Details over at TaxProf, where I am guest-blogging this week.

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The Yale Law Journal Pocket Part has published Part I of its Sovereign Wealth Fund Symposium, including a brief but valuable contribution by Mihir Desai and Dhammika Dharmapala.  Desai and Dharmapala's essay responds to my paper, A Theory of Taxing Sovereign Wealth, in which I argue that current law subsidizes investment by sovereign wealth funds, and that we should change existing law to eliminate this subsidy.

Desai and Dharmapala argue that the subsidy I identify is illusory.  Similar to the work of Bittker, Knoll, and others on the tax exemption for non-profits, Desai and Dharmapala argue that because sovereign wealth funds are tax-exempt on all of their investments, they must employ a higher (after-tax) hurdle rate in evaluating investments than do taxable investors.  As such, they argue that imposing a tax on dividends at the same rate as taxable investors would drive sovereign wealth funds out of the equity sector and to other countries where such investments would not be taxed.  Exempting sovereign wealth funds from tax, they conclude, does not give them a competitive advantage over private investors, but merely allows them to make the sound financial investments that they would otherwise make. 

I disagree with Desai and Dharmapala for three reasons.  The first is factual.  Sovereign wealth funds are not, as they assume, exempt from tax everywhere.  In Germany and much of Europe, they are taxed as private investors. 

Second, as Michael Knoll has suggested, the difference in tax rates between interest and dividends for foreign private investors (zero vs. 30%, or 15% if a treaty applies) and SWFs (zero for both) may lead SWFs to allocate more investment into equities than private investors do.  In other words, the relevant comparison is not limited to how SWFs are taxed abroad, but also how equity is taxed relative to debt. 

Third -- and this is not so much a disagreement as an observation -- Desai and Dharmapala are engaged in a somewhat different inquiry than I am.  They assume that SWFs are investing purely for financial reasons, while I assume that some SWFs have mixed financial and geopolitical motives. 

This debate raises an empirical question that is difficult to answer -- if the US were to impose a tax on dividends received by SWFs, where would they shift their investments, assuming they would shift at all?  Because their investments are typically structured as convertible debt/equity hybrids, and because SWFs are sensitive to geopolitical concerns, I suspect that the closest substitute would be a subordinated debt investment in the US, not an equity investment abroad.  If that's right, then the difference between tax rates on debt and equity for private and sovereign investors is more important than the difference in tax rates on equity investments here and abroad. 

References

Mihir Desai & Dhammika Dharmapala, Taxing the Bandit Kings (Yale Law Journal Pocket Part)

Michael Knoll, Taxation and the Competitiveness of Sovereign Wealth Funds (SSRN draft)

Victor Fleischer, A Theory of Taxing Sovereign Wealth (NYU L Rev, forthcoming)

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Gregg Polsky (Florida State) has posted a new paper, Private Equity Management Fee Conversions.  Here's the abstract:

Because of the uproar over "carried interests," it seems that almost everyone knows that the tax law currently allows private equity managers to pay capital gains taxes on a substantial part of the (often substantial) income generated by their services. While this result raises significant tax policy concerns, the basic tax law governing carried interests is well-settled, and legislative action therefore would be necessary to address these concerns.

In contrast, a little-known technique utilized by private equity managers to convert the character of their remaining compensation income is extremely aggressive and subject to serious challenge by the IRS. Private equity managers regularly attempt to convert their fixed annual two percent management fees into additional carried interest through so-called "management fee conversions." The tax result, if this technique is successful, is the conversion of current ordinary income into deferred capital gains.

Despite the recent spotlight on the taxation of private equity management compensation, surprisingly little attention has been paid to this particular tax minimization strategy. This article attempts to fill that void. Its purpose is twofold. First, it will describe the mechanics of management fee conversions, which are pervasive within the private equity community but not widely appreciated or understood outside of it. Second, it will discuss the tax issues stemming from management fee conversions, focusing on the IRS arguments that could be made to disallow their intended tax results.

Gregg's contribution is an important one to the carried interest debate.  While my Two and Twenty paper focused on the "in plain sight" conversion of service income into capital gain through the straightforward use of carried interest, Polsky focuses on the more subtle gamesmanship of converting management fees into additional shares of carried interest. 

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I've posted my Sovereign Wealth paper on SSRN.  The paper will be published in the NYU Law Review in 2009. 

You can download the paper here.

Here's the abstract:

Sovereign wealth funds enjoy an exemption from tax under section 892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign sovereign earns income from non-commercial activities in the United States. The provision, which was first enacted in 1917, reflects an expansive view of the international law doctrine of sovereign immunity that the United States (and other countries) discarded fifty years ago in other contexts. The Treasury regulations accompanying section 892 define non-commercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. Because section 892 was not written with sovereign wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined before.

This Article provides a framework for analyzing the taxation of sovereign wealth. I start from a baseline norm of “sovereign tax neutrality,” which would treat the investment income of foreign sovereigns no better and no worse than private investors’ income. Nor would it favor any specific nation over another. Whether we should depart from this norm depends on several factors, including the external costs and benefits created by sovereign wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage sovereign wealth fund investments in the equity of U.S. companies. If desired, the tax could be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability.

The case for repealing the existing tax subsidy is strong. We should tax sovereign wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize sovereign wealth. My analysis also shows that imposing a special excise tax may not be the optimal regulatory instrument for managing the special risks posed by sovereign wealth funds, although a carefully-designed tax would be more effective than the status quo.

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It's been a year since the peak of the uproar about taxing carried interest.  In the year since, the conventional wisdom about what happened has been established.  It fits pretty tightly with what some public choice theory suggests:  legislators engage in rent-seeking behavior.  In other words, it's not just the interest groups and their lobbyists who play hardball.  Kimberley Strassel writes in the WSJ:

The corporate world got an early taste of this last year, when New York Sen. Chuck Schumer used his majority status to take advantage of his home-state financial industry. It works like this: Mr. Schumer steps up to protect hedge funds and private equity from his own party's threats of taxation. In return, a grateful industry writes enormous campaign checks that Mr. Schumer, as head of the Democratic Senatorial Campaign Committee, is now using to increase his party's majority. Somewhere, Mr. DeLay is whistling in appreciation.

