Taxation of private equity and hedge funds

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Structure of a private equity or hedge fund, which shows the carried interest and management fee received by the fund's investment managers. The general partner is the financial entity used to control and manage the fund, while the limited partners are the individual investors who receive their return as capital interest. Fund Structure.png
Structure of a private equity or hedge fund, which shows the carried interest and management fee received by the fund's investment managers. The general partner is the financial entity used to control and manage the fund, while the limited partners are the individual investors who receive their return as capital interest.

Private equity funds and hedge funds are private investment vehicles used to pool investment capital, usually for a small group of large institutional or wealthy individual investors. They are subject to favorable regulatory treatment in most jurisdictions from which they are managed, which allows them to engage in financial activities that are off-limits for more regulated companies. Both types of fund also take advantage of generally applicable rules in their jurisdictions to minimize the tax burden on their investors, as well as on the fund managers. As media coverage increases regarding the growing influence of hedge funds and private equity, these tax rules are increasingly under scrutiny by legislative bodies. [2] Private equity and hedge funds choose their structure depending on the individual circumstances of the investors the fund is designed to attract.

Contents

Basic structure: U.S. domestic fund

A private equity or hedge fund located in the United States will typically be structured as a limited partnership, due to the lack of an entity-level tax on partnerships and other flow-through entities under the U.S. tax system. [3] The limited partners will be the institutional and individual investors. The general partner will be an affiliate of the manager of the fund. Typically, the manager of the hedge fund is compensated with a fee based on 2% of the gross assets of the fund, and a profits interest entitling the manager (or, more typically, its affiliated general partner) to 20% of the fund's return (subject, in many cases, to minimum guaranteed returns for the limited partners). [4]

Carried interest

Because the manager is compensated with a profits interest in the fund, the bulk of its income from the fund is taxed, not as compensation for services, but as a return on investment. Typically, when a partner receives a profits interest (commonly referred to as a "carried interest"), the partner is not taxed upon receipt, due to the difficulty of ascertaining the present value of an interest in future profits. [5] Instead, the partner is taxed as the partnership earns income. In the case of a hedge fund, this means that the partner defers taxation on the income that the hedge fund earns, which is typically ordinary income (or possibly short-term capital gains), due to the nature of the investments most hedge funds make. Private equity funds, however, typically invest on a longer horizon, with the result that income earned by the funds is long-term capital gain, taxable to individuals at a maximum 20% rate. Because the 20% profits share typically is the bulk of the manager's compensation, and because this compensation can reach, in the case of the most successful funds, enormous figures, concern has been raised, both in Congress and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary 39.6% marginal income tax rates that an average person would have to pay on such income. [4] To address this concern, Congressman Sander M. Levin introduced H.R. 2834, which would eliminate the ability of persons performing investment adviser or similar services to partnerships to receive capital gains tax treatment on their income. However, the Treasury Department has suggested, both in testimony before the Senate Finance Committee [6] and in public speaking engagements, [7] that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration of the potential impact.

Congressman Charles B. Rangel included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. A line item on taxing carried interest at ordinary income rates was included in the Obama Administration's 2008 Budget Blueprint. [8] On April 2, 2009, Congressman Levin introduced a new and substantially revised version of the carried interest legislation as H.R. 1935. On May 28, 2010, the House approved carried interest legislation as part of amendments to the Senate-passed version of H.R. 4213. [9] On February 14, 2012, Congressman Levin introduced H.R. 4016. [9]

Publicly traded partnerships

In mid-2007, the Blackstone group, a major private equity fund, went public. Ordinarily, a publicly traded partnership is taxed as a corporation. [10] There is, however, an exception for publicly traded partnerships earning only “passive-type” income, such as interest and dividends. [11] Although the investments made by a private equity fund are actively managed, Blackstone took the position that the investments they engaged in fell squarely within literal language of this exception to the usual treatment for publicly traded partnerships. [12] To address what they viewed as a loophole in the law, Senators Baucus and Grassley introduced S. 1624, which would remove the ability for publicly traded partnerships performing asset-management and related services to avoid being taxed as corporations. [13] The result of this bill would be to change the tax treatment of private equity and hedge funds from a single level of taxation at a 15% rate (or 35% in the case of most hedge funds) to a corporate-level tax of 35%, plus a 15% tax on dividends when distributed. While acknowledging that there are concerns with the current treatment of publicly traded partnerships, Treasury Secretary Paulson has declined to endorse the treatment that would be provided under S. 1624. [7]

The House extenders package included a carried interest provision that would apply to publicly traded partnerships beginning in tax years after 31 December 2009.

Various private equity and hedge fund managers followed Fortress, the first fund manager to go public as a PTP. The funds include Oaktree, Blackstone Group, Och-Ziff, KKR, Apollo Global Management, and Carlyle Group.

