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Thursday, June 21, 2007
Ways & Means to Examine Fund Managers' Tax Rates
The House Ways and Means Committee has announced hearings after the July 4 recess to examine tax rates applying to private equity and hedge funds managers. Committee chair Charles Rangel (D-NY) said he and ranking member Jim McCrery (R-LA) agree "it is imperative" that the committee conduct a hearing to explore taxation issues surrounding the "carried interest" issue.
Currently, about 70 percent of blue-chip fund managers use a scheme to qualify most or all of their income for the 15 percent capital gains rate by structuring their management fee as a share of profits. Victor Fleischer, a University of Illinois tax professor, told Bloomberg News yesterday that this practice costs taxpayers $4-6 billion a year (though this figure excludes some similar practices by venture capital, real estate, and oil and gas fund managers).
The two principal arguments in support of such schemes and the main counter-arguments go as follows:
1. Risk and Reward: Traditionally, managers have required investors to pay a fee equivalent to two percent of a fund's assets, a fee taxed at ordinary rates of up to 35 percent. The managers also receive fees of 20 percent of profits above a specified return, called "carried interest," subject to the 15 percent capital gains rate. To pay only the capital gains rate, fund managers agree to waive their two percent management fees. Doing so exposes them to contingency risk tied to value of the funds' holdings, putting them in the same position as the funds' investors, who pay capital gains rates on realized profits. They share the risk; shouldn't they share the rate?
This tax advanatge would be justified if -- or to the extent that -- the managers actually owned funds' securitized assets, as the investors do. But, except in rare instances, they do not. According to the logic of this argument, lawyers' fees from contingency cases should also be taxed at the capital gains rate.
2. Comparative Dis/advantage: The argument is propounded by "business representatives" (see today's
New York Times) that because some countries permit this practice, removing the tax advantage for American-based fund managers "could stifle American competitiveness."
First, this is tantamount to arguing that no American sector should pay more in any form of business tax than the lowest tax rate applied to any global competitor. Not only would such a policy's aggregate cost to American taxpayers be several hundred billions dollars a year, so many provisions of our tax code would need to be revised so often that tax planning itself would become impracticable, stifling American competitiveness. Second, this argument puts financial fund managers at pains of explaining why their sector deserves such a bountiful tax advantage at the expense of every other sector in the American economy. Given how profitable -- and politically unpopular -- the sector is today, that could be a pretty painful argument to make.
Posted by Dana Chasin
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