Nobody likes taxes. Even less popular are increases in existing taxes and the creation of new ones. However, in these times of financial austerity, taxes have become the easy way for governments around the globe to make up for budgetary shortfalls.
For private equity real estate firms, this assault seems to be happening on two fronts. On one front, governments are targeting both the firms and individual professionals over capital gains and carried interest. On the other, property investors are being hit by new or increased property and transaction taxes. Neither is a welcome development.
In the US, the debate over a tax hike on carried interest has raged for the past few years, with Republicans defending its current capital gains designation and corresponding lower rate and Democrats arguing that it is part of compensation and should be taxed as ordinary income. This summer’s contentious debt ceiling debate seemed to swing momentum in favor of the Republican position, but President Barack Obama recently revived the discussion with his jobs bill proposal, which would be funded in part by taxing the carried interest of private equity managers, real estate investors and venture capitalists as ordinary income.
There is some logic to the move. After all, the average US worker pays ordinary income tax rates on his or her compensation, so why shouldn’t private equity professionals, who arguably are more able to afford the burden, pay ordinary income tax rates on the entirety of their compensation, a significant portion of which can come in the form of carry?
Furthermore, the US is not alone in its pursuit of appropriate taxes on capital gains. For example, India is in the process of overhauling its tax system, a move that could result in a 10 percentage point increase in the tax on carried interest. Of course, that change is part of the subcontinent’s plan to create a uniform 30 percent rate for all taxpayers on all types of income.
Meanwhile, the UK recently created an exemption for offshore private equity real estate investors to preserve returns as capital gains instead of ordinary income. Still, that victory is relative, as the UK capital gains tax rate for high earners already is 28 percent.
Overall, the issue surrounding capital gains and carried interest comes down to a matter of fairness. Whatever the eventual rate, governments need to ensure that carried interest is treated fairly relative to the taxes other workers pay on income as well as the treatment other types of capital gains receive. In other words, the tax rate that the chief executive of a Fortune 500 company pays on stock options given as part of his compensation should be no different than the rate private equity professionals pay on carried interest.
On the other hand, there is nothing fair or even-handed about the wave of new or increased property and transaction taxes around the globe. In many instances, these additional or increased taxes – the most common of which have surrounded the value-added tax and transfer taxes – are nothing more than blatant money-grabs with no real substance or rationale behind them. In some ways, they are representative of the systematic nickel-and-diming of property investors worldwide.
For governments, however, such taxes represent the lesser of all evils. After all, no one is being forced to buy and sell property. Still, it sends a subtle message to property investors that it is going to cost more to play in certain markets. In regions where there are multiple jurisdictions containing comparable assets, it even may be enough to discourage investment in one market in favor of another with a lower tax burden.
Indeed, firms are more cognizant than ever before of tax issues, which are one of several important factors in their cost-benefit analysis. While it is the rare investor that will make an investment decision based solely on tax implications, it has become a significant concern. Governments may want to take that into consideration lest they drive away an important driver of economic growth.
There is no doubt that taxes are an important generator of revenue to support national defense, public services and valuable social programs, and I’m all for everyone paying their fair share at a rate equal to everyone else. That said, I’m against the irritating practice of nickel-and-diming property investors to fill a temporary revenue gap.
Perhaps, the developed markets of North America and Western Europe should look to the emerging economy of India for guidance on how best to deal with the increasingly complicated question of taxes. Their solution: rip up the existing tax code and start over with a uniform tax rate for all taxpayers on all types of income. At least, no one could complain of being treated unfairly.
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