Return to search

Carry crossfire

Amid the chorus of opinions on the taxation of carried interest in the US, PEI Manager hosts the definitive debate between two US tax experts with opposing views on the issue.

The taxation of carried interest became one of the hottest issues on Capitol Hill in 2007, as private equity's heightened profile drew the attention of US lawmakers looking to offset revenue declines from the expected repeal of the hated Alternative Minimum Tax (AMT).

The belated congressional discovery of carried interest set off a debate that until last year had been confined largely to theoretical discussions over the nature of carried interest. Central to the debate was the question of whether carried interest should be regarded as a capital gain, and thus be subject to the lower 15 percent tax rate, or as ordinary income, and thus subject to a tax as high as 35 percent. At press time, the US Senate had passed a bill that addresses the AMT without a tax hike on carry, and in the House of Representatives, House Ways and Means Committee Chairman Charles Rangel indicated that he would for now drop the issue of raising the tax rate for carried interest.

?There's no need to grant a subsidy to encourage people to go to work. In this particular market, the market sufficiently rewards fund managers such that we don't have an undersupply of these types of admittedly important services. There hasn't been a demonstrated need for treating one group of laborers better than another group of laborers.?

While politicians sort through the highly complex issues of carry tax, we asked two leading tax experts to have a discussion on the matter. The conversation started the way formal debates start ? with a resolution. In this case the resolution was, ?Resolved: The status quo should be maintained with regard to the taxation of carried interest.?

PEI Manager: Darryll, why do you believe that the status quo with regard to the taxation of carried interest should be changed?

Darryll Jones (DJ): I think that the amounts paid to private equity fund managers are quintessentially labor income, and historically the reasons why we grant a lower rate of tax for income derived from capital is because we want to make sure we're taxing real economic gains. We don't have that same problem with respect to the taxation of labor income or income from services. That's it in a nutshell.

Mary Kuusisto (MK): The tax code reflects various policies and Congress has instituted various different policies to a number of specific provisions of the Code. One of those policies is to encourage the ownership and the development of businesses; to spur investment in the economy. Part of the way they have encouraged this is to allow preferential treatment for certain types of equity compensation. To the extent that you become an owner of a business for which you perform services, the Code has a long history of allowing preferential capital gain rate taxation.

DJ: Certainly, the Code is calibrated in certain instances to encourage the long-term investment rather than short-term and immediate consumption of previously taxed dollars. We're not talking about that effort with respect to labor income. There's no need to grant a subsidy to encourage people to go to work. In this particular market, the market sufficiently rewards fund managers such that we don't have an undersupply of these types of admittedly important services. There hasn't been a demonstrated need for treating one group of laborers, if I may use that term, better than another group of laborers. There's just no reason for it.

MK: To go directly to that point, I don't think anybody is saying that private equity or venture capital fund managers are not paying ordinary income tax on a very significant portion of their income that is received in exchange for the services that they perform for the organization. The management fees that are paid to them as salary ? depending on the type of fund and the size of the fund and where it is in the organization's life cycle ? are either significant or at least comparable to what other wage earners are paying ordinary income tax on.

But the distinction is that there's another kind of property that they're receiving in exchange for the services that they perform. And that is an interest in the ownership of the organization for which they have to meet a whole lot of other requirements in order to obtain capital gain tax treatment. For example, in order to be an owner of a partnership, there's a prevailing view that you also have to have a capital interest. So to that extent, the carried interest is economically comparable to what the founder of a company receives as restricted stock or founders stock. The ability to obtain capital gain treatment if the value of that business is built up, in addition to the salary, taxed as ordinary income, that founders receive on an annual basis, is something I believe Congress is still trying to encourage and something that the [recently proposed tax] Bill doesn't take away in these other contexts. Instead, it only takes it away with respect to private investment fund managers but not with respect to founders of companies, not with respect to folks who found companies that are formed as operating LLCs, not with respect to restaurant partnerships, or most oil and gas partnerships. So it's a little difficult to understand why Congress has decided to do it for this one narrow group, this one narrow industry, instead of applying it to all equity compensation ? if they determine that equity compensation is no longer appropriate. They certainly have thought it's been appropriate for a long time.

DJ: Certainly I agree that the Bill ? I assume you're referring to the Bill in the House ? is under-inclusive. It's like saying, ?We ought not to stop some speeders because we can't stop all speeders.? I can't think of a single instance where, for example, in the area of corporate formations, if you receive stock as a result of your contribution of services to a corporation, the stock is taxed as a capital gain, notwithstanding the fact that later any yields on the sale of the stock might be treated as capital gain. I think the argument that this is under-inclusive almost admits to the fact that equity-for-services ought to be taxed as ordinary income, notwithstanding the fact that we're singling out one industry. I disagree with singling out the fund managers and not having a solution to this ?accidental? problem to all those who gain equity as a result of performance of services.