Sounds right to me.  For a more complete discussion, see Darryl Jones, The Taxation of Profits Interests and the Reverse Mancur Olson Phenomenon.  Darryll testified to Ways and Means last September.   On legislators as rent-seekers, see generally Ed McCaffery & Linda Cohen's Shakedown at Gucci Gulch and McChesney & Doernberg, On the Accelerating Rate and Decreasing Durability of Tax Reform, 71 Minn. L. Rev. 913 (1987) (available here).

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I decided to see how often the Internal Revenue Code and Immigration and Nationality Act have been amended of late.  And, as you probably expected, nothing beats the IRC for congressional tinkering.  Here's the number of sections of the code amended since 2001:

For a little comparison, here's the number of sections of the INA over the past few years:

Both huge statutes, both big issues - but man, Ways and Means stays involved in our tax affairs.  The DHS oversight people and Tom Tancredo have nothing on those guys.

Of course, the methodology employed here might be suspect.  Here's what I did, and I'd welcome your comments about what I did wrong.  I downloaded the credits for each section of each act from Westlaw.  That gave me a massive text file.  Then I used Concordance to give me a frequency count for each time a year was cited in the credit sections.  And voila, a hit for each year that the GPO recorded an amendment for each section.  Of course, I'm sorta depending on the GPO or whoever to accurately record amendments, but I'm not really sure how else I could do it.  Thoughts?

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The WSJ reports that some high profile horse trainers are sponsoring an investment fund that will buy promising thoroughbreds, complete with a 2&20 carried interest management structure. 

The carried interest portion of the structure will presumably qualify for long-term capital gains treatment for the trainers under current law.  But I have trouble imagining the argument that they, or the racing industry, deserves a subsidy.  I like horse racing as much as the next guy, probably more.  But why would want to use the tax code to subsidize investment in horses?  I'm having trouble seeing the positive externalities generated by the sport. 

This will provide a nice talking point the next time Congress holds hearings on carried interest. 

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Have you filed your taxes, yet?

Normally, I wait until April 15, but I decided to get on it early this year. I filed electronically yesterday. Today I received emails indicating that my filings had been accepted.

Thank you, Turbo Tax!

I was just reflecting on whether there is another product for which I have such warm feelings today as Turbo Tax.

Canaria Cheese, perhaps. We had some of this wonderful cheese, from Carr Valley Cheese in LaValle, Wisconsin. this afternoon.

Or Les Schwab Tire Centers. I have written about Les Schwab before, and I was absolutely thrilled last summer to find a Les Schwab outlet a mile from my house. We replaced the tires on one of our cars almost immediately after arriving in Utah, then did another car this past Friday. Impeccable service. One of our neighbors noted that we could have saved money at Costco, but Les Schwab is well worth the premium.

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The Senate Finance Committee is interested in taxing sovereign wealth funds.  Or at least they want to learn more:  Baucus and Grassley have asked the Joint Committee on Taxation to write a report. 

Meanwhile, on the non-tax front, Gilson & Milhaupt have posted Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to New Mercantilism.  They suggest suspending the voting rights of SWF equity investments (the voting rights would return when sold to a private investor).  Seems very sensible, and a good start, although I'm not sure that it's sufficient to fully address the concern.  If you are a 10% owner of a publicly traded corporation, I'm not sure you need voting rights or a board seat to have influence over corporate policy.  Still, Gilson & Milhaupt's proposal seems like a sensible place to start the corporate governance discussion.  See also Paul Rose, Sovereigns as Shareholders.  Paul prefers the best practices / code of conduct approach.

I hope to post my own tax-focused paper in a couple of weeks.  Stay tuned ...

Prior posts: 

Current Law on Taxing Sovereign Wealth Funds: Why It's Good to Be the King (March 5, 2008)
Taxing Sovereign Wealth Funds (March 4, 2008)

Related Research:

Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone (forthcoming Tax L Rev)

Press Coverage:

AP / SF Chronicle (March 7, 2008)
Financial Week (March 5, 2008)
NYT Deal Book (March 5, 2008)
Dealbreaker (March 4, 2008)

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For those interested in non-tax issues, The House Financial Services Committee is currently holding a hearing on Sovereign Wealth Funds.   

For the tax nerds out there, I thought I might offer a short overview of how SWFs are currently taxed.  In future posts, I will propose some reform alternatives for Congress to consider.

The big picture is that Sovereign Wealth Fund investments in the United States are generally exempt from tax under Section 892 of the Code.  The idea is that when a foreign sovereign makes a portfolio investment in the United States, the sovereign is acting as a sovereign and is entitled to sovereign immunity. 

There is an exception for commercial activity.  So, for example, if the government of Italy were to operate a cycling touring company in the United States, the profits from that active business activity would be taxed as business income.  (Similarly, if a customer of that touring company fell off the bicycle and got hurt, Italy would not be immune from tort liability.)  The key for Sovereign Wealth Funds is that portfolio investing is *not* treated as a commercial activity under current law.  So the returns from their investments -- interest, dividends, capital gains -- are categorically exempt from tax.

The detail start to get a little complex, so I'll continue below the fold.

General Rule.  The general provision is Section 892(a)(1).  That section says that a foreign government's income from investments in the United States in (1) stocks, bonds, and other domestic securities, (2) financial instruments held in the execution of governmental fiscal or monetary policy, and (3) interest on deposits in US banks isn't includible in gross income and is therefore exempt from US tax. 

Section 892(a)(2) then carves an exception for income derived from a commercial activity, a controlled commercial entity, or the disposition of an interest in a controlled commercial entity.  These are all terms of art, which I'll explain in a minute. 

If any income isn't exempt, then Section 892(a)(3) says that the foreign government will be taxed as a corporate resident of its own country.

Foreign Investors.  What would it mean to tax a SWF as a corporate resident of its own country?  If the income is effectively connected with a US trade or business (ECI), then the income would be taxed on terms similar to a US business.  For non-ECI investments, however, the rules are a little different for foreign investors than US investors.  For non-ECI investments, a foreign corporation would be subject to tax on its FDAP income.  FDAP stands for fixed or determinable, annual or periodic income -- which means things like dividends, interest, rents and royalties.  What makes these streams of income special is that they can be withheld at the U.S. source of that income.

