The US Congress is considering major tax legislation, including repealing the alternative minimum tax. However, in the current "pay-go" environment, in which tax cuts are required to be offset by tax increases or spending cuts, Congress is looking for revenue raisers. As a result, the Congressional spotlight has turned to hedge funds, private equity funds and other private investment funds in pursuit of both revenue raisers and tax reform. Although only time will tell what legislation will be enacted, below is a general summary of certain legislative proposals that have targeted private investment funds.

Carried Interest

Investment managers generally receive their compensation from US funds through a management fee and a "carried interest." The carried interest is commonly structured as a profits interest that entitles the investment manager to a percentage (eg, 20%) of the US fund's income. Under current law, if the investment manager's share of a US fund's income is longterm capital gain, such income is subject to favorable capital gain tax rates of 15%. The capital gain treatment of the carried interest is especially important to investment managers of private equity funds and venture capital funds whose investments tend to generate long-term capital gains, while it is less important to hedge fund managers that trade more frequently and generate short-term capital gains that are taxed as ordinary income at rates up to 35%. 

On October 25, 2007, US Congressman Charles Rangel introduced House bill H.R. 3970 (the "Rangel Bill") which provides that net income earned with respect to an "investment services partnership interest" (ie, an interest held by a partner that provides investment services to the partnership) would be treated as compensation subject to ordinary income tax rates and self-employment taxes. Thus, an investment manager's share of a US fund's income earned with respect to its carried interest would be treated as compensation regardless of whether such income was derived from long-tem capital gains. In addition, the Rangel Bill states that any gain recognized on the sale of a carried interest would be treated as compensation. However, the Rangel Bill does provide that any portion of the carried interest that is attributable to capital invested by the investment manager would not be treated as compensation under the above rules.

Deferred Compensation

Investment managers often defer all or a portion of their compensation from non-US funds pursuant to nonqualified deferred compensation arrangements. Published reports that such deferral arrangements have enabled some investment managers to defer millions of dollars of compensation over several years have caught the attention of Congress. Earlier this year House bill H.R. 2 was proposed, which would have placed an annual limit on deferred compensation equal to the lesser of $1 million or the service provider's average annual compensation during the five previous taxable years. This proposed legislation has not been enacted, but some tax lobbyists believe that the same or similar legislation is likely to resurface again as a revenue raiser in future legislation. For example, the Rangel Bill includes a provision that would require compensation deferred in taxable years beginning after December 31, 2007 pursuant to a nonqualified deferred compensation plan of certain non-US entities to be currently includible in income, unless such income was subject to a substantial risk of forfeiture. This legislation is expressly targeted at eliminating the ability of investment managers to defer compensation earned through non-US funds.

Publicly Traded Partnerships

Publicly traded partnerships ("PTPs") are generally treated as corporations for US federal income tax purposes. Thus, PTP investors are subject to tax on profits earned and distributed at both the company and investor levels. However, in general, if 90% or more of a PTP's gross income is "qualifying income" (eg, capital gains), then the PTP is treated as a partnership for US federal income tax purposes and its investors are only subject to one level of tax. The recent US initial public offerings by certain investment managers in which the investment managers were able to avail themselves of the public markets while still being eligible for a single level of taxation and favorable capital gain rates garnered much attention from Congress. In response, Senate bill S. 1624 and House bill H.R. 2785 were proposed, which generally provide that the qualifying income exception does not apply to a PTP that derives income from investment advisory or related asset management services. Thus, these legislative proposals would result in many investment managers that go public being PTPs which are taxed as corporations for US federal income tax purposes.

Debt-Financed Income

US tax-exempt investors typically invest in funds through non-US corporate "feeders" or "blockers" in order to avoid having "debtfinanced income" imputed to them where the fund uses leverage to acquire investments. In general, income earned by US tax-exempt investors that is generated from an investment acquired through leverage is treated as "unrelated business taxable income" and is subject to US tax. Recently, Congress has voiced concerns over the flow of capital invested by US tax-exempt investors to non-US jurisdictions. The Rangel Bill would provide that debt incurred by a partnership (eg, a fund) to acquire securities and commodities would not be imputed to US tax-exempt investors that are limited partners for purposes of the debt-finance rules. If enacted, the Rangel Bill would likely eliminate the need for many US taxexempt investors to structure their investments in funds through non-US vehicles.