MK: Here's a baseline question ? is it your view or proposal that in order to be fair and equitable there should be no preferential capital gain treatment for any type of equity compensation, whether in partnership or corporate form?

?We've seen that Congress is very concerned about maintaining an environment in the US that is nurturing to innovative, small, start-up, risky companies, and specifically with respect to technology that is risky to develop. If the United States is going to tax carried interest at close to 50 percent ? when you include state, local and employment taxes ? it's not going to be as competitive, and the US risks losing a market.?

DJ: Yes. I think that's a fair summation. What we're talking about is the discrimination essentially between lower-paid laborers and higher-paid laborers. We're talking about service income. The reason why I think venture capital or private equity or hedge fund managers are being singled out is simply the notoriety that's been generated around this particular industry. I agree that they shouldn't be singled out. But the fact that they shouldn't be singled out is neither here nor there with respect to whether they're being treated fairly vis-à-vis other laborers in the first place.

MK: Certainly, the folks in the investment fund world view equity compensation as a very, very powerful tool in order to allow businesses to grow in the United States. The venture capital industry views it as a way to get talented people to form start-up companies and to allow smart, intelligent people to forego more lucrative jobs. Instead of being paid very high salaries, the founders and employees agree to take equity in the companies they form with the hope they'll be built up into valuable businesses. One measure, in a mix of measures, of encouraging them to do that ? to take that risk ? is by permitting them to get a lower tax rate upon the sale of that business. The idea is that the amount of risk that they're taking in putting their energies ? which they could have been put into a different kind of service ? into a business which could be a valuable part of the US economy is something that should be rewarded.

The idea is that certain types of human capital should get the same preference as financial capital, even though it hasn't been previously taxed. And that is okay because a lot what people might consider to be ?previously taxed? financial capital often is not, once you look and see who the taxable unit is. There've been a lot of folks who have been able to invest ?previously taxed? financial capital on a tax-advantaged basis, but it was perhaps their parents or grandparents who were taxed on that income, or maybe that income was never taxed. So the previously taxed argument might go a little too far as well.

DJ: To address a couple of your points ? one of your points is we want to encourage people to take risky ventures. I think that argument is over-inclusive. If we want to encourage risky ventures, then we should extend the capital gains rate to a whole host of other activities. But more importantly, I think that the use of the tax code to encourage a behavior is appropriate when the behavior would not occur in sufficient quantities without the tax subsidy. I think the market, at least in the venture capital, private equity and hedge fund area, sufficiently rewards talented fund managers such that we would not have a shortage of people going into this industry. On the contrary, I think that the subsidy might create ? at least in reference to classical economic theory ? might create an oversupply in this area and take talented people away from areas that need their services. Your point is well taken that a lot of capital that is invested and given capital gains rate is not previously taxed such as capital that's inherited or given as a gift, but that's an argument really for narrowing the scope of the capital gains tax, not broadening it for hedge fund managers.

PEI Manager: Both of you have talked about the possible effect a change to the tax on carry might have on behaviors within the us. But to what extent do tax rates in other countries come to bear in considering a change to us policy? In other words, if the tax rate on carried interest in a competing economy is zero, to what extent should policymakers take that into consideration?

MK: In the venture capital community, it's viewed as incredibly important to know how other countries are taxing similar types of activity in order to be competitive in what is, increasingly, a global market. Part of the reason is to attract talent, as Darryll was referring to a little while earlier. If I talk to my clients, I'm forever hearing how difficult it is to find talented people to join their venture capital organization. If you look at the conference circuit, there are all kinds of conferences geared towards compensation and how to retain people and how to attract people in the industry. There are a lot of ways that venture capital and other investment funds can't compete with organizations like investment banks, law firms, etc. And that's because the returns received by professional working in the investment fund space are contingent upon the value of the businesses they invest in and are delayed. It often takes seven years or more before a venture capitalist sees a dollar of carried interest. In order to get that carried interest, almost across the board, it requires a financial outlay personally by the individual venture capitalist. So you have all those factors stacked up against you in trying to compete for talent in this industry.