So the tax Code imposes a 30% tax on FDAP income to foreign investors, withheld at the U.S. source, such as a US company paying a dividend.  This tax rate is often reduced by treaty agreement.  Also, certain portfolio interest is also exempt, allowing US companies to borrow more freely abroad.

Capital gains are not FDAP income.  Portfolio capital gains are not taxed in the US -- they are instead treated as foreign source income and therefore not taxed here.

Lastly, direct U.S. real estate holdings and certain indirect real estate holdings are subject to FIRPTA, which imposes a withholding tax on gains from the sale of US real property. 

Why It's Good To Be the King.   There are thus a limited but significant number of ways in which it's better to be treated as a foreign sovereign than a foreign private investor--most notably, dividends, certain types of interest payments, and real estate holdings.  Under the applicable 892 regulations, the exemption for sovereigns is extended to "integral parts" or a foreign sovereign (such as an agency) or a "controlled entity" of a foreign sovereign, i.e., a separate juridical entity (such as a corporation).  Foreign-controlled pension trusts for employees of the foreign government also qualify under the regulations. Under the regs, then, SWFs qualify as controlled entities of a foreign sovereign. 

The regs also require that to qualify as a controlled entity, the earnings must not inure to a private person.  For some government funds, like those controlled by Norway or Canada, this doesn't seem too difficult to show.  Singapore also seems pretty transparent on this point.  For others, like UAE, Saudi Arabia, and China, it's harder to know what happens to the earnings. 

How the rules work in practice.  SWFs are usually organized as separate juridical entities, funded and controlled by a foreign sovereign, and therefore qualify under the regulations as "controlled entities" of a sovereign.  The usual investments by SWFs in stocks, bonds, bank deposits, and government obligations are exempt from tax.  When these passive investment activities are mixed with commercial activities in the same investment vehicle, the tax rules get complicated.  There may also be circumstances where the SWF may blur the line between passive investing and operating a financing business.  But for present purposes, the analysis of current law is pretty straightforward.

To my knowledge -- and I welcome any comments from practitioners out there -- the Service has not looked into whether the earnings from SWF inure to a private person rather than the sovereign.  This inquiry is difficult, of course, in the case of royalty -- is a Prince a private person or a sovereign? 

That's enough current law for now.  In the next post, I'll talk a bit more about why all of this matters.

For more, check out the Tax Management Portfolio (913), U.S. Income Taxation of Foreign Governments, International Organizations and Their Employees.  Brett Dick (Heller Ehrman) is the author, and it's a great companion to the code and regs.

Prior posts: 

Taxing Sovereign Wealth Funds (March 4, 2008)

Related Research:

Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone (forthcoming Tax L Rev)

Press Coverage:

Financial Week (March 5, 2008)
NYT Deal Book (March 5, 2008)
Dealbreaker (March 4, 2008)

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My newest research project looks at the taxation of sovereign wealth funds.  The paper is still a work-in-progress, but here is where I think I am headed:  Under current law, Sovereign Wealth Funds are exempt from U.S. tax.  Congress should consider amending Section 892 of the code to tax these state-owned investments under certain conditions, and the Code should not favor state-owned investors over private foreign investors.  As with Two and Twenty, I think this is an example where the investment world has changed since Congress wrote the rules, and it is time for an update.

Overview. Under current law, based on the principle of sovereign immunity, investments by foreign state-owned funds and controlled entities are generally exempt from tax.  Commercial activities in the US may be taxed, but portfolio investing is not considered a commercial activity. 

By contrast, investment returns by private foreign individuals and corporations are taxed at rates as high as 30%, although this rate is often reduced by treaty agreement, or, in the case of most capital gains, treated as foreign source income and therefore exempt from U.S. tax.  Encouraging foreign investment in the United States generally increases overall welfare.  But there is no sound policy reason to unconditionally exempt state-owned investment funds from U.S. taxation, and it is not at all clear that we should give state-owned funds a competitive advantage that crowds out private investment.  At the same time, policymakers should proceed with caution, as raising tax rates on Sovereign Wealth Funds could be perceived as a protectionist signal that could discourage both state-owned and private foreign investment.

Regulatory arbitrage between investment regulation and tax.  One policy concern is how the funds want to have it both ways.  On the one hand, they present themselves to the SEC and other regulators as if they are just like any other institutional investor, investing for purely commercial purposes.  And thus, they argue, they should not be subject to any additional regulatory burden of disclosure, transparency, or anything else.  On the other hand, for tax purposes they are treated as sovereign states and thus entitled to sovereign immunity from taxes.  The net result of our regulatory scheme, then, is to give state-owned funds a competitive edge over private investment.

Continued below the fold.

What Are SWFs?  Sovereign Wealth Funds are investment vehicles funded and controlled by foreign governments.  The largest funds are controlled by Abu Dhabi (UAE), Saudi Arabia, Norway, Singapore and China.  These funds have grown rapidly in recent years.  Together these funds control perhaps $2-$3 trillion in capital, an amount which exceeds the size of the US private equity industry.  Fueled by oil profits and/or trade surplus, SWFs are expected to grow to as much as $10 trillion or more over the next ten years.  Historically, foreign governments would often recycle trade surplus back into the United States by buying Treasury bonds.  More recently, these governments are taking a more active investment role, seeking a higher yield than what Treasury bonds offer.  SWFs are the investment vehicles they use to do that.  Their portfolio investments include a mix of corporate debt, governmental obligations, and corporate equity stakes. 

Sovereign Wealth Funds have a complex relationship with the private equity industry.  For the last 20 years or so, SWFs have often been limited partners in private equity funds.  At times, SWFs make direct investments in target companies, competing with PE funds for deal flow.  Most recently, SWFs have purchased direct equity stakes in private equity sponsors and other US financial institutions such as Blackstone, Citigroup, and Merrill Lynch.  One way to think about SWFs is as a low-cost (and tax-subsidized) provider of capital to the PE industry. 

