Waive goodbye?

US President Barack Obama's proposal to tax carried interest as ordinary income could spell the end of management fee waiver programmes, at least if previous attempts are anything to judge by.

Under such programmes, the general partners waive any management fees they are entitled to, and limited partners in the fund contribute amounts equal to the waived fees into the fund on behalf of the management team. When an investment is exited, the general partners receive a pro rata share of the profits. Previously, these profits were taxed at capital gains rates, rather than ordinary income as normal management fees would be.

But law firm Paul, Weiss, Rifkind, Wharton & Garrison recently said in a client memo that the new tax regime will likely seek to close this loophole, basing its conclusion on language from similar legislative proposals that failed in 2007 and 2008.

Both the earlier bills included under the umbrella of carried interest “investment services partnership interests”, which are any interests in a partnership that is held by any person who provides, directly or indirectly, a substantial quantity of investment advisory or management services to the partnership. The proposals include exceptions for GP's contributions to a fund that don't include a loan made to a partner, directly or indirectly, by another partner or by the partnership.

But capital contributions made under management fee waiver programmes, or “management profits interests”, would be caught in the carried interest net, Paul Weiss says. Management fee waivers would still have the effect of deferring tax payment on the capital contribution, which has the benefit of allowing the GP to satisfy their capital commitment to the fund with pre-tax dollars.

But, if a GP receives the fee income, pays taxes on it, and then invests it into the fund, profits on this investment would be taxed as long-term capital gains. GPs will have to evaluate the merits of each strategy under the new tax regime and decide which is more advantageous.

If the past is any guide…
Text from the 2008 House bill that sought to tax carried interest as ordinary income:

(c) INVESTMENT SERVICES PARTNERSHIP INTEREST – For the purposes of this section –

(1) IN GENERAL – The term ‘investment services partnership interest’ means any interest in a partnership which is held by any person if such person provides (directly or indirectly), in the active conduct of a trade or business, a substantial quantity of any of the following services to the partnership: