It remains to be seen how the US Congress will deal with the several private fund tax issues before it.
One partnership expert says he believes deferred compensation techniques are most likely to be changed in a way that GPs will not appreciate (see p. 26). Proposed legislation designed to change the tax rules governing publicly traded partnerships, casually called the ?Blackstone Bill?, stands a weaker chance of getting passed, says the legal source. And efforts to change the tax characterization of carried interest to ordinary income from capital gains will likely fail, adds the source.
In the meantime, members of Congress in both the Senate and the House of Representatives have been subject to an absolute data dump on the topic of private equity, hedge funds, offshore partnerships and vagaries of the IRS code that only a highly paid tax expert could love. Last month, both the Senate Finance Committee and the House Ways and Means Committee held hearings designed to help them decide whether any further legislation is necessary to govern the private fund industry, and if so what shape it should take.
The hearings occurred on the same day. In the Senate was ?Carried Interest Part III: Pension Issues.? In the House was the all-day ?Hearing on Fair and Equitable Tax Policy for America's Working Families.? An observer at the second event said one exchange between a witness and a member of the House led to a hopeful bit of proposed legislation being crafted the very next day. The issue at hand was taxexempt investors, such as public pension funds, creating ?blocker? structures to invest in private funds.
A member of the House ?asked why tax-exempts invest in the offshore [corporations] instead of the parallel Delaware limited partnership that US taxable investors invest in,? recounts the hearing observer.
The House was told that private funds, such as hedge funds, often use leverage in pursuing their investment strategies, which generates unrelated debt-financing income (UDFI) for tax-exempt limited partners. UDFI is a subset of unrelated business taxable income (UBTI), which tax-exempt investors will always seek to avoid. Income that is otherwise kosher for tax-exempt investors, such as capital gains from the sale of securities, interest and dividends, becomes UBTI if debt is used.
The result of this learning experience was for the Ways and Means Committee to propose legislation that was the exact opposite of what battle-hardened private fund lawyers expected. ?We thought that the House was going to prevent UDFI from being blocked through offshore [corporations],? says the observer. ?But instead ? amazingly, [Representative Sander Levin, a member of the committee] said, you're right ? there is no policy reason for UDFI to be taxable when the partnership? borrows. So we'll just eliminate that rule.?
Last month, Levin, together with other members of the Ways and Means Committee, introduced a bill that would create an exception to the debt-finance rules for tax-exempt investors that is designed to keep these limited partners onshore.
?This bill will fix a problem that unfairly forces our pension funds, universities and foundations offshore to make certain investments,? Levin said in a statement. ?These rules were never meant to apply to this kind of investment, and we should allow these institutions to bring their investments home.?
In a client memo, law firm Proskauer Rose calls the proposal ?a silver lining in the legislative cloud over private investment funds.? But the memo warns that the bill ?is not a complete repeal of the UDFI rules, since a tax-exempt organization would still be subject to tax on income and gains from debt-financed investments held directly by such tax-exempt organization.?
The memo also noted: ?We believe Congress is hopeful that eliminating tax-exempt investors' need for offshore blocker corporations will discourage the use of mechanisms to defer incentive fees in such offshore blocker corporations by hedge fund managers.?
In July, Levin introduced legislation to recharacterize carried interest as ordinary income. A legal expert says that the sensitive issue of the ?deemed contribution mechanism,? by which private equity GPs contribute a portion of the management fee toward their commitment to the fund, is already implicitly addressed by the carried interest bill, and therefore may not be specifically addressed in separate legislation.