Carried away

This June, the US House of Representatives, for the second straight year, passed a bill that would tax carry as ordinary income, at a rate of up to 35 percent, rather than as capital gains at 15 percent. The revenue-generating measure was contained within the Alternative Minimum Tax Relief Act of 2008, which was passed by a vote of 233 to 189. A slightly different version of the bill was approved by a vote of 216 to 193 last year.

The carry tax still faces an uphill battle in the Senate, which rejected a similar measure last December amid intense lobbying from the private equity, venture and hedge fund communities.

“The problem is no one has a crystal ball, no one to my knowledge has the magic bullet that will effectively, address this issue. Because no one knows exactly if, when and how such legislation will be written and passed.”

“Democrats are not very confident they can force the Senate to agree to this AMT legislation,” Dustin Stamper, legislative affairs partner in the US National Tax Office of global accounting firm Grant Thornton, told sister news service PrivateEquityOnline in June.

The White House has threatened to veto the bill in its current form, and Senate Finance Committee Chairman Max Baucus, a Democrat from Montana, reportedly said “why go through the motions?” with regard to again including the carry provision as part of an AMT fix, according to The Washington Post.

Political observers from the private equity community say that the real battle over carry will likely come sometime next year, after the election of a new president and Congress. Democratic presidential nominee Barack Obama has repeatedly expressed his disappointment over the tax hike's defeat last year. Republican nominee John McCain has argued against changing the tax treatment of carry and has pushed for a lowering of the capital gains tax rate.

While it's far from a sure thing, an increase in the tax rate for carried interest is certainly a real threat. There's simply too much revenue to be gained, many in the industry say. Without knowing when a tax hike might occur or what form it might take, however, it will be hard for GPs to proactively plan to protect themselves.

Fund managers currently in the process of drawing up limited partnership agreements are trying to find ways to give themselves some flexibility to respond to a change if it occurs during the life of the fund, says Robert Friedman, a partner in Dechert's private equity practice. But as yet, no clear solution has appeared.

“It's definitely been an issue that has come up, and there's been LP pushback on amending the LP agreement to change the economic deal between the general partner and the limited partners,” Friedman says. “That said, we are seeing funds that have general language about being able to restructure general partner profit participation in a way that's accommodative in the event of a change in the tax treatment of carried interest.”

No crystal ball
There may not be a very easy way to do it, he says. It is highly unlikely, to say the least, the LPs in even the most sought after funds will agree to bear the entire cost of a tax hike. A more likely solution may require sitting down with the LPs and completely reconstructing the economics of the fund. Dechert is talking about ways to do it internally but hasn't come up with anything yet, he says.

Carl de Brito, also a partner in Dechert's private equity group, says he hasn't seen any clear solutions emerge anywhere that have found the support of both LP and GP.

“I hear a lot of sponsors saying, ‘I wish I could do something about this, let's give it some thought.’” he says. “And there may be some provisions that you see drafted by various law firms out there to try to cover the point, but I don't see any support for it right now.”

A number of GPs have tried to address the issue in one of two ways, says Howard Rosenblum, a partner in DLA Piper's fund formation group. The first type of provision allows the GP to terminate the fund early, so the GP can restart the firm under new terms based upon the new legislation. Most LPs don't like that or have objected to that type of mechanism, Rosenblum says. The second type of provision says if there's a tax legislation change, the GP can amend the agreement to work within and accommodate the new tax structure.

But the problem with both these methods is they require LPs to sign what is essentially a blank check. Without knowing in advance how the government will change the carried interest tax regime, it's hard to specify exactly what sort of flexibility to give the GP to respond.

“I think there's still significant uncertainty about whether it will happen and, if so, how it would happen that it would be hard to put into an agreement at this point,” says Marc Gerson, a tax attorney at Miller & Chevalier. “So, for example, it's a question of if it would occur, when would it occur, how would it be implemented, and what form would the legislation take. Would there be transition rules, or would there be a delayed effective date? Would it be a general rule that would apply to all carried interests, or would it only apply to certain industries?”

If and when the change occurs, however, what LPs want most is a voice in the GP response.

“The common cry of those limited partners is ‘We'll be reasonable, but we want a seat at the table when you start redoing the limited partnership agreement,’” says Ian Warner, a partner in Pinsent Masons's investment funds group. “But an unfettered right to amend to agreement is perhaps just a bit too broad… The problem is no one has a crystal ball, no one to my knowledge has the magic bullet that will effectively, address this issue. Because no one knows exactly if, when and how such legislation will be written and passed.”

Brito recently worked on a fund where an LP actually wanted a side letter guaranteeing that the GP would not dissolve the fund because of a change in the taxation of carried interest, or a change to the capital gains rate. The case is ongoing, and it's unclear if the sponsor will accept those terms, he says.

Looking across the pond
Warner suggests, however, that if the UK is any example, a change in the tax rate on carried interest in the US might not be as big a deal as some believe. The UK government last year increased the 10 percent “taper relief” private equity executives received on capital gains to 18 percent for gains on more than £1 million during an individual's lifetime.

“From what I've seen, by and large it hasn't really affected the drafting or the fund terms,” Warner says. “I think certainly from the UK point of view, it's fairly well trodden past that there's a management fee of roughly 2 percent and a carried interest of 20 percent. And I think it's still a pretty good deal from the UK fund manager's point of view, to get 20 percent carried interest on the tax rate still not particularly high.”

He points out that at many firms with an international base of executives, a wide variety of tax rates area already being paid on carried interest income. A UK domiciled person is taxed at a certain rate, and a Swedish national is taxed at another, much higher rate.

“I think we're a long way off the change in taxation rates actually affecting the basics of the fund terms,” he says