Why This Matters.  The big worry is that these sovereign wealth funds are Trojan horses which will allow foreign governments to shape and influence American enterprise in a manner inconsistent with our economic and national security interests.  Even if funds are currently acting in a manner consistent with other, non-governmental institutional investors--and by most accounts they are--there's no guarantee that they will continue to do so in the future in circumstances where the financial interests of the fund and the political interests of the government that controls the fund diverge.  Giving foreign governments partial ownership of companies like Citigroup and Merrill Lynch gives those countries new leverage in foreign policy discussions; sudden withdrawal of foreign state-owned investment could harm the financial services sector of the U.S. economy.  Of course, one can also view these investments in a more positive light; China's investment in Blackstone might help it learn to modernize its own financial infrastructure, a development which would benefit the U.S. and China alike. 

How They Are Taxed Currently.  Section 892 of the Internal Revenue Code exempts foreign sovereigns from income tax on their passive investment activities.  Foreign individuals and corporations, by contrast, pay taxes on most passive investment activities at rates ranging from 0% to 30%, depending on treaty agreements and the nature of the investment.  With the exception of certain real estate investments, foreign investors generally don't pay tax on capital gains from portfolio investments.   The tax code thus has the unintended effect of subsidizing state-owned capital over private capital, particularly on debt investments.

What To Do About It.  The policy objective is to tax Sovereign Wealth Funds as we tax private foreign  investors, and perhaps only on the condition that they are investing in a manner consistent with commercial portfolio investment. 

The most far-reaching option would be to raise the baseline tax rate on all returns from sovereign wealth portfolio investments, including capital gains, at a 30% rate.  Like the flat 30% rate on passive "FDAP" income to foreign individuals and corporations, this tax rate would be reduced by treaty agreement.  This approach would raise significant amounts of tax revenue, and it would give the U.S. a new policy lever to achieve nontax objectives, such as encouraging SWFs to comply with best practices of transparency, disclosure, and accountability.  Because capital gains cannot be withheld at a US source, however, this approach would be very difficult to administer.

An intermediate option would simply put SWFs on equal footing with other foreign investors.  As such, most capital gains would be exempt from tax, but passive FDAP income (interest, dividends, etc.) would be taxed at a 30% rate (withheld at the source), unless a lower rate were negotiated by treaty.  This option would be easier to administer and enforce, and it would still help achieve some of the nontax policy objectives noted above.

I'll discuss other reform alternatives--and the many complexities of the proposals--in future postings. 

Prior Related Research:

Two and Twenty (forthcoming NYU L Rev)

Taxing Blackstone (forthcoming Tax L Rev)

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This was the opening line of Mike Huckabee's speech yesterday, who, of course, is running on the idea of abolishing the IRS and all federal income tax. To be replaced with the "fair tax," a national consumption tax. To be sure, people disagree about whether the tax will be fair, or if it would hit low-income households harder than others because they sometimes pay more for the items that they consume. Nevertheless, it was an opening that received lots of cheers.

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At a conference on elections at the University of Maryland School of Law, Dorothy Brown gave a very interesting presentation on tax issues and the presidential elections. She began with an anecdote that Warren Buffett used at a fundraiser last year, and which made the round of some of the blogs.  In 2006, Warren Buffett had $46 million of taxable income, while is secretary earned $60,000.  Warren Buffett’s tax rate was 17.7% and his secretary’s was 30%.  Although he surely did not object to his relatively lower tax rate, Buffett made it a point to emphasize that he was not deliberately trying to avoid paying higher taxes, and hence did not utilize tax shelters.  Of course Buffett’s taxable income stems from capital gains, while his secretary’s taxable income stems from wages.  As Dorothy Brown pointed out, however, Buffett’s point appeared to be that the tax system favored wealth over wages.  For people who believe that giving a preference to wealth creation is critical to stimulating the economy and thereby enhancing the market, Buffett’s comments may not be viewed as troubling.  However, they certainly reflect some inequities in the system.  After an evaluation of all the tax plans of the presidential candidates (at least all of those who were in the race last week), Brown concluded that the tax plans advanced by Senator Obama and Senator Edwards appeared most likely to address Buffett’s concerns because they would increase the capital gains rate, and Obama’s plan would create new tax credits for workers aimed at offsetting payroll taxes.  To be sure, your presidential decision may not be driven be either tax concerns or Warren Buffett.  However, Brown’s talk raised some interesting points of comparison.   Brown also noted that Buffett’s comments were made at a $4600 fundraiser for Senator Clinton, whose tax plan was apparently one of the ones least likely to resolve the issues he raised.

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... 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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My interview with Andrew Ross Sorkin appears in the NYT Dealbook print section today, or click through to Dealbook. 

The carried interest buzz today is all about Senator Schumer, who has announced that he'll be introducing a broader carried interest bill very soon.  From here on out, I think the serious carried interest debate is about scope and timing, as well as the mechanics of the reform. 

At one extreme, you could see a very broad carried interest bill, hitting all industries, enacted in November.  At the other extreme, you could see the Baucus-Grassley PTP bill enacted, which would hit only a handful of PE firms, and that bill might be coupled with long transition relief rules.  Broader carried interest reform would have to wait.  (For more, see Taxing Blackstone.) 

I would have thought that the narrower PTP bill would be more likely to succeed in the short run, but Schumer's bill could certainly change the dynamics.  Any predictions?   

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Senator Levin introduced new legislation today on the tax treatment of stock options.  Under current law, companies take a financial accounting expense for stock options up front, when the options are granted (or ratably over the vesting period).  But they take a tax deduction later, when the options are exercised.  Levin's bill would harmonize the tax and financial accounting treatment.  So far so good.

But there is a bad side effect of Levin's proposal.  He may be replacing one gamesmanship opportunity with another.  Specifically, Levin's proposal severs the traditional link (in section 83(h)) between the employer's tax deduction and the employee's tax inclusion.  This too is an important matching principle that restrains gamesmanship.  By accelerating the tax deduction for the corporation to match its financial accounting expense but leaving the deferral for the employee's tax inclusion in place, Levin's proposal creates a new arbitrage opportunity which might be worse than the status quo. 

David Walker and I are writing a paper on this (tentatively) titled "The Paradox of Executive Compensation Book/Tax Conformity."  We don't yet have an SSRN-worthy draft, but here's the basic idea:

We should resist the allure of book/tax conformity, at least in the context of executive compensation. Conformity between the tax and financial accounting treatment of executive compensation seems appealing because it would restrain certain types of gamesmanship. Managers could continue to massage reported earnings, or to minimize corporate taxes, but they could not do both at the same time. By focusing on gamesmanship by the employer, however, book-tax conformity proponents overlook other elements critical to the integrity of our existing approach to taxing executive compensation, such as the importance of preserving tax rules that match the executive’s timing of income with the employer’s deduction.

