how carried interest should be taxed is one.

On both sides of the Atlantic, the threat to its capital gains status has hung over the private funds industry for at least a decade with the calls for change gaining volume in recent months.

That's perhaps loudest in the US, where carry is taxed at a 20 percent capital gains rate rather than ordinary income, which carries a rate of up to 39.6 percent.

Once again carry's tax rate has become a US presidential election issue, with nearly every White House contender coming out against carry's tax status.

Republican candidate Trump has been reported saying: “The hedge fund guys are getting away with murder,” while Democratic candidate Hillary Clinton has often referred to carry's tax designation as an offensive loophole benefitting the nation's wealthiest citizens.

“In connection with the upcoming elections, this phrase 'carried interest loophole' has become a catchphrase for many of the candidates, and they have all come out and got on the bandwagon saying they will close the loophole,” says Matthew Saronson, a partner in the tax department at the law firm Debevoise & Plimpton.

“If you look at what they are saying, 90 percent of their statements are really about hedge fund managers, which suggests that very few people appear to understand the way that carry works.”

Carried interest recipients are taxed on a look-through basis based on the type of income generated by the fund. Most hedge funds generate ordinary income and short term gains, so the resulting carried interest is taxed at ordinary rates and does not benefit from the reduced rates applicable to long-term capital gains.

“From my perspective it's not a loophole at all – it's the way that partnership tax has worked from the beginning,” says Saronson. “For now, people are just sitting tight; there does seem to be a substantial risk that it will be switched to being taxed as ordinary income rather than looking through to the underlying income, but the big question is whether or not they can get it through Congress. The Obama administration has not managed to do so in eight years of trying.”

Alan Van Dyke, a partner in the tax and private funds team at Latham & Watkins, agrees. “People are constantly proposing legislation around this, but the odds of any of that becoming law in the near term are pretty slim,” he says. “Paul Ryan, the last head of the Ways and Means committee of Congress [the chief tax-writing committee in the House of Representatives] specifically said that this is something where changes ought not to be made other than in the context of a major overhaul of the entire tax system. On a standalone basis, he said, it is not a change that should be made.”

Ryan is now the Speaker of the House, the most powerful position in the House.

Still, between the need to generate tax revenue and politicians eager to distance themselves from 'Wall Street', it's an issue that is expected to keep popping up. As Mel Schwarz, legislative affairs partner in the US National Tax Office of global accounting firm Grant Thornton, told us back in 2007: “The old joke is there's nothing in the tax code that hasn't been talked about for 10 years before they put it in. Once one of these things comes on the table, it's very difficult to get it off the table.”

One thing that the Washington DC-based Private Equity Growth Capital Council is trying to do in the meantime is ensure politicians understand the asset class and how carry works . “We are spending a lot of time on the educational front, to make sure new members of Congress are educated on carried interest, why it's important, why it's a longstanding practice, and why it's beneficial to the economy,” says the lobbying group's head of public affairs, James Maloney. 

Across the pond

Until recently, the story was similar in the UK, with the House of Commons Treasury committee notably looking into the rate on carry in 2007. But last summer, things started to change with the abolition of the so-called 'base cost shift'.

Base cost shift enabled an investment manager to take advantage of a share of the capital invested by external parties in calculating the gain on its carried interest. With its abolition, only actual investment by an individual participating in the carried interest can be taken into account when calculating the capital gain on the realisation of the underlying investments.

Next, new investment management rules were published that sought to define carried interest for the first time, and set out that unless gains to the GP fell within either carry or co-invest, they would be taxed as income.

Now new rules intended to come into force on 6 April, but which are still being consulted on, propose all carried interest to be treated as income-based unless a fund satisfies a statutorily defined average holding period for its investments. This is part of an effort to define whether funds are 'investing' or 'trading', with the starting point that a fund that invests in unlisted equity with an investment horizon of five years is probably investing, while a hedge fund with a frequent turnover of assets is probably trading.

To the extent that a fund is investing, then the carried interest performance fees may be taxed as capital gains by the fund manager, and taxed at 28 percent, rather than 45 percent.

Once the average holding period is calculated, the proportion of the return eligible for taxation as capital gain will be set out in the rules.

“We finally had a legislative definition of what carry is, and that's in many ways helpful,” says David Irvine, a tax partner in the London office of law firm Weil Gotshal & Manges. “Broadly, where amounts arise from profit-related returns, and are subject to significant risk, then they should, prima facie, fall within the new carried interest definition.

“But, based on the latest legislative proposals, we are about to further complicate this and will find ourselves in a world where carry will be automatically treated as management fee income if certain fairly arbitrary holding period requirements, calculated based on average investment holding periods across a fund's life, are not satisfied. So, we will have all of the historic record-keeping requirements for tracking where everything is coming from, plus new requirements to track the details of investment holding periods in order to work out what falls within the narrow boundaries of what can be treated as carry and how that carry is taxed.”

The British Private Equity and Venture Capital Association has expressed its fears: “We are very concerned that the approach taken will, at best, result in significant uncertainty as to the ultimate tax treatment of carried interest returns across the industry, with the result that the UK could become a significantly less attractive jurisdiction for the establishment and operation for fund management businesses.”

Several other concerns have been raised by tax experts.

Darren Docker, a tax partner at PwC specialising in funds, says: “The curious thing about what we have now is that, while different parts of the alternative assets market have lobbied HMRC to have slightly more advantageous holding periods, it still comes down to the question of the longer I hold something, the better my tax position is likely to be. So we are starting to get concerned investors talking about conflicts of interest, because you might start seeing behaviour that is not necessarily what the managers would have done if you had taken tax out of the equation.”

Until the exact scope of the legislation is finalised there is little that funds can do to mitigate the effects. Longer term, we could see some structures doing away with limited partnerships that were only there to increase the chance of performance-linked rewards being taxed as capital gains, and some performance allocation or growth share corporate structures may revert to simply having a performance fee.

Ceinwen Rees, a senior UK tax associate at Debevoise, says: “All funds should be thinking about their average holding period and looking at their documentation to work out what they have at the moment. For funds not in existence yet there are some things that can be done, depending on what the sponsor has done previously. If you are looking at successor funds you are limited in what you can do because there are very wide anti-avoidance rules, but for brand new funds to the market there are structuring changes that can be made, but it is difficult to be explicit about them until the rules are in their final form.” 

Carried interest taxation in Hong Kong

The Hong Kong Inland Revenue Department (IRD) does not currently tax carried interest in the hands of individual recipients. As part of its audit process of private equity managers and advisors the IRD has been effectively applying a transfer pricing analysis to a portion of the carried interest and ruling that the Hong Kong share should have been reported as income in the profits tax return.

“There may be red-flag factors that the IRD has seen as triggers for an audit,” says one Asia-based private equity tax lawyer, who did not wish to be named, “such as firms not bringing as much management fee onshore as they might, or carried interest arrangements where the carried interest is effectively used by the management company to pay bonuses. But as far as we understand it, those aren't common to all of the investigations that have happened.”

Private Equity International understands that industry bodies including the Hong Kong Private Equity & Venture Capital Association are working with the IRD to come up with an agreement as to the consistent treatment of carried interest in the future.