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White House Wary of Raising Private-Money Tax
Rates
Private-Sector Groups To Study Fund Oversight
By John Godfrey
July 11, 2007A senior Treasury Department official Wednesday cautioned lawmakers about the risks of proposed changes to the tax treatment of private equity funds, hedge funds and their managers. The current system of allowing such managers to pay relatively low tax rates on carried interests in funds is good for business and good for the economy, Treasury Assistant Secretary for Tax Policy Eric Solomon said in testimony prepared for delivery before the Senate Finance Committee. In prepared remarks, Mr. Solomon had nothing positive to say about any of the proposed tax law changes. Under subsequent questioning, however, he declined to respond directly when asked whether Treasury is opposed to changing such tax laws.
"We should be cautious about making significant and unsettling changes in tax law," Mr. Solomon said when asked about a proposal to change the tax treatment of carried interest for fund managers. Asked whether Treasury opposes a proposal to treat as regular income the carried interest paid to a fund operating as a publicly traded partnership, Mr. Solomon said that proposal "raises very difficult issues." Treasury Secretary Henry Paulson directly criticized the proposal last month at the Wall Street Journal Dealer and Deal Makers conference in New York. "I don't believe it makes sense to single out one industry," he said at the time. With recent public offerings drawing new attention to hedge funds and the lucrative pay their managers receive, lawmakers are wondering whether they couldn't afford to pay more in taxes. Managers often pay the relatively low 15% capital gains tax rate on compensation paid in the form of carried interest rather than the regular income tax rates, which can be as high as 35%. PRIVATE MONEY ON CAPITOL HILL
Finance Committee Chairman Max Baucus (D., Mont.) and ranking Republican Charles Grassley (R., Iowa) have already introduced legislation that would change the tax treatment of hedge funds that are publicly traded partnerships. They would subject publicly traded partnerships engaged in investment management, such as The Blackstone Group and some other private equity and hedge funds, to corporate taxes. Messrs. Baucus and Grassley say they are concerned these investment management firms would use income exemption rules available to partnerships to claim their investment activities are "passive," thereby qualifying for lower capital gains and dividend tax rates, generally at 15%. Messrs. Baucus and Grassley instead would impose the maximum 35% corporate rate on these activities. 'Taking Advantage of the Tax Code' Mr. Solomon testified Wednesday that "while it is important to review our tax laws and policies, we must be cautious about making significant changes to partnership tax rules that we worked successfully to promote and support entrepreneurship for many decades."
But, Mr. Baucus said, it could be that "some people of great wealth are merely taking advantage of the tax code to pay less than their share." Mr. Grassley also rebutted the claim that the bill would impose a new tax on capital. "It is not an attack on the investor class," he said, adding the question is whether a manager's income should be taxed as capital or as labor. Mr. Grassley said the answer is clearly the latter: "This issue is about closing loopholes, not raising taxes." Mr. Solomon also criticized a proposal being considered in the House. Democrats introduced late last month legislation clarifying that any income received from a partnership -- capital or otherwise -- in compensation for services is ordinary income for tax purposes. As a result, the managers of investment partnerships who receive a carried interest as compensation would pay regular income tax rates rather than capital gains rates on that compensation. Mr. Solomon testified against the changes, arguing that the House Democratic plan would be difficult to administer and would overturn years of precedent. More importantly, the current tax system "encourages the pooling of capital, ideas and skills in a way that provides entrepreneurship and risk-taking," he said. 'Sweat Equity' Congressional Budget Office Director Peter Orszag said there may be an argument for treating some portion of a hedge fund manager's compensation as capital gain. But, Mr. Orszag said, there is "no solid basis" for treating no portion of that compensation as labor and therefore at the regular income tax rates. "A general partner in a private equity or hedge fund undertakes a fundamentally different economic role from that of limited partners, because the general partner is responsible...for managing the fund's assets on a day-to-day basis," Mr. Orszag said. Kate Mitchell, managing director at Scale Venture Partners, Foster City, Calif., said that her and her colleagues' work is not labor, but "sweat equity" and should be taxed accordingly. "Carried interest is like the stock received by the founder of a start-up company," Ms. Mitchell said. Raising the taxes on that interest, she said, would give managers "less incentive to spend the time and money" on their work. Private-Sector Groups to Study Regulation Separately, Treasury Undersecretary Robert Steel will tell the House Financial Services Committee that federal overseers are creating two private-sector groups, one for hedge-fund managers and another for hedge-fund investors, to develop practices for protecting investors and guarding against risks to the broader markets. The President's Working Group on Financial Markets, the interagency group, "is looking to highly respected leaders in these industries to create these guidelines because when leaders adopt best practices, others in the industry feel pressure to do the same," Mr. Steel said in the text of prepared remarks. The House committee is holding its own hearing on hedge funds to explore how federal overseers monitor systemic risk, and to learn whether any improvements are warranted. The hearing comes amid turmoil at some hedge funds after bets on subprime mortgages -- made to borrowers with weak credit -- went bad. The effort comes months after the working group, which includes members of Treasury, the Federal Reserve and other regulators, said that the current system of regulating hedge funds and other private pools of capital was working fine, and that no new rules were needed. Instead, the interagency group said "market discipline" was the best way to protect against systemic risk. Since then, some investors have been rattled by problems at two Bear Stearns hedge funds, which suffered after bets on the market for subprime home loans -- offered to borrowers with weak credit histories -- went bust. No 'Immediate Systemic Risk Issues' Mr. Steel and Federal Reserve board member Kevin Warsh noted that regulators' approach of working within the current regulatory system isn't a sign that federal overseers are taking a hands-off approach. "The emphasis on market discipline neither endorses the status quo nor implies a passive role for government," Mr. Warsh said in his prepared remarks. He said that, while banks have improved their practices for managing their exposure to hedge-fund risks, "further progress on this front is needed -- in no small part because of the increasing complexity of structured credit products such as collateralized debt obligations." Questioned about problems at hedge funds that bet on home-loans given to people with weak credit, Mr. Warsh said financial markets are repricing risk in light of those problems, but that they are not for now threatening to spill over and affect the broader markets. "We might not be at the bottom of this tumult," Mr. Warsh told the committee, but "we don't see any immediate systemic risk issues." Two top House lawmakers at the hearing remained cautious about saddling hedge funds with new regulations, saying more information is needed about the investment pools. Both House Financial Services Chairman Barney Frank, D-Mass., and Rep. Spencer Bachus (R., Ala.), the panel's top Republican, said hedge funds are worth more study. "I don't think anybody can be confident that all's entirely well here," said Mr. Frank. "But neither is there any obvious thing we ought to be doing."
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Mr. Baucus said there may be an argument for taxing that income
as a capital gain. Hedge fund lobbyists say managers are investing
in their funds, either directly or with their intellectual property,
and should be taxed accordingly. 