"Blocker" corporations

Although a partnership structure is advantageous for most investors due to the elimination of an entity-level tax, it is not the desired form for all investors. In particular, foreign investors and domestic tax-exempt organizations both have reasons to prefer to interpose a corporation in the private equity or hedge fund structure. [4]

Foreign investors are generally not required to file tax returns unless they have “effectively connected income,” derived from the active conduct of a U.S. trade or business. [14] Passive investment in a corporation does not give rise to a U.S. trade or business. However, active investment management of the type performed by private equity funds or hedge funds typically does. [15] Because partners in a partnership are treated as engaged in whatever business the partnership itself is engaged in, this means that if a foreign investor invests in a hedge fund or private equity fund, it will generally be forced to file a U.S. tax return. To avoid this requirement, a foreign investor will often invest through a blocker corporation (usually located in the Cayman Islands or another offshore jurisdiction). The corporation itself will be required to file U.S. tax returns, and will pay taxes at the normal U.S. corporate tax rate, but the foreign investor will receive only dividends or capital gains from the blocker, and will therefore not be required to file a U.S. return. As an alternative to the “blocker” structure, hedge funds seeking to attract foreign investors can also structure as partnerships, but simply restrict themselves to activities that are not treated as a U.S. trade or business. For example, U.S. tax law provides that trading in securities for the taxpayer's own account will not constitute a U.S. trade or business. [16] Thus foreign hedge funds formed as corporations do not generally pay corporate income tax. [17]

Domestic tax-exempt entities face similar concerns when investing in funds structured as partnerships. While tax-exempt on income related to their tax-exempt purpose, tax exempt entities are required to file tax returns and pay income tax on “unrelated business taxable income,” commonly referred to as UBTI. Because the activities of an entity structured as a partnership flow through to its investors, if the partnership receives income that would be UBTI in the hands of the tax-exempt investor, the investor is forced to file an income-tax return and pay unrelated business income tax. To avoid this requirement, tax exempt entities use offshore blocker corporations in much the same way foreign investors do. [4] To date, no bill has been introduced to change this treatment, although concerns over the tax gap have led to increased scrutiny of business structures involving offshore corporations in general. For example, in May 2007, the Senate Finance Committee held a hearing about offshore structures used for tax evasion. [18]

Related Research Articles

A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments. In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.

Business is the practice of making one's living or making money by producing or buying and selling products. It is also "any activity or enterprise entered into for profit."

In the field of finance, private equity (PE) is stock in a private company that does not offer stock to the general public. Private equity is offered instead to specialized investment funds and limited partnerships that take an active role in the management and structuring of the companies. In casual usage, "private equity" can refer to these investment firms rather than the companies that they invest in.

An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Types of investments include equity, debt, securities, real estate, infrastructure, currency, commodity, token, derivatives such as put and call options, futures, forwards, etc. This definition makes no distinction between the investors in the primary and secondary markets. That is, someone who provides a business with capital and someone who buys a stock are both investors. An investor who owns stock is a shareholder.

A real estate investment trust is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, including office and apartment buildings, warehouses, hospitals, shopping centers, hotels and commercial forests. Some REITs engage in financing real estate.

An income trust is an investment that may hold equities, debt instruments, royalty interests or real properties. It is especially useful for financial requirements of institutional investors such as pension funds, and for investors such as retired individuals seeking yield. The main attraction of income trusts, in addition to certain tax preferences for some investors, is their stated goal of paying out consistent cash flows for investors, which is especially attractive when cash yields on bonds are low. Many investors are attracted by the fact that income trusts are not allowed to make forays into unrelated businesses; if a trust is in the oil and gas business, it cannot buy casinos or motion picture studios.

<span class="mw-page-title-main">Resolution Trust Corporation</span> American government-owned asset management company

The Resolution Trust Corporation (RTC) was a U.S. government-owned asset management company run by Lewis William Seidman and charged with liquidating assets, primarily real estate-related assets such as mortgage loans, that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision (OTS) as a consequence of the savings and loan crisis of the 1980s. It also took over the insurance functions of the former Federal Home Loan Bank Board (FHLBB).

<span class="mw-page-title-main">Offshore fund</span>

An offshore fund is generally a collective investment scheme domiciled in an offshore jurisdiction. Like the term "offshore company", the term is more descriptive than definitive, and both the words 'offshore' and 'fund' may be construed differently.

A private equity fund is a collective investment scheme used for making investments in various equity securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years. At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From the investors' point of view, funds can be traditional or asymmetric.

In the United States, a master limited partnership (MLP) or publicly traded partnership (PTP) is a publicly traded entity taxed as a partnership. It combines the tax benefits of a partnership with the liquidity of publicly traded securities.

A blocker corporation is a type of C Corporation in the United States that has been used by tax exempt individuals to protect their investments from taxation when they participate in private equity or with hedge funds. In addition to tax exempt individuals, foreign investors have also used blocker corporations.

Unrelated Business Income Tax (UBIT) in the U.S. Internal Revenue Code is the tax on unrelated business income, which comes from an activity engaged in by a tax-exempt 26 U.S.C. 501 organization that is not related to the tax-exempt purpose of that organization.