Consider three potential policy goals in the context of executive compensation: (1) book/tax conformity, (2) matching the employer’s tax deduction with the employee’s inclusion, and (3) preserving a realization-based system for individual taxpayers. This Article argues that we cannot achieve all three of these goals at the same time. Rather, we must choose only two. The first goal, book/tax conformity, prevents regulatory arbitrage between the tax and financial accounting systems. The second goal prevents regulatory arbitrage between the tax treatment of employers and employees. The third goal, preserving the realization doctrine, makes the tax system more administrable and furthers other tax policy goals. Shifting toward book-tax conformity might reduce gamesmanship in one area but would increase arbitrage opportunities in another area. In light of this trade-off and other consistency considerations, we conclude that the status quo—which forgoes book/tax conformity in favor of employer-employee matching in a realization-based tax system—remains the best policy option.

Any comments or suggestions would be most appreciated.

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Here's an excerpt from the National Venture Capital Association, talking about compensation and economic growth.  Can you guess what [x] is? 

Without a doubt, [x] [is] an important part of a successful formula.  Venture-backed companies, steeped in the culture of shared ownership, have had an enormous impact on the American economy. ... In the current shower of negative press over the excesses of a few, it is important to keep our eye on the real economic prize and the role that [x] [has] played in maintaining economic growth.

As we can see from the troubles in many economies, here and abroad, growth in jobs and GDP cannot be taken for granted.  ... Just as [x] [has] been an essential part of the engine that has driven America's entrepreneurial leadership and economic growth over the last decade, [it] can be a key to a brighter future for many more.  ...

But the U.S. does not have a monopoly on [x].  We see an example of the need to be prudent in the technology area, which has serious competitors outside the U.S.  Taiwan, for example, has built great technology companies on the foundation of [x].  ... These strong Taiwanese companies have been built with American engineers and managers who joined them in part because of more favorable [x] treatment in Taiwan.  The Peoples Republic of China is also beginning to build a technology industry with the help of [x].  Several European nations are revising their accounting rules to encourage the use of [x].  The world has taken notice of our economic success and has discovered the importance of [x] as a competitive tool.

So .. can you guess what [x] is?  Hint:  It's not carried interest.

It's stock options.  The NVCA lobbied heavily against the proposal to record stock options as an expense on the income statement, arguing that the accounting change would substantially harm the technology industry.  The accounting change was eventually made a couple of years ago, and yet the sky has not fallen, and Silicon Valley has not moved to Taiwan. 

The same goes for carried interest.  Changing the tax treatment of carried interest will not cause the sky to fall, I promise. 

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I'm heading down to DC in the morning for a debate on carried interest hosted by the American Enterprise Institute.   The event is at 2 pm; details here. 

The carried interest buzz today was about the National Venture Capital Association breaking ranks with the private equity industry by suggesting that legislation, if enacted, should carve a distinction between the buyout industry and the venture industry.  It was suggested that this could be accomplished by retaining the status quo for funds that invest in new companies.  But even if that were a good idea--and I remain unconvinced that VCs need a tax subsidy--I don't understand how it would work mechanically. 

For example, when a buyout fund buys a division of an existing public company, those assets go into a new corporation managed by the fund.  Does that count as a new corporation?  Or an old one?  What about start-ups that struggle along with angel financing for a few years and then get venture financing.  Newco or Oldco?  Limiting the capital gains preference to companies held for more than 4 years excludes "buy it and flip it" deals, but also creates a greater lock-in effect.  I'm struggling to think of a way to distinguish between venture-funded portfolio companies and buyout-funded portfolio companies that would work.  One possibility, I suppose, is to revitalize section 1202, which reduces the capital gains rate for investments in small business corporations, measured by the size of the assets of the firm at the time of the investment.  This could be added into the Levin bill as an exception to the rule stating that investment partnership services income is treated as ordinary income. 

The best tax policy for encouraging entrepreneurship is to have a broad tax base with low rates.  The carried interest bill broadens the base and might stave off a hike in the top marginal rates.  Even assuming we want to use the tax code to encourage entrepreneurship, carving out venture capital from the Levin bill isn't the way to go about it. 

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Politico reports on the hottest tax issue in DC:  How much revenue would be raised by the carried interest bill -- or, as the tax nerds say, how will the Joint Committee score it? 

The Joint Committee on Taxation has responsibility for scoring tax bills, and they've been mum for some time.  That's understandable.  It's a difficult proposal to estimate, as one has to make and justify a lot of assumptions about how the industry works and how it might adapt to the new rules. 

The word on the street, from a couple of different sources in DC, is that the proposal will score "way higher" than the current estimates, including both Professor Knoll's $2-3 billion estimate or my own back of the envelope $4-6 billion annual estimate.  (The Politico story refers to Knoll as an "academic deity", which is even better than an "intellectual godfather."  Something to aspire to.)

One reason for the higher score is that we just looked at private equity, while the Levin bill would reach real estate, venture capital, and certain hedge funds as well.  The Levin bill would also raise a lot of revenue from the Medicare tax, which, by treating carry as ordinary income, subjects those wages to a 2.9% tax (uncapped, unlike social security).  Add it all up and I wouldn't be shocked by a score over $10 Billion annually.    Not enough to repeal the AMT by itself, but enough to make a dent.  Or maybe a dimple.

I should note that my sources are non-governmental, so who the heck knows what the Joint Committee -- the only source that matters -- is actually thinking.   Maybe someone will set up a prediction market.

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I'm in DC for tomorrow's Ways & Means Hearing on Fair and Equitable Tax Policy for America's Working Families.  In preparing for the hearing, I was reading the Joint Committee on Taxation's report on carried interest, which cites the Glom. (!)  See footnote 112. 

In the meantime, I've just posted a new paper on SSRN, Taxing Blackstone.  Here's the abstract:

This Essay analyzes the "Blackstone Bill," which would treat Blackstone and other publicly-traded private equity firms as corporations for tax purposes.  Earlier this year, the Blackstone IPO fueled a heated, somewhat confusing debate about taxing private equity.  This Essay seeks to clarify what the legislation will accomplish, and what it won't.

