US budget assumes $23bn from carry tax hike

A raft of recently introduced US bills could impact private equity funds at the federal and state level if passed.

Among these is President Obama’s 2010 budget blueprint, released yesterday. The proposed budget, which is then used by Congress in debating a final budget, includes a one-line description of the following new source of revenue: “Tax carried interest as ordinary income”.

The Obama budget plan would increase the tax rate on carried interest from 15 percent to up to 39.6 percent, starting in 2011. The budget proposal says the tax hike will raise $2.742 billion in 2011. Between 2010 and 2019 the tax hike is expected to raise a total of $23.894 billion, according to the White House Office of Management and Budget.

The budget serves as a blueprint for the House of Representatives and the Senate as they draft legislation. David Winter, a partner at Hogan & Hartson, says deferring the tax increase until 2011 is smart policy for Obama both economically, as the length of the recession is unclear, as well as smart politically in order to win support as it goes through.  

Although the budget was officially unveiled this week, many tax lawyers have reportedly been advising their clients for months to start restructuring their partnerships in order to circumvent the higher tax rate. Some fund sponsors have instead inserted – with the consent of their investors – a provision that should the proposal become law, the relevant parties will revise the agreement to alleviate the hit on a sponsor’s income.

Winter says that such provisions are a good idea, but that spending a lot of time and money to restructure a partnership before a final budget is passed is unwise. “The best thing to do is wait and see,” he said. “This tax increase is not a slam dunk, because there are members of Congress who are powerful and for whom this is an important issue.”

Separately, a bill introduced in the US House of Representatives would eliminate the registration exemption to the Investment Advisors Act of 1940 for investment advisors with fewer than 15 clients.

The amendment to the ’40 Act, HR 711, was introduced by Representatives Michael Capuano and Michael Castle. It will eliminate Section 203(b)(3) of the Act, which exempts advisors with fewer than 15 clients – which in the case of private equity firms is typically interpreted to mean 15 pooled investment vehicles – from registering with the Securities and Exchange Commission.

If the bill passes, all US advisors to private equity funds would be required to register, as well as non-US advisors of US domiciled funds. It imposes restrictions on advisory contracts, requires that advisors use “qualified custodians” for client assets, requires advisors to file Form ADV, subjects advisors to SEC inspections, requires extensive recordkeeping, and requires the development of a systematic compliance programme.

The bill was introduced around the same time as a bill in the Senate that would require all private funds with more than $50 million in assets to register with the SEC, by modifying key exemptions under the Investment Advisors Act of 1940.

“Both of these proposals were clearly written by people who don’t have a great deal of understanding about how private equity and hedge funds are run,” says Timothy Clark, a partner in Proskauer Rose's private equity practice. “None of the nuances that you’d like to see were there. They were clearly thrown together with a great deal of haste. Hopefully our legislators can be educated as to why some of this would be extraordinarily damaging to our industries.”

Legislators in the state of Connecticut have proposed three new bills that would apply to private equity funds domiciled there. Bill No. 953 would not permit funds to have individual investors with less than $2.5 million in investment assets, or institutional investors with less than $5 million in investment assets. It would also require funds to disclose side letters, and undertake an annual audit. Bill No. 6480 would require funds to disclose information about their portfolios to Connecticut pension plan investors. Bill No. 6477 would require funds to buy a $500 license each year in order to conduct business in the state.

Kevin Ley contributed to this report.