Private equity real estate is a term used in investment finance to refer to a specific subset of the real estate investment asset class. Private equity real estate refers to one of the four quadrants of the real estate capital markets, which include private equity, private debt, public equity and public debt.

<span class="mw-page-title-main">Carried interest</span> Fee paid to an investment manager.

Carried interest, or carry, in finance, is a share of the profits of an investment paid to the investment manager specifically in alternative investments. It is a performance fee, rewarding the manager for enhancing performance. Since these fees are generally not taxed as normal income, some believe that the structure unfairly takes advantage of favorable tax treatment, e.g. in the United States.

<span class="mw-page-title-main">Low-profit limited liability company</span> Legal form of business entity in the US

A low-profit limited liability company (L3C) is a legal form of business entity in the United States. Commonly referred to as a hybrid structure, it has characteristics of both for-profit and non-profit entities. L3Cs were created to comply with the Internal Revenue Service (IRS) program-related investments (PRIs) rules which allow most typically private foundations the ability to maintain tax-exempt status through investments in qualifying businesses and/or charities. With a social mission as the primary objective and a secondary objective of profit generation, the L3C legal form is considered a viable option for businesses seeking a reputation or marketability for being a social enterprise.

Publicly traded private equity refers to an investment firm or investment vehicle, which makes investments conforming to one of the various private equity strategies, and is listed on a public stock exchange.

Non-profit housing developers build affordable housing for individuals under-served by the private market. The non-profit housing sector is composed of community development corporations (CDC) and national and regional non-profit housing organizations whose mission is to provide for the needy, the elderly, working households, and others that the private housing market does not adequately serve. Of the total 4.6 million units in the social housing sector, non-profit developers have produced approximately 1.547 million units, or roughly one-third of the total stock. Since non-profit developers seldom have the financial resources or access to capital that for-profit entities do, they often use multiple layers of financing, usually from a variety of sources for both development and operation of these affordable housing units.

A royalty fund is a category of private equity fund that specializes in purchasing consistent revenue streams deriving from the payment of royalties. One growing subset of this category is the healthcare royalty fund, in which a private equity fund manager purchases a royalty stream paid by a pharmaceutical company to a patent holder. The patent holder can be another company, an individual inventor, or some sort of institution, such as a research university.

<span class="mw-page-title-main">Qualifying investor alternative investment fund</span> Irish zero-tax legal structure

Qualifying Investor Alternative Investment Fund or QIAIF is a Central Bank of Ireland regulatory classification established in 2013 for Ireland's five tax-free legal structures for holding assets. The Irish Collective Asset-management Vehicle or ICAV is the most popular of the five Irish QIAIF structures, it is the main tax-free structure for foreign investors holding Irish assets.

References

  1. ↑ Fleischer, Victor (2008). "Two and Twenty: Taxing Partnership Profits in Private Equity Funds". New York University Law Review. SSRN   892440.
  2. ↑ Michael S. Knoll, Article: The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of taxing Profit Interests as Ordinary Income, 50 WM. & MARY L. REV. 115, 117 (2008).
  3. ↑ See generally, subchapter K of chapter 1 of the Internal Revenue Code, Title 26 of the U.S. Code.
  4. 1 2 3 4 Marples, Donald (2 January 2014). "Taxation of Hedge Fund and Private Equity Managers" (PDF). Congressional Research Service . Retrieved 4 March 2014.
  5. ↑ See, e.g., Campbell v. United States (8th Cir. 1981). This approach was adopted as a general administrative rule by the IRS in a notice in 1993, and again in proposed regulations in 2005.
  6. ↑ Microsoft Word - 07.11.07 TESTIMONY Solomon on Carried Interest.doc Archived July 26, 2007, at the Wayback Machine
  7. 1 2 Donmoyer, Ryan J. (2007-06-27). "News". Bloomberg.com. Retrieved 2014-07-30.
  8. ↑ "See page 122 of the White House version of "A New Era of Responsibility - Renewing America's Promise"". Office of Management and Budget . Retrieved 2014-07-30– via National Archives.
  9. 1 2 "H.R. 4016: Carried Interest Fairness Act of 2012". Democrats of the United States House Committee on Ways and Means. Archived from the original on 18 April 2014. Retrieved 17 April 2014.
  10. ↑ 26 U.S.C. 7704(a) (2007)
  11. ↑ 26 U.S.C. 7704(c) (2007)
  12. ↑ Donmoyer, Ryan J. (2007-03-29). "News". Bloomberg.com. Retrieved 2014-07-30.
  13. ↑ "FDsys - Browse Congressional Bills" (PDF). Frwebgate.access.gpo.gov. Retrieved 2014-07-30.
  14. ↑ 26 U.S.C. 871 & 881 (2007)
  15. ↑ 26 U.S.C. 864 (2007) and regulations thereunder
  16. ↑ 26 U.S.C. 864(b) (2007)
  17. ↑ Humphreys T, Man A. (2006). Introduction to US Tax Aspects of Hedge Fund Formation [ permanent dead link ]. Morrison & Foerster LLP.
  18. ↑ Finance Archived June 27, 2007, at the Wayback Machine
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