A debate worth monitoring

For those who know this industry well, it’s hard not to be suspicious of any fresh claim that private equity types are exploiting a tax loophole to which the authorities are, for some reason, turning a blind eye.

In past Monitors, we’ve defended the industry when an investigation into inter-company lending was misleadingly described as a private equity problem. And we've shot down the myth that offshore funds structured in exotic places like the Cayman Islands necessarily represent a tax avoidance strategy (as opposed to a neutral tax environment for a multi-national collection of LPs).

So naturally we were a little suspicious when Gregg Polsky, a law professor at the University of North Carolina, published a piece in the Feb. 3 edition of the journal Tax Notes arguing that monitoring fees (the fees charged to portfolio companies for the GP’s management and advisory services) are actually just “disguised dividends” – i.e. a way for portfolio companies to funnel (pre-taxed) money back to their private equity owners while passing it off as a business expense.

It’s worth stressing that Polsky isn’t a disinterested observer in this debate. In his capacity as a lawyer, he's representing an IRS whistle-blower whose case is based on this argument; so as his attorney, Polsky presumably has a financial incentive to see that the IRS takes a harder line (if the IRS uses information provided by the whistle-blower, it can award that individual up to 30 percent of the additional amounts it collects).

His argument boils down to this: monitoring fees should not be tax-deductible, because they don't actually represent compensation for services rendered, as the law requires.

One key issue is that under some (although not all) monitoring fee contracts, GPs are not actually required to perform any specific services, and can terminate agreements while still receiving all future fees. As such, says Polsky, it can't be compensation. “A payer with compensatory intent would not allow the service provider to decide unilaterally when and how to provide future services that are only ambiguously described,” he writes.

It's true that the definition of 'compensation' is slightly more nebulous than Polsky makes out: after all, many organizations (including most law firms) work on a retainer basis, where they'll agree an advance payment for work to be specified later, and often times get to keep that money even if no work is ultimately performed. However, he surely has a point that there are not many retainer agreements where the service provider is allowed to terminate at its sole discretion, at any time, and still get paid the present value of all of the fees that it would have received had the contract run its course. It's very hard to see how an arrangement like this could ever truly be classed as 'compensation'.

Then there's Polsky's other argument – that in consortium deals, monitoring fees are paid pro rata according to shareholding, rather than being based on the specific services performed by the groups involved. It's easy to see why this happens, because trying to quantify exactly who did what will often be extremely challenging (even if you worked on the basis of individual hours worked, some firms might argue that their input was more valuable than that of their partners). But challenging doesn't mean impossible – and if the managers concerned are serious about proving that these fees are actually compensation for services, as opposed to 'disguised dividends', it may be worth the time and negotiation to agree on some sort of better approximation.

All in all, then, this is (unlike some other recent ones) a private equity tax 'controversy' worthy of the name. Of course the IRS may decide otherwise. And it’s worth noting that the tax agency has already tacitly approved this practice, by not challenging audit reports of portfolio companies that use monitoring fees as a tax write-off. But it wouldn't be a surprise if this case prompts the IRS to revisit its current interpretation of a fee stream that remains a large source of revenue for many GPs.