Biting the bullet on carry

For years now, US-based GPs have enjoyed capital gains tax status on their carried interest – their share of fund profits that can represent a significant percentage of total compensation. But with Congress once again engaged in a stare down on tax increases and spending cuts, some believe the tax treatment of carried interest will be used as a negotiating chip during discussions. If so, is there anything GPs can do to mitigate the tax impact?

Perhaps not, according to various tax lawyers speaking with PE Manager, meaning GPs would have to just grin and bear higher taxes on carry should they take effect (which would be 40.5 percent for top earners under ordinary income rates, up from a 23.8 percent capital gains tax for wealthy GPs). “I’m not sure there is any great idea out there that would work,” says Pepper Hamilton tax partner Steven Bortnick. “And if I did have it, I sure wouldn’t publish it,” he adds, explaining that past bills have been amended to close loopholes exposed by tax lawyers.

Often these loopholes would be exposed by the press, adds Edwards Wildman tax partner Scott Pinarchick. Policymakers reading the newspaper would become aware of “potential workarounds” in their legislation and address them by later inserting broad anti-abuse provisions, he explains. “My feeling is that if the US eventually passes carried interest legislation, it will be difficult to structure around it.”

Carl Levin: taxman personified

Indeed the latest legislative effort to raise taxes on carry, introduced in February by Senator Carl Levin, titled the The Cut Unjustified Tax Loopholes Act, or CUT Loopholes Act, includes anti-abuse provisions which allow the government to issue follow-up rules or guidance in the event some “loophole” is discovered.

However, until Levin’s bill passes, private equity lawyers emphasize it’s difficult to know what options private equity firms have before them in the event taxes on carry go up. And should a bill pass, there is “certainly no silver bullet” to mitigate the tax, says Debevoise & Plimpton tax partner Matt Saronson, who adds that planning ahead, before final language passes, can be counter-productive.

SENSITIVE OPTIONS

While no easy solution to tax hikes on carry exists, lawyers say some options are on the table, but none of them are particularly appealing.

“People might try to restructure holdings in existing investments in a way that may trigger the gain inherent in those investments today, even though they are not disposing of the asset yet,” says Saronson. This wouldn’t change the way firms structure their carry but rather provides a pre-emptive strike against any tax increase. Firms would be able to do this by refinancing transactions, where GPs borrow money and pay a leveraged distribution, according to lawyers.

However legal sources predict the option would experience limited popularity with GPs, even in the event carry tax hikes started to gain more traction in Congress.

Recently, “there was a lot of talk about putting structures in place to accelerate the gain, not really because of the carry bill, but because of the certainty that come 1 January the capital gains rate would be higher,” says Saronson, referring to so-called fiscal cliff negotiations in late December.

He elaborates: “Some would argue that if people didn’t do it in the face of a near certain increase in rates, it’s questionable whether they would do that in light of the carry bill.”

Another method that legal sources believe still works is structuring a GP’s carry with “founders stock”, which is the way portfolio management teams are incentivised. This works by providing the GP with shares in the portfolio company instead of carry in order to lock-in a capital gains tax rate.

“The problem is that it’s cumbersome, you are now doing this for every investment, and it totally changes the nature of carry to a deal by deal waterfall,” argues Bortnick.

LPs too have taken issue with a deal-by-deal waterfall arrangement. And any attempt to turn the structure back into a net sharing arrangement, where the GP would give money back from more profitable divestments if later on there was a loss on an investment, would be hit by “substance over form” principles. These principles would likely rule that the net sharing arrangement, although not a partnership in form, is in effect the same structure because the carry received from each investment is not separated, according to legal sources.

TAXING RELATIONS

GPs should also be mindful of their investor relations when searching for ways to soften the blow of higher carry taxes, should they arrive. In the past GPs have tried to negotiate provisions in their partnership agreements that said they could modify the agreements to minimise the impact of any carry legislation, says Michael Harrell of Debevoise & Plimpton.

Some GPs negotiated very aggressive language that said they could amend the agreement to minimize the impact of the change in tax law on their economics, he said. But most provisions soften that language by adding that no change can be made if it would adversely affect the LPs.

Unfortunately for fund managers, sophisticated investors are unlikely to grant such a request. “Like the rest of us, they have to deal with the taxes as they come,” said one public pension official in reaction to the trend. “I don’t think those would be terms that investors who have the downtown lawyers would go for.”

ODDS OF CHANGE?

But one thing LPs, GPs and their respective lawyers agree on is that there is no point in sweating over carry tax hikes until legislation is passed. And with Republicans in the lower chamber of Congress taking a hard stand on any tax increases after conceding some tax hikes on the rich earlier this year, that day may be long away, should it ever come at all. 

The industry too is doing what it can to convince Congress that the status quo should be preserved.  The Private Equity Growth Capital Council (PEGCC) recently releasing a video that aims to explain (using accessible language) why carry should remain a capital gain.

The group’s defence shows carry as a return on investments made by private equity partners. This is a rebuttal against those who argue it better represents a form of compensation for services rendered and thus should be taxed as ordinary income.

One such opponent is the nonpartisan Urban-Brookings Tax Policy Center. The independent tax analysis group, which has the ear of policymakers, released a paper arguing that “for too long, this income has simply been considered gain from the sale of stock and treated as capital”. The paper argues that as carry arises from the everyday operation of a business, it should be treated as income. 
Private equity firms may disagree, but should a bill make it through Congress that redefines carry as ordinary income, their best option appears to be taking it on the chin.