Three-headed attack

The US is inching closer to a settlement on its long standing debate over the tax treatment of carried interest.

In a recent ruling that could lead the US Treasury to issue regulations interpreting carried interest payments as ordinary income (up to 35 percent), a US tax court has rejected the argument that carry should remain under the more favourable capital gains rate (up to 15 percent).

This, alongside President Barack Obama’s interpretation of carry treated as capital gains a tax loophole and Congress’ desire to cut the deficit by either increasing revenues, slashing spending, could finally change the tax treatment of carry.

The court case, Dagres v. Commissioner, addressed whether a sour personal loan worth $5 million made by venture capitalist Todd Dagres to a well-connected business associate (who was expected to provide future investment opportunities) could be claimed a “bad debt loss” in his tax filings.

The Internal Revenue Service rejected the claim, arguing that it was unrelated to a trade or business and thus did not qualify for the tax exemption he sought.

Dagres took the matter to court where it was ruled he did in fact make a tax deductible business loan as a result of his managing role with Battery Ventures. The loan, it was ruled, was provided to help Battery (a trade or business) screen new deal flow potentially brought in by the borrower.

Importantly, as a result of ruling Battery a trade business, the court interpreted Dagres’ carried interest income as compensation for services performed as a fund manager.

The court’s interpretation is an important one as it falls under the IRS’s definition of ordinary income without being taxed as such. “Like a stockbroker or a financial planner, the GP received compensation for services they rendered to clients,” the court ruled.

Neither Battery nor Dagres, who has since moved on to form Spark Capital, could be reached for comment.

The court’s judgment of carry as a form of ordinary business income could grab the attention of policymakers at the US Treasury Department, says Michael Graetz, a Columbia University tax law professor and former Treasury department official.

“The ruling provides Treasury greater justification in releasing regulations that interpret carried interest as ordinary income,” says Graetz who adds that courts have recently been showing greater deference to the Treasury department’s interpretation of the tax code.

The deadline for the IRS to appeal the case passed in late July with no action taken, according to public documents. The IRS declined to comment.

However, the executive branch of government has not remained muted on the debate. Over the summer, President Obama took direct aim at fund managers during a televised press conference, directing Congress to place a carried interest tax hike firmly on the table.

“If you are a wealthy CEO or a hedge fund manager in America right now, your taxes are lower than they have ever been,” said Obama. “They’re lower than they’ve been since the 1950s. And you can afford it. You’ll still be able to ride on your corporate jet; you’re just going to have to pay a little more.”

While Republicans have been able to block Democrats from changing the tax treatment of carry, a fervent debate on the country’s national debt has resulted in both political parties’ sacred cows being considered at the negotiating table. On the other hand, a number of Republicans have refused to support tax increases of any kind.

Depending on the details, treating carry as ordinary income could raise between $15 billion to $24 billion over the next decade, according to government estimates.

At press time, a 12-member panel of lawmakers, dubbed the “super committee”, was working to identify $1.5 trillion in savings over the next 10 years in addition to the $2.1 trillion deficit reduction deal reached in August. The bipartisan panel must craft an agreement before a 23 November deadline to head off automatic, across-the board spending cuts.

Moreover, Congress has in its pipeline a future debate on George W. Bush-era tax cuts which have been pushed back to December 2012. Assuming they expire, the capital gains rate will increase to 20 percent from 15 percent. A bittersweet outcome for GPs if carry stays under the capital gains rate.