Last week, President Obama introduced his $3.6 trillion budget proposal for 2010. Although many details will be subject to implementing legislation, a number of revenue-raising budget proposals will be of interest to private equity and hedge fund managers. Of particular note:  

  • “Carried interest” or “incentive allocations” would be treated as ordinary income from the provision of services, beginning in 2011.  
  • The Bush individual income tax cuts would be allowed to expire at the end of 2010, which would result in the highest marginal tax rate rising from 35% to 39.6% and the top capital gains rate rising from 15% to 20%. Under the budget proposal, these top rates would apply to taxpayers earning more than $250,000 in the case of married filers and $200,000 in the case of individual filers, which are lower thresholds than applied at the time the Bush tax cuts went into effect.  
  • Qualified dividend income would continue to be taxed at the preferential capital gains rate, albeit at the higher rates mentioned above.  

This week, Senator Levin of Michigan introduced a bill in the Senate known as the “Stop Tax Haven Abuse Act” (which was also introduced in the House by Representative Doggett of Texas) aimed at curbing perceived abuses relating to “offshore secrecy jurisdictions,” although many of the provisions apply more broadly. The bill includes a number of provisions that, if enacted into law, could have significant tax consequences for hedge funds and private equity funds, such as:  

  • Certain offshore corporations that are managed and controlled from the United States would be treated as domestic corporations for US federal income tax purposes and would be fully subject to US net income tax. The proposal would cover offshore entities which satisfy a two-part test requiring that they (i) have at least $50,000,000 in gross assets or are publicly traded and (ii) are “managed and controlled” from the United States (note that this concept of “managed and controlled” is specifically defined to include control by US based investment managers). The proposal would be effective two years after the date of enactment, which should give fund managers and fund investors time to consider planning strategies.  
  • Dividend equivalent and substitute dividend payments made to non-US persons, including through the use of swap contracts, other derivative instruments, and securities lending transactions, in respect of dividends paid by domestic corporations would generally be subject to the 30% US withholding tax (unless otherwise reduced by treaty), as if they were actual dividends. The proposal would be effective 90 days after the date of enactment.  
  • Hedge funds and private equity funds generally would be required to adopt anti-moneylaundering procedures under rules to be promulgated by the Treasury, in consultation with the SEC and CFTC. Such rules would be required no later than 180 days after the date of enactment.  
  • A variety of compliance related rules would be targeted at investments made through entities in “offshore secrecy jurisdictions” and other offshore investments, including, in certain cases, adverse evidentiary presumptions, the extension of statutes of limitations from three years to six years, additional reporting (including as to passive foreign investment companies (PFICs)), additional penalties, etc.  
  • The judicially developed “economic substance doctrine” would be codified (and defined to require, where applicable, that a transaction change, in a meaningful way, the taxpayer’s economic position and that the taxpayer have a substantial non-tax purpose for entering into the transaction). Note that this codification is also proposed under the Obama budget.  

The likelihood of passage of some or all of these provisions is unclear. Carried interest legislation has been previously proposed, and a similar version of the Levin bill was introduced in 2007 and was cosponsored by then Senator Obama, although the specific investment fund provisions described above were not included in the previous Levin bill.