October 28, 2007
... of the carried interest bill. Rep. Rangel introduced a new version of the Levin Bill on carried interest (i.e. the broader House version) as part of his "mother of all tax reform" proposal. Of greater relevance is the possibility that the carried interest bill will be split off as part of an AMT patch.
$50 Billion. The Joint Committee on Taxation estimated the revenue from the carried interest legislation at $25 billion over 10 years. This is a bit lower than my back-of-the-envelope estimate, but still an impressive chunk of change. When you add in the proposal to end offshore deferral for hedge fund managers, you get about $50 billion, which is about what's needed to pay for the AMT patch.
The loan "workaround." One workaround to the original Levin bill would be to have the fund manager borrow money from the limited partners at a zero or below market rate of interest, followed by an investment of the loan proceeds in the fund. The net result would be a mix of ordinary income and capital gain. The new bill shuts down this strategy, treating a partnership interest purchased with proceeds of such a loan as an "Investment Management Services Partnership Interest," rather than a normal capital interest in the partnership. As such, any distributions to the service partner/fund manager would be treated as ordinary income. I would imagine that this amendment increased the revenue estimate by 20% or so. There is some additional language that shuts down similar avoidance strategies.
Offshore Deferral. I find it curious that hardly anyone is talking about the proposal to end offshore deferral for hedge fund managers. Under current law, hedge fund managers achieve deferral by organizing the fund in the Caymans and electing to be treated as a foreign corporation under U.S. law. (Because the Cayman Corp is engaged in securities trading, it's not treated as effectively connected with a US trade or business, even if the fund managers are working in Greenwich or elsewhere in the US.) In lieu of carried interest, the hedge fund managers structure their comp as an "incentive fee" from the Cayman Corp. They then set aside a large portion of their fee for deferral and reinvest the money (still using pretax dollars) offshore. The House legislation would end this strategy for corporations organized in certain tax haven jurisdictions.
The Senate. It's still not clear to me what's going on in the Senate. As I understand it, the Senate Finance Committee would rather waive the pay-go rules and provide an AMT patch without paying for it. It's not at all clear what's going on with carried interest--Schumer announced that he'd be introducing a new bill, but I haven't seen it introduced. At this point, I'd bet on the offshore deferral bill (introduced by Kerry) getting passed before carried interest. The Blackstone/PTP bill still seems to be alive as well.
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1. Posted by anon on October 28, 2007 @ 16:42 | Permalink
Can you explain the difference between offshore deferral and more common deferred income on Wall Street? Wall Street (and other industries) offer deferred compensation in an effort to lock in employees, or at least raise employment switching costs. Deferred compensation is granted as part of the bonus package, and vests over a minimum period, typically 4 years. The deferred comp is usually invested in investment options offered by the companies, but not necessarily hedge funds. Taxes aren't paid at the time of grant, rather at the point of receipt of the income. So if it vests over 4 years, 25% of the tax deferred income hits the paycheck each of the 4 subsequent years, unless the employee chooses a longer deferral.
I don't think this has anything to do with the companies being domiciled offshore in a tax haven, domestic companies that don't have any offshore subs are able to offer this option - so how is the offshore hedge fund special?
I don't think the employers are allowed to deduct the income as an expense until the year of vest, so for companies that are incorporated, I don't think there's a net impact to Treasury, which I guess would be different with pass-throughs.
2. Posted by anon on October 28, 2007 @ 16:50 | Permalink
Also - when you say, "which is about what's needed to pay for the AMT patch." isn't this a little misleading? Unless I'm mistaken, the JCT estimates on PE and HFs are revenues raised over the subsequent 10 years, and I don't think they're in current dollars. The AMT patch is for one year, and is essentially in current dollars.
3. Posted by Vic on October 28, 2007 @ 20:23 | Permalink
1. With the offshore deferral, the loss of the deduction to the Cayman Corp doesn't help because the Cayman Corp doesn't pay income tax in the Caymans (or the US). You are right that the usual deferred comp arrangement on Wall Street doesn't rely on offshore subs. As you suggest, if the employer is a taxpaying US corp, we can rely on substitute taxation to make up the revenue gap.
2. I don't mean to mislead about the AMT patch--that just the way that Rangel framed it. Presumably they'd have to find another "loophole" to close for another patch next year. (All the more reason to consider AMT repeal.) The JCT estimates are over 10 years; I assume it's discounted, but I'm not sure.
4. Posted by Joe on October 29, 2007 @ 14:21 | Permalink
Not sure I get Vic's #2 point above -- if it costs $50 billion for a one year fix, how is that a reason to consider outright repeal? Do you mean without offsets? I don't think you are saying that "it's expensive" is a good argument for not paying for something. Are you saying, instead, that this is a huge problem and we should identify the offset now in a big chunk rather than scramble each year to pay for it?
5. Posted by Vic on October 29, 2007 @ 14:41 | Permalink
Joe - exactly right - patching the AMT year by year masks the true cost of repeal. We need to face up to our increasing revenue reliance on AMT and figure out the broader array of spending cuts and tax increases necessary to repeal it. Of course, that doesn't seem politically likely this year, so maybe a one year patch is the best we can do in the short run.
6. Posted by Bewildered on October 30, 2007 @ 12:47 | Permalink
Vic describes the loan "workaround" that the bill shuts down as a loan to the manager from LPs "at zero or below-market rates of interest". In fact, the bill shuts down ANY LP loans, including ones with interest rates at or above market. I had thought Vic believed that the "cost of capital" approach to carried interest was ok. What's wrong with a market-rate loan from LPs to GPs on the "cost of capital" approach?