There are two ways of looking at the Blackstone Bill.  The first way is as a substantive change in the tax law.  Specifically, the bill may be viewed as a rifleshot approach to changing the tax treatment of carried interest.  The second way is to think of the bill as a mechanical correction of the publicly-traded partnership rules.  Specifically, the bill may be viewed as a technocratic response to the regulatory gamesmanship of Blackstone's deal structure, which allows it to avoid the corporate tax that other, similarly-situated financial intermediaries pay.

In terms of a change in the substantive tax treatment of carried interest, the merits of the Blackstone Bill are questionable.  The efficiency and distributive consequences are unclear; the revenue potential is indeterminate.  The bill fails to achieve what we ultimately want: taxing the returns from managing financial assets consistently regardless of the form in which the business is conducted.

But the Blackstone Bill is nonetheless defensible as a response to aggressive regulatory gamesmanship.  To put it more provocatively, the bill is justifiable because the Blackstone IPO structure is offensive to the rule of law values on which our tax system relies.

You can download the paper here, or email me.

Or, if you prefer the snazzy visuals (click on the images for a less-blurry view):

This paper was a tough one to write.  The normative case for taxing Blackstone as a corporation is weaker than I thought when I started the paper; the weakness relates directly to the shaky case for having a corporate tax at all.  And yet there is something to be said for enforcing rules, flawed as they may be.  I would prefer that Congress reform the taxation of carried interest and, so long as I'm at the wishing well, I would wish for reform of Subchapter M and integration of corporate and shareholder-level taxes.  But taking the corporate tax and current tax treatment of carried interest as a given (at least in the short run), I do think the Blackstone Bill is worth passing. 

I welcome your comments and suggestions by email. 

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Lynnely Browning profiles Lee Sheppard in the Int'l Herald Tribune.  I don't always agree with Lee, but she does a wonderful job of asking the hard questions and keeping us all current.  And give her credit -- a couple of years ago when the Treasury proposed partnership tax regulations which would quasi-codify the status quo on carried interest, Lee was the only one out there making a fuss. 

And what would we do without her cultural commentary on what the fashionable set in the Hamptons is wearing these days?

Speaking of the Hamptons, the rioting over carried interest has begun.

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Michael Knoll has a cool new paper estimating the revenue effects of changing the tax treatment of carried interest.  Depending on various assumptions, he comes up with about $3 Billion a year (see paper at p. 12; if character is changed to ordinary income, then additional tax collected would amount to between 2.4 and 3.4 billion).  I'd previously done a very rough back of the envelope calculation to come up with $4-6 billion a year. 

Among Knoll's key assumptions:

1) $200 Billion a year invested in private equity. Is this too low?  This is a high estimate by historical standards, but low given recent trends.  On the other hand, the recent credit market shakeup may slow fundraising for a while. 

2)  Scope of the change.  Knoll only looks at private equity, but at a minimum the change would also apply to hedge funds.  Hedge funds that make long-term investments might also be affected.  It's also possible that real estate, timber, and oil and gas partnerships might also be affected, depending on how the politics play out in DC.

3)  Volatility.  Knoll uses a Black-Scholes model to value the carry and estimates volatility of the average fund at 20%.  No idea if this is right - average volatility for a portfolio company would be much, much higher, but of course most PE funds have 10 or more companies in the portfolio.  I suspect we could find some historical return data that would help here.  Unfortunately, academics are at a distinct comparative disadvantage here, as the best data sources are proprietary and expensive. 

I'm also not sure what the Black-Scholes model gets you here, i.e., why it's better to use option methodology rather than just looking at historical returns for the sector as a whole. 

Knoll also discusses some possible re-structuring of the carried interest that might take place, and how that might affect revenue.  He notes, for example, that incentive fees might be paid by portfolio companies instead of the funds themselves, which -- if the portfolio company has a high effective tax rate -- generates a valuable tax deduction.  On the other hand, this changes the economics of the deal in ways that the LPs might not like (by measuring carry on a company-by-company basis rather than an aggregate basis), and it's not clear how many portfolio companies have a high effective tax rate.  (Recall that most portfolio companies take on a lot of debt in connection with the buyout.) 

It will be interesting to compare Knoll's paper with government's revenue estimate and methodology. 

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The Senate Finance Committee held another hearing on Carried Interest today; you can read the written testimony here. 

While the political issue is very much up in the air in DC, even among some Democrats, it's safe to say that there is an academic consensus among tax profs on the issue:  the status quo is problematic, and it should be addressed.   Three academics testified to that effect today - Joe Bankman (Stanford), Charles Kingson (Penn), and Darryl Jones (Stetson).  I'd previously testified at a committee roundtable, and Mark Gergen (Texas) testified at an earlier hearing.

We may not all agree on exactly what to do about the tax issue -- (1) tax the grant of a profits interest at ordinary income rates, (2) tax the returns at ordinary income rates at the back end, or (3) a hybrid approach (like my Cost of Capital or loan approach), or (4) even repealing the capital gains preference altogether.  Some of us would apply the changes to all partnerships, others would limit it to smaller partnerships.  But as more tax academics weigh in, it's clear that there's a consensus that this is an issue worthy of legislative action.  There's myself, Mark Gergen (Texas), Joe Bankman (Stanford), Dan Shaviro (NYU), Lily Batchelder (NYU), Noel Cunningham (NYU), Darryl Jones (Stetson), Alan Auerbach (Berkeley), Chris Sanchirico (Penn), and many others -- everyone agrees that there's a case for reform.  And this isn't a bunch of lightweights; nor is it a group that generally believes in higher taxes, or more redistribution. We tend to believe in a broader base and lower rates, and that's one way of viewing carried interest reform.  There are really few academic voices in dissent; the most prominent voice in dissent had his research sponsored by the Private Equity Council, so I'm not sure he counts on this issue.

What's remarkable about all this is that we tax profs are not a group that agrees on much -- there's division in the tax academy about income tax vs. consumption tax, corporate tax vs. full integration, territorial vs. worldwide taxation, whether to have an estate tax. 