And then when you compare this to other jurisdictions' rules, it's even more competitive. I think there was one study done or commissioned by the NVCA [National Venture Capital Association] that found that 25 percent of entrepreneurs in US start-ups are from non-US countries but are working now in the United States. To the extent that their home countries have a more nurturing and encouraging environment for start-ups and for venture capital, it would be very easy for those entrepreneurs, in this more and more global market, to move back to those environments. We've seen that Congress is very concerned about maintaining an environment in the US that is nurturing to innovative, small, start-up, risky companies, and specifically with respect to technology that is risky to develop. So if you have the UK currently proposing an 18 percent tax on capital gain ? that would include carried interest ? if you're talking about Germany, which treats carried interest as capital gain currently, if you're talking about Israel where you can obtain a tax ruling from the government and get a very preferential rate of taxation on carried interest, then if the United States is going to tax carried interest at close to 50 percent ? when you include state, local and employment taxes ? it's not going to be as competitive, and the US risks losing a market.

DJ: Let's be clear ? we're talking about fund managers, not necessarily the capital investors. The capital investors will continue to enjoy a preferential rate of 15 percent. There was a gentleman who testified before the Ways and Means Committee who, I think, quite correctly pointed out that people are going to make decisions as to where to live and work not just on the tax rate. His intuitive conclusion ? this is a person who's a fund manager based in London ? was that raising or requiring fund managers to pay ordinary rate will not create a significant outflow of talent from the United States because there's too many other things people take into consideration in where they want to live and work. I think in theory of course if all we're considering is the tax rate in one locale as opposed to another, certainly I'm going to go to the place that's least expensive. But I think it's unrealistic to assume that the tax rate itself without any other consideration, very strong ties ? family and so forth, are going to cause a dearth of fund managers.

MK: On that point, I agree with you that the tax rate will not, in and of itself, cause an exodus from the industry. Nobody has a crystal ball to know what could happen. But I think the tax rate is one factor in a number of factors as to whether the environment is going to help your company versus not help your company.

In addition, for the investors, the tax rate on managers' carried interest affects whether the cost of managing their money is going to be too high for them. If, for example, the Bill is enacted into law in the form the House recently passed, and if investment fund managers pass on some of the cost of that tax increase to their investors ? through a higher fee and a lower carry or through a higher carry or through some other mechanism ? then LPs will bear higher costs than they otherwise would. This might cause them to invest more with non-US managers, if those non-US managers can charge lower costs.

DJ: All of these are legitimate theories. To respond to the idea that fund managers would necessarily pass along the cost, I think that the leverage and the bargaining is on the side of the investors. The investors are large, wealthy, exempt organizations, pension plans, or just wealthy individuals. I think that the carry has discouraged some degree of fiscal discipline in the payment of fund managers. I think that the reason why the carry is so popular is because it's much more lucrative than it's fixed to be. That would speak against the idea that the investors' cost would go up.

MK: Investors like the concept of carry because the interests of LPs and GPs are aligned. If the companies do very well, the fund managers do very well, but so do the investors. The rising tide lifts all boats. With respect to fund managers, if they look at this new method of taxation and say, ?Well gee, if I'm going to be taxed at the same rate on this contingent, speculative kind of remuneration, i.e. carry, as I'm going to be taxed on this very guaranteed, very stable kind of remuneration ? management fee ? I'm going to negotiate for something different and I'm going to try to get more of this guaranteed kind of income because that will allow me to attract more people and do better.?

But maybe different incentives as to the companies' performance will develop. Even if they don't, the limited partners like that kind of alignment.

DJ: Certainly the limited partners like this alignment. They have to deal with these agency costs but so do corporations that have other types of profit sharing interests. There are lots of examples of profit and bonus type plans that are designed to align the interests of the owners and the managers and yet in other instances these alignment techniques don't result in a labeling of the income that derives from this structure designed to align the interests being labeled as capital gain. Capital gain is income from previously taxed capital, notwithstanding the gifted income or inherited income. That is the quintessential reason that we have different rates on essentially the same types of successions to wealth. And we don't have that with labor income. We don't previously tax human capital so there's no reason to tax labor income differently.

PEI Manager: Mary, it may be appropriate to step back and discuss your views on the nature of capital gains versus ordinary income.

MK: I actually think there isn't just one policy reason for having a lower rate on capital gain, and that equity compensation ? the mechanism by which valuable companies are built by rewarding the investment of human capital in a similar way to financial capital ? is a laudable policy goal. I also believe that investment fund managers and any other participants in a partnership should be taxed in the way they have been taxed since the inception of the enactment of the partnership provisions of the Code ? for almost a hundred years. Partners who are service providers are taxed no more beneficially than owners of restricted stock or founders stock in the corporate world. They're afforded capital gain treatment in order to encourage the building of valuable businesses. This is precisely the same with respect to carried interest except there are a number of businesses in one pool.