From The Economist:
“PRETTY much everybody hates us,” admits one private-equity executive. The industry once wore its unpopularity as a badge of honour. Now it is a liability as Congress considers removing some of the tax perks that helped inflate the private-equity bubble. “There’s no senator or congressman who represents the interest of private equity,” says the executive. Not even the charms of the industry’s big hitters seemed to have worked. Stephen Schwarzman (pictured), the boss of Blackstone, one of the largest buy-out firms, travelled to Washington, DC, to lobby against the proposals. To no avail, it seems. The House of Representatives has already passed them and the Senate is due to consider them this month.
The legislation in question is the “American Jobs and Closing Tax Loopholes Act of 2010”. This would change the tax treatment of “carried interest”, or the profits that private-equity firms and other investment partnerships make when the funds they run perform well. Currently, carried interest is taxed at the lower rate of capital gains (15%), as opposed to income (35%). The bill suggests changing this and taxing 75% of carried interest as income and 25% as capital gains, starting in 2013. That might sound fiddly, but the sums involved are big. The tax change would help raise around $18 billion over ten years and affect mostly buy-out shops, venture-capital firms, real-estate partnerships and some hedge funds.
Opponents of the bill say that carried interest deserves capital-gains treatment because it is a long-term investment and carries risk. Buy-out shops don’t get any of the profit unless the fund performs well for investors, and they get their cut of profits only after investors are paid back. But the idea that a benefit received can be classified as a capital gain simply because it is risky seems specious. After all, payments from bankers’ bonuses to authors’ royalties fluctuate, yet are still classified as income. Furthermore, the bulk of the original cash in private-equity funds, from which all profits are ultimately made, is not supplied by managers but by clients. They actually stump up the capital, and will continue to be taxed at the lower rate.
Support is growing for the idea that carried interest is actually compensation for services rendered (for example, choosing which companies to buy and then helping to monitor them), and should be taxed as income. Victor Fleischer, a professor of law at the University of Colorado at Boulder, says carried interest is a “quirk” in America’s tax code that allows some of the richest workers in the country to pay lower taxes than others do on their bonuses.
Many executives privately admit that carried interest is a grey area and should probably be taxed somewhere in between capital gains and income. That hasn’t stopped the industry funding a big lobbying effort and making dire predictions about the proposals’ implications. Doug Lowenstein, who runs the Private Equity Council, the industry’s lobby group, says that the tax change could wreck buy-out shops by discouraging young talent from going into private equity and driving buy-out firms to relocate to countries that offer more favourable tax treatment.
Josh Lerner, a professor at Harvard Business School, says the tax change won’t “have the cataclysmic effect” the industry claims it will. The private-equity industry won’t leave America en masse and will adapt its compensation structure to keep talent. The fairest objection comes from venture-capital firms, says Mr Lerner, which depend more on carried interest than buy-out shops to incentivise managers. But there is no way to carve out venture capital from the bill, without risking buy-out shops wiggling their way through that hole too.
Carried interest is not the only concern weighing on the minds of private-equity bigwigs. Another provision in the bill would change the tax treatment of publicly traded private-equity firms, such as Blackstone and Fortress Investment Group. Currently, listed partnerships don’t have to pay corporate income tax as an entity, but that would change, starting in 2020. This could discourage other buy-out shops from floating their shares, and may dent share prices for those that are already quoted on the stockmarket.
Private-equity firms have more than just Congress to worry about. In Britain the new government is considering raising capital-gains tax and closing loopholes, and a decision is expected soon from Australia’s tax office about whether the country should tax carried interest as income or capital gains. In the meantime, buy-out shops are already trying to figure out ways to adapt by changing the structures of their deals, says Steve Puccinelli of Investcorp, a private-equity firm. On past performance there’s a good chance they’ll come up with something.