One way to see why a consensus has emerged on this issue is to consider what happens to carried interest in a consumption tax world.  Consumption tax advocates tend to believe that not taxing capital income is the best way to grow the economy, as it encourages saving over consumption.  Now imagine a capital gains rate of zero, i.e. no tax on investment income.  In that world, private equity fund managers would pay no tax at all on their carry, since it qualifies as investment income.  (The fund managers get to exchange services for an investment in their own fund using pre-tax dollars -- and pay no tax on the back end, either.)  That can't be the right result -- carried interest obviously represents a return on labor, not capital.  So even if you have an underlying belief that encouraging investment is the best system for economic growth, we need to deal with the carried interest issue.  And it's this kind of thinking that explains why, in addition to the likes of the New York Times and Washington Post, you also have the Economist and Financial Times in favor of carried interest reform.

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Wow, did I pick the wrong week to move.  Blackstone went public, KKR is rumored to do the same, the Baucus-Grassley PTP amendment gathered momentum, Blackstone may lose its 5 year transition relief, and then the big one -- on Friday some House Dems introduced a bill that would tax carried interest at ordinary income rates.  Busy week.  I discovered that it's awfully tough to find a public wifi connection in the middle of Missouri (I was hoping to read the text of the House bill before close of business Friday).  Highlight of the trip was talking to a British reporter about the Blackstone IPO from a McDonald's in Macon, Missouri.  I managed not to ask the cashier what her tax rate is, fearing it might be higher than the Blackstone guys. 

A few quick thoughts about Blackstone and the new bill.

1.  What Blackstone's "poplet" means.  Blackstone closed its first day of trading about 13% above its IPO sale price, a modest pop.  But this almost certainly would have been higher if the Baucus-Grassley amendment hadn't gathered momentum and House Dems hadn't introduced new legislation.  All things considered, a successful IPO, and a good day for Blackstone. 

2.  The Blackstone IPO is not the new Netscape IPO.  Some folks are comparing the Blackstone IPO to the Netscape IPO - an indication both of a new bubbly era on Wall Street (then, a dot com era, now, a private equity era) and a loss of investor rationality.  But I think the better comparison is to that of Goldman Sachs back in 1999.  Goldman Sachs had been a partnership for a long time, and it was surprising to see Goldman go public.  But GS has thrived since then.  Similarly, Blackstone is becoming a mature, diversified, financial services firm, and its IPO makes sense for a lot of reasons, including acquiring a base of permanent capital for growth and shares for acquisition currency, as well as providing some liquidity to the founders and managing directors.

3.  Taxes are a small issue.  Senator Baucus suggested this week that he's open to the idea of shortening the transition relief period for Blackstone (and Fortress and Oaktree).  And of course if the House Bill passes Blackstone would pay 35% on its carried interest allocations.  But Goldman Sachs has done just fine despite paying tax at a 35% corporate rate.  Blackstone will be okay too -- the tax hike just takes a little froth out of the cappuccino. The fact that Blackstone completed a successful IPO in the midst of all of this shows that the real forces driving private equity returns go way beyond tax. 

4.  The House Bill seems rushed.  I still need to sit down and read the legislative text carefully, so I'll save my nits for later in the week.  Naturally, I'm pleased that someone has introduced legislation on the broader taxation of carried interest issue, but I'd been hoping that it would emerge first as a bipartisan bill from Senate Finance before being formally introduced in the House.  I don't see this as a class warfare issue, and I hope it doesn't become that.  To be sure, in an era of rising inequality, watching the richest pay tax at 15% doesn't make much sense.  But the longer we can keep the focus on good tax policy, the better.

5.  "We Pay Less in Taxes Than Our Janitors."  To defuse the class warfare issue, PE fund managers need a soundbite that works -  the "private equity pays less tax than the cleaners" soundbite is killing PE in Britain, and it will really hurt them in the US too.  Just as the civil liberties crowd is always hurt by the "Constitution is Not a Suicide Pact" line, PE needs to find a soundbite that works, and fast.  Suggestions welcome in the comments.  Nominations include "Assault on the Investor Class" (WSJ op ed), and "This Year's Man Behind the Tree" (Holman Jenkins).  Anti-PE slogans are more fun, like  "You Don't Know What a Few Extra Decimal Places Taste Like" (Return of the Player, via Percy Walker), Subsidizing the Barbarians at the Gate, or And You Thought CEOs Were Rich.

Related Posts:

Pricing Blackstone's Tax Risk

Oaktree Capital: The Other PE PTP?
The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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It's a taxation of carried interest fiesta at the WSJ today:

Editorial, The Blackstone Tax (calling Congress a bunch of communists)
Alan Murray, The Real Answer on the Blackstone Tax Rate (mentioning my cost-of-capital analysis)
Sarah Lueck & Brody Mullins, Rangel May Back Higher Levies on Buyout Firms (noting consideration of the Baucus-Grassley bill may happen as soon as July)
Peter Lattman, Academic Gets His Close-Up In Private Equity Tax Fracas (profiling me)
Peter Lattman, Law Blog (same)
Yvonne Ball, Blackstone IPO Expected to Make its Trading Debut on NYSE Friday (deal will be priced tomorrow night)

Curious how the tax issue will affect the pricing of the Blackstone IPO, which will be priced tomorrow.  Blackstone would get five years transition relief from the corporate tax under the Baucus-Grassley bill, which would dampen the effect of the change, plus it's hardly a sure thing that the bill will pass.  On the other hand, I've been hearing rumors that the Finance Committee is indeed considering a bigger bill on the taxation of carried interest (not just the PTP issue), which would moot the transition relief issue if passed.  But I should emphasize that I've heard this from reporters who are hearing this from lobbyists (not Senate aides) so who knows.  Across the pond, there's even more momentum for increasing the tax rate on carry. 

Related Posts:

Oaktree Capital: The Other PE PTP?
The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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The Blackstone Amendment stirred a lot of press coverage (see Paul Caron for all the links); I'm quoted in the NYT and WSJ today.  

What about Oaktree?  Most of the attention has been on Fortress and Blackstone.  But I suspect the legislation also affects Oaktree Capital, an investment management company based in LA.  Oaktree has about $40B assets under management, about half the size of Blackstone.  In a recent deal that bears many similarities to Blackstone, Oaktree sold about 15% of itself to institutional investors in a quasi-public offering.  The twist is that only a limited number of accredited investors can buy the shares, and they can only trade their shares through a portal managed by Goldman Sachs called GSTrue (Goldman Sachs Tradable Unregistered Equity).  (See the WSJ stories here and here.)  The idea is to get (most of) the liquidity of the Blackstone structure without the hassle of securities regulation that weighs on public companies.  

