New tax legislation introduced in the House and Senate would have a significant impact on private funds and their managers. In each case, the proposed legislation represents an expanded version of bills introduced in prior years. A bill recently introduced by Rep. Sander Levin (D-Mich.) would change the way that income and gains earned from carried interests are taxed, subjecting them entirely to the higher ordinary income tax rate, rath¬er than the lower long-term capital gains rate, and subjecting them to self-employment tax. Another tax bill, introduced by Sen. Carl Levin (D-Mich.) and Rep. Lloyd Daggett (D-Texas), labeled the “Stop Tax Haven Abuse Act,” would have a significant impact on the offshore structures used to facilitate investments in U.S. hedge funds by tax-exempt entities such as charitable organizations and pension plans.

New Proposal To Tax Carried Interest Gains as Compensation Income Would Sweep More Broadly Than Prior Versions

Legislation introduced by Congressman Levin on April 2 proposes to tax all income and gains earned with respect to carried interests as compensation income. President Barack Obama has included the enactment of such a carried interest tax provision in his fiscal year 2010 budget. The House of Representatives has twice passed similar bills in 2007 and 2008. Although the prior House provisions were essentially identical to each other, Rep. Levin’s new bill expands the scope of the prior provisions significantly.

Proposed Change in Tax Treatment of Carried Interests

Under current law, a partnership’s issuance of a carried interest is not a taxable event for the recipient and, thereafter, the recipient generally recognizes income and gain with re¬spect to the carried interest in the same manner as other partners recognize income and gain with respect to their partnership interests. To the extent the partnership generates long-term capital gains and to the extent an ultimate sale of an interest in the partnership results in long-term capital gain, the owner of the carried interest will generally benefit from the lower federal income tax rates applicable to long-term capital gains. The cur¬rent favorable tax treatment for carried interests has helped to make them a ubiquitous mechanism for providing incentive compensation to managers of hedge funds, private equity funds and venture capital funds. Although none of the bills attacking the tax treatment of carried interests has contem¬plated a change in the tax treatment of the receipt of a carried interest, the prior House bills and the new Levin bill focus instead on the tax treatment of income and gain that is ultimately earned by the holder of such an interest. They provide that investment manag¬ers are to be taxed at ordinary income rates on income from, and gain recognized on sale or other taxable disposition of, an “investment services partnership interest.” In addition, the new Levin bill provides for the first time that all such income and gain recognized by an individual will be subject to self-employment tax.

Expanded Definition of “Investment Services Partnership Interest”

The bill defines an “investment services partnership interest” as any interest in a partner¬ship held by any person (or any person related to such person) under the expectation that such person would provide (directly or indirectly) a substantial quantity of any of four types of services: (1) advising as to the advisability of investing in, purchasing or selling any specified asset; (2) managing, acquiring or disposing of any specified asset; (3) ar¬ranging financing with respect to acquiring specified assets; or (4) any activity in support of any of the foregoing services. A “specified asset” means securities, real estate held for rental or investment, interests in partnerships, commodities, or options or derivative contracts with respect to any such assets.

The inclusion of partnership interests as specified assets in Rep. Levin’s new bill is a significant expansion in the scope of the provisions from the prior House versions. By leaving partnership interests out of the definition of specified assets, the prior bills would have allowed funds (especially private equity funds) to avoid the recharacterization of income by investing in portfolio companies structured as partnerships. That potential loophole has now been eliminated.

Another difference from the prior versions of the carried interest legislation is that in prior versions related persons were not included, leaving what appeared to be a loophole for a structure under which one entity provides services and a related entity receives the carried interest. The new bill seeks to close that loophole by including related persons within its reach. The definition of a related person is fairly broad, encompassing, among other things, family members and entities with specified levels of common ownership.

Denial of “Qualified Capital Interest” Treatment for Certain Financed Interests

As was the case with the prior bills, the new bill provides an exception for interests acquired through the investment of capital – i.e., interests, or portions of interests, that are not carried interests at all. Under the exception, gains attributable to such “qualified capital interests” escape recharacterization to the extent they are proportionate to gains recognized by other partners who are not service providers.

But the new bill imposes a significant new restriction on the definition of a “qualified capi¬tal interest”: An interest acquired with capital borrowed from the partnership or another partner, or from a party related to any such person, or obtained with credit support from any such person or related party, does not qualify. The relatively common technique of financing the acquisition of fund interests by employees through a loan program will, under the new provision, have the effect of converting all gain ultimately attributable rules is so broad that loans or credit support among family members can likewise taint a partnership interest that has been financed with such arrangements.

Effective Dates

The new carried interest bill applies by its terms to income and gain recognized with respect to carried interests after an effective date that remains to be specified. Presi¬dent Obama’s fiscal year 2010 budget proposal contemplates that the change in the tax treatment of carried interests will be effective for income and gain recognized in taxable year 2011. In its current form, the Levin bill provides no grandfathering for pre-existing partnership interests and financing arrangements.

Proposed New Tax Bill Would Tax Foreign Corporations in U.S. Hedge Fund Structures

The bill proposed by Sen. Levin (Rep. Sander Levin’s younger brother) and Rep. Doggett is a new version of the “Stop Tax Haven Abuse Act” that these legislators proposed last year. The current version is broader than the previous version, which focused largely on tax enforcement matters relating to the abusive use of offshore entities and accounts, and, if enacted, will have a significant impact on the offshore structures used to facilitate investments in U.S. hedge funds by tax-exempt entities, such as charitable organizations and pension plans.

Proposed Change in Tax Treatment of U.S.-Based Foreign Corporations

The most significant of the proposed new provisions in the Stop Tax Haven Abuse Act is one that would tax as a domestic corporation any foreign corporation that is managed and controlled in the United States. Among other things, that provision would treat as a U.S. corporation any foreign corporation the assets of which consist primarily of assets being managed on behalf of investors, if the decisions about how to invest the assets are made in the United States.

At present, many U.S. hedge fund structures include foreign feeder funds that are corpo¬rations for U.S. federal income tax purposes. Those foreign entities – so-called “blocker corporations” – insulate U.S. tax-exempt investors from potential “unrelated debt-financed income” that could otherwise result if the tax-exempt investors were instead to invest directly in the hedge funds. If enacted, the bill would tax these offshore corporations as U.S. corporations, thereby eliminating their usefulness to tax-exempt investors.

Effective Date and Prospects for Enactment

As proposed, the new provision would be applicable only to taxable years beginning on or after the date that is two years after the date of enactment. If the legislation is ulti¬mately enacted, it appears that there will be some time for structures involving offshore feeder funds to be modified in response to the change in law.

The new bill appears to have significant support. It has three co-sponsors in the Senate and 59 co-sponsors in the House, including 13 members of the House Ways and Means Committee (where Federal tax legislation originates). When asked about the bill shortly after it became public, Treasury Secretary Timothy Geithner testified that the Obama administration “fully supports” the bill, although it is not entirely clear that he meant to include in that comment the provisions that were added in the most recent version.