Friday Letter Carried away

Lawmakers in the UK and US are considering plans to substantially increase taxation on carried interest. Industry calls to keep the status quo will likely fall on deaf ears. The time is right for all sides to start compromising.  

When governments globally came to the rescue of their country’s financial systems with massive infusions of taxpayer money, everybody knew there would ultimately need to be a payback time.

Nobody was sure when that time might be, but it was as inevitable as night following day that in trying to save Wall Street and its global equivalents, governments would need to extract something in return, if only to show Main Street that it really wasn’t just a one-way relationship.

Taxation – and the personal taxation of wealthy business men and women – was always expected to be the likely tool of choice. That time has now come in both the US and UK, following the introduction of new proposals to treat carried interest as ordinary income.

In the UK, the new Conservative-Liberal Democrat coalition government has warned it plans to raise revenues from “taxing non-business capital gains at rates similar or close to those applied to income, with generous exemptions for entrepreneurial business activities”. The thinking is that the current 18 percent tax rate for capital gains tax – which carried interest is subject to – will rise to as much as 40 percent, and possibly even 50 percent, although it is unclear exactly what “non-business” activities will be hit.

In the US House of Representatives this week, a hybrid proposal was also introduced that would tax 75 percent of a GP’s carried interest take-home as ordinary income, while the remaining 25 percent would get the lower capital gains rate.

On both sides of the pond there has been vociferous campaigning against the proposals. The US lobbying group, the Real Estate Roundtable, this week warned a “dramatic” increase in carried interest tax would affect more than one million real estate limited investment partnerships and constitute the “largest tax increase on real estate, ever”.

It is too late though to be lobbying for a complete abolition of such tax increases. Although the proposals were introduced very recently – and in the case of the US, surprisingly so as well – it is inevitable the private equity and real estate industry will be affected by some form of increased taxation. For politicians of all colours, squeezing wealthy financial professionals for some additional monies is something that must, not should, happen.

Perhaps though there is hope of a compromise – something the US hybrid proposal suggests. As PEI Media’s editor in chief David Snow explains in “Carry is strange”, the proposal from US Senator Max Baucus and US Representative Sander Levin inadvertently – acknowledges the strange hybrid nature of carried interest.

As he writes: “Carry is a capital gain because it is derived from investment proceeds and then later distributed among partners however they see fit. It is ordinary income because it recognises the service that the GP has provided in order to earn a disproportionate share of the profits. It is a capital gain because its payment to the GP depends entirely on the success of investments. It is ordinary income because the GP is paid from capital that others put at risk. No tax code was designed with carry in mind because very few people in the world earn it.”

By treating carried interest neither as 100 percent capital gain, nor as 100 percent ordinary income, there is scope to finally find a taxable solution to carry that is palatable to the industry, and also politicians.

But one thing is clear, in this current political and financial environment, the status quo cannot continue. As they say there are only two things certain in life: death and taxes. Unfortunately, the time of higher taxes is here.