Brother, can you spare an offering memo?  I'm working at a bit of an informational disadvantage here, since I don't have an offering memo.  So I don't know exactly how the Oaktree structure works, or, for that matter, how Goldman's portal works; rather, I'm guessing based on the information in news reports.  Such are the challenges of academic research on private equity.

The PTP Rules.  With that caveat, it's hard to see why Oaktree wouldn't be affected by the Blackstone Amendment.  The PTP (publicly-traded partnership) rules affect both (1) companies that trade on established securities markets and (2) those that are readily tradable on secondary markets.  Surely Goldman's GSTrUE market counts as a secondary market.  And I would imagine that Oaktree is relying on the "qualifying income" exception to the PTP rules.  The new legislation, introduced Thursday by the Senate Finance Committee, would prohibit firms like Oaktree from relying on that "qualifying income" exception, and as a result, one would expect Oaktree's quasi-public partnership to get pulled in to the world of corporate taxation by Blackstone's undertow. 

Like Fortress and Blackstone, Oaktree would get five years of transition relief.  Oaktree was rushing to beat Blackstone to market.  I'm sure they are glad they did.  Five years of avoiding corporate tax is better than none. 

The future of quasi-public entities.  None of this heralds the end of the blurred public/private entity distinction.  There are broader forces at work (see generally Ribstein, and this recent paper by Ron Gilson & Chuck Whitehead).  But the Baucus-Grassley bill does signal that tax policy will not remain neutral on this topic; if you want to access our public (or quasi-public) equity markets, you must pay the corporate tax.  In light of how the capital markets have developed, whether that tax policy is sustainable in the long run is debatable. This isn't to say that the Baucus-Grassley bill is a bad idea.  So long as we have a corporate tax, we might as well police the rules.  The Baucus-Grassley bill is a sensible first step on the way to re-examining the taxation of carry (i.e. labor income vs. capital income) and the normative justification for the corporate tax (i.e. corporate tax vs. partnership tax).  Those topics may take years to resolve. 

Comments are closed as Miranda and I pack up to join the Bloggiest Law School Ever.  I welcome comments (and offering memoranda) at victor.fleischer (at) gmail.com.

Related Posts:

The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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A bill by Baucus and Grassley was just announced.  See here.  It's a rifleshot approach that makes investment advisory and asset management firms ineligible for the 7704(c) "passive-type" income exception.  Blackstone, as a publicly-traded partnership, will be taxed as a corporation under the general rule of section 7704.

Interestingly, as I read the statute, Fortress and Blackstone would receive five years of transition relief, with the amendment not kicking in until 2012.  The legislation shouldn't affect the pricing of the Blackstone IPO too severely, then, although the additional 35% tax at the entity-level will still bite a little, even discounting it five years out. 

Of course, if Congress changes the tax rules relating to carried interest before 2012, the transition relief becomes less helpful. 

This is all pretty sensible.  Congress will close the PTP loophole using a very narrow fix, and will continue to consider the taxation of carry, but without completely blowing up the Blackstone deal in the meantime over a tax issue. 

(N.B. Because the amendment targets investment advisory and asset management firms, oil and gas partnerships - the main users of PTPs, are not affected.  Which sort of begs the question why oil and gas firms should get the benefit of avoiding the corporate tax while financial services firms have to pay up.  But I can see why the Finance Committee doesn't want to open up that particular can of worms.)

Previous posts on Blackstone:

The Blackstone IPO: Two and Twenty on Drugs

AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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Congress is considering closing the loophole that allows Blackstone to go public as a publicly-traded partnership without being taxed as a corporation.  What makes the deal so interesting is that the issues go beyond entity classification into the nature of Blackstone's income. 

I presented an early draft of my Blackstone paper at the Junior Tax Scholars Conference last weekend and received some really useful comments from Adam Rosenzweig and Alex Raskolnikov.  I won't have a chance to post the paper before the IPO closes (rumored to be the week of June 25), so I thought I'd record my thoughts in case there are any investors out there trying to assess the tax risk on the deal. 

As I discussed in grueling detail in previous posts, Blackstone squeezes itself into the "passive-type income" exception to Section 7704, which normally treats publicly-traded partnerships as corporations.  Because Blackstone earns most of its income in the form of carried interest distributions, which give rise to capital gains, and because capital gains are listed as passive income under the statute, it can fit into the passive income exception.  Active income like management fees, deal monitoring fees, breakup fees and so on are passed through a blocker entity that "cleanses" the bad income by paying a corporate level tax on that income and distributing the after-tax income up to the public partnership in the form of a dividend.  Blackstone gets two big tax breaks, then: (1) the capital gains preference on carry and (2) avoiding an entity-level tax.

Congress may simply close the loophole by repealing the passive-type income exception from section 7704.  To my knowledge, other than a few oil and gas partnerships, few investment vehicles use the exception, so little is lost by repealing it. 

It's worth noting, though, that the heart of the problem in the Blackstone deal is the tax code's treatment of carried interest distributions as capital gains rather than ordinary income.  If carry were properly treated as ordinary income, then Blackstone would have to run the income through the blocker entity and pay a corporate tax anyway.  But if carry is treated as capital gain, then it can be passed directly up to investors, who benefit from the capital gains preference. 

The Blackstone deal underscores the fallacy of treating carried interest distributions as passive income.  The deal is, as one of my discussants noted, "Two and Twenty on Drugs."  What he meant by that was that the Blackstone IPO structure takes the tax advantage of carried interest's treatment as capital gains and leverages that tax treatment into a vehicle for going public without paying an entity-level tax.  Fix the tax treatment of carry, and the Blackstone deal structure falls apart. 

Previous posts on Blackstone:

AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

Update:  A helpful reader points out that there are more than "a few" existing PTPs.  See here.  By my count, still fewer than 100, mostly natural resources.  An handful of real estate partnerships, and of course, Fortress (the first private equity/hedge fund management company to go public using this structure).