An overdue tax ‘victory’

It seems Democrats are learning from past mistakes. For five years now the party has failed in its efforts to tax carried interest like income. Now they have signalled a concession on so called “enterprise value tax”, which relates to the goodwill behind a private equity firm’s identifiable brand – i.e. the value of the partnership above and beyond its physical assets.

The concession is long overdue.

In plain terms, past proposals would have seen buyout firm founders paying a partial ordinary income tax rate on the goodwill value of the partnership when selling some or all of their holdings to outside investors, for example through an initial public offering.

However, that seems impossible to defend, given that all other entrepreneurs selling their business pay the capital gains rate on the goodwill they’ve created.

Now President Obama has said in his latest budget proposal that his administration would work with Congress to “ensure more consistent treatment with the sales of other types of businesses”, in other words, he wouldn’t make a special case of investment partnerships. And unlike past proposals linked to the carry tax debate, the latest bill floating in Congress, sponsored by Democrat Representative Sander Levin, sets a similar objective of equal treatment under law.

The move could be Democrat’s way of pushing a carry bill through a Republican-controlled house, with some commentators, perhaps prematurely, describing the concession a major victory for buyout firms.

It seems lawmakers originally included the provision as a way of closing a perceived tax loophole. At the time the carry debate first started, Blackstone had gone public, and in the process of doing so had employed a one-sided tax structure that allowed the selling partners to pay a capital gains rate on goodwill, whilst at the same time amortising the goodwill over 15 years at ordinary income rates by entering into a tax receivable agreement with the buyers. 

Notwithstanding the questions of fairness, the result was that Congress effectively took a shotgun approach based on Blackstone’s structuring, potentially subjecting an entire private equity industry to this new enterprise value tax. This would have been a heavy blow, considering the goodwill element constitutes a significant portion (possibly even the majority) of the value of a private equity firm.

In practice, the buyout industry remains sceptical that enterprise value can be effectively separated from the firm’s carry and other assets. Because enterprise value is difficult to pin down, the industry argues, no one is ever really sure which part of a gain on the sale of a ownership interest should be attributable to future carry streams (and thus taxed as ordinary income), and which is part of the firm's goodwill (to be taxed a capital gain).

“Democrats want everyone to believe this problem is solved in order to get public opinion on their side”, gripes one industry lobbyist. 

One US-based tax lawyer told PE Manager he was advising clients to remove any carried interests from the parent advisory group as a potential solution to the problem. “If you keep it totally separate you hope the rule doesn’t come to bite you.”

No matter what solution is (hopefully) reached in the enterprise value challenge, it is a concession that should have been made five years ago, when the more worthy carry debate first opened.