(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
Tax Bills Opposed by Hedge Fund Group Do Not Advance as Congress Recesses
Congress has recessed for August without taking up a bill that would temporarily
extend many expiring tax provisions of the Internal Revenue Code. The bill is
opposed by the hedge fund industry because it would wrongly pay for those
extenders by increasing the tax obligations of the hedge fund industry, in the
view of the Managed Funds Association. Similarly, Congress failed to act on a
bill fixing the alternative minimum tax that would also have ended the capital
gains treatment of carried interest earned by hedge fund and other asset
managers.
Just before the recess, cloture on the extenders bill was rejected by a
party-line vote, with 43 Republicans opposing cloture. In a letter to Senate
Republicans, the Managed Funds Association said that provisions of the bill
would adversely affect the competitiveness of U.S.- based hedge fund managers.
The House passed (H.R. 6049) the Energy and Tax Extenders Act of 2008 earlier
this year. The bill is now stalled in the Senate, primarily over these and other
revenue raisers.
To be competitive with non-U.S. based hedge fund managers and to meet the
demands of foreign and U.S. tax-exempt investors, explained the association,
U.S.-based hedge fund managers have established investment funds offshore.
Currently, the Code makes it necessary from a practical standpoint for U.S.
tax-exempt entities and non-U.S. investors to invest directly in those offshore
funds. The investors in these offshore funds expect the managers of the fund to
invest in the foreign fund in order to align their interests. U.S.-based hedge
fund managers establish offshore funds to meet the needs of these investors,
even though the managing of offshore funds can have negative tax consequences
for the manager and its employees.
Hedge fund managers therefore utilize both qualified and non-qualified deferred
compensation to attract and retain key personnel. Further, investors in offshore
funds frequently expect managers to make such deferrals because the deferred
amounts remain as general assets of the foreign fund, which continues to subject
them to risk of loss, thereby continuing the alignment of interests between the
manager and the investors. Ultimately, any deferred compensation is repatriated
and then generally taxed at the top ordinary income tax rate.
The proposal to eliminate the ability of hedge fund managers to defer taxation
on their compensation could affect existing contracts between hedge funds and
their managers and employees in a way that acts as a retroactive change in
settled law. The proposal would also have the effect of disrupting compensation
programs that have been legitimately established. The MFA argued that such a
retroactive change could disrupt the management of offshore funds at a time when
the U.S. capital markets need the liquidity provided by such funds.
As explained by the House Ways and Means Committee, H.R. 6049 would tax
individuals on a current basis if they receive deferred compensation from a tax
indifferent party. Current law allows executives and other employees to defer
paying tax on compensation until the compensation is paid. This deferral is made
possible by rules requiring the entity paying the deferred compensation to defer
the deduction that relates to this compensation until the compensation is paid.
Matching the timing of the deduction with the income inclusion ensures that the
executive is not able to achieve the tax benefits of deferred compensation at
the expense of the Treasury. Instead, the entity paying the compensation bears
the expense of paying deferred compensation as a result of the deferred
deduction.
The Alternative Minimum Tax Relief Act passed the House by a vote of 233-189,
but has also stalled in the Senate. To make the bill revenue neutral, the House
offset the AMT fix by providing that carried interest earned by hedge fund
managers be taxed as income rather than at the lower capital gains rate at which
it is currently taxed. Hedge fund managers often receive asset-based management
fee of 2 per cent and 20 percent of fund profits, which is called carried
interest. The House believes that carried interest is money earned on a service
provided by the asset managers and should thus be taxed as income.
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