On November 9, 2007, the House passed the Temporary Tax Relief Act of 2007 by a vote of 216 to 193 that was largely along party lines. The prospects for the legislation in the Senate are at best uncertain, and President Bush has threatened to veto the legislation in its current form. The legislation includes a one-year AMT patch, a one-year extension of various temporary tax provisions, and provisions that would have a significant negative impact on managers of hedge funds, as well as private equity, venture capital, and real estate funds. The provisions affecting fund managers are intended to offset the cost of the AMT patch under the House “pay as you go” rules. Also of interest to fund managers is a favorable provision in the bill that would benefit tax-exempt investors in certain funds that utilize leverage.
The provisions affecting fund managers, as well as those impacting tax-exempt investors, were originally contained in the broad-ranging Tax Reduction and Reform Act of 2007 that was introduced by House Ways and Means Committee Chairman Charles Rangel on October 25, 2007.
Proposed Changes to the Treatment of Carried Interests
Because the character of a partnership’s income passes through to its partners, a fund manager’s share of income from a carried interest has the same character as the income realized by the underlying fund. Accordingly, under current law, income from carried interests may be reported as long-term capital gains to the extent that the fund’s income is attributable to gains realized from long-term capital assets.
The legislation, if enacted, would overhaul the tax treatment of carried interests by treating as ordinary income (i) income received from an “investment services partnership interest”; and (ii) gain on the disposition of an investment services partnership interest, except to the extent such income or gain is attributable to a partnership interest acquired on account of a contribution of cash or other property. Moreover, the legislation would subject such ordinary income to self-employment tax, a provision that would affect all fund managers, including fund managers whose income is not currently characterized as long-term capital gain because of the nature of the income generated by their funds. The bill would also require that gain be recognized by a partnership in the case of distributions of appreciated property by the partnership with respect to any investment services partnership interest as if the partnership had sold the property at the time of the distribution.
The legislation defines an “investment services partnership interest” as any interest in a partnership that is held by any person if such person provides (directly or indirectly) a substantial quantity of any of the following services: (A) advising as to the advisability of investing in, purchasing, or selling any specified asset; (B) managing, acquiring, or disposing of any specified asset; (C) arranging financing with respect to acquiring specified assets; or (D) any activity in support of any such services. The term “specified asset” means securities, real estate, or commodities, or options or derivative contracts with respect thereto.
The provisions affecting carried interests would generally be effective for taxable years ending after November 1, 2007. However, for partnership taxable years that include November 1, 2007 (such as calendar year 2007), the amount of income that will be treated as ordinary income is determined by taking into account only items attributable to the portion of the taxable year that is after such date. The provision affecting dispositions of partnership interests and distributions would apply to dispositions and distributions after November 1, 2007.
Proposed Changes to the Treatment of Deferred Fees
The legislation, if enacted, would severely restrict the ability of fund managers to defer income recognition on incentive compensation that is structured as a fee from an offshore entity. Under current law, a manager of an offshore fund who reports on the cash method generally can defer receipt and recognition of incentive fees from the fund. The legislation provides that any deferred compensation for investment services provided to a fund that is a foreign corporation or a partnership with foreign or tax-exempt partners must be taken into account at the time there is no substantial risk of forfeiture of the right to such compensation. The legislation provides that the right of a person to compensation shall be treated as subject to a substantial risk of forfeiture only if such person’s right is conditioned upon the performance of substantial services by any individual. Special penalty and interest rules apply where the amount of compensation is not ascertainable at the time it would otherwise be required to be taken into income.
The provision affecting deferrals would apply to amounts deferred that are attributable to services performed after December 31, 2007. The bill also requires that amounts deferred prior to 2008 be taken into income no later than the last taxable year beginning before 2017.
Proposed Changes to the Unrelated Business Income Tax Rules
Under current law, borrowing by a fund classified as a partnership for tax purposes results in acquisition indebtedness for tax-exempt partners. Thus, a tax-exempt partner’s distributive share of partnership income would, to the extent of such acquisition indebtedness, be considered debt-financed income, resulting in unrelated business income tax. To avoid this result, tax-exempt entities typically invest in funds through offshore “blocker” corporations.
The legislation, if enacted, would make the use of offshore blocker corporations unnecessary. More specifically, the legislation would modify the definition of “acquisition indebtedness” to provide that it does not include, with respect to partners with limited liability, indebtedness incurred or continued by a partnership in purchasing or carrying securities or commodities. Thus, tax-exempt investors could invest directly in funds utilizing leverage as part of their strategies without incurring unrelated business income tax. An additional benefit of direct investment by tax-exempts would be the elimination of U.S. withholding taxes attributable to certain U.S. source income that would otherwise result from U.S. tax-exempt investors investing through offshore blocker corporations.
This provision would be effective for taxable years beginning after the date of enactment of the legislation.
In summary, the legislation, if enacted, would result in fund managers being subjected to tax at ordinary income tax rates on all income and gains associated with carried interests and would significantly restrict the ability of managers to defer performance fees from offshore funds. The legislation would also largely obviate the need for U.S. tax-exempts to invest in funds through offshore blocker corporations. Whether and when this particular legislation or similar legislation will be passed in the Senate and signed into law by the President is extremely uncertain. We will continue to follow this legislation closely.