The United States has the highest corporate tax rate in the developed world. 1 Hence it is no surprise that corporations may try to avoid recognizing income in order to avoid paying taxes on that income. One of the ways a multinational corporation can achieve this result is by manipulating their transfer prices with foreign affiliated…
Tag: Tax
Burger King-Tim Hortons Merger: Another Corporate Desertion or Good Business Strategy?
In late August, Burger King announced that it intended to acquire the Canadian coffee and donut chain Tim Hortons for $11 billion.1 The combined company will be headquartered in Canada.2 By purchasing Tim Hortons, Burger King has faced criticism that it is yet another U.S. corporation deserting its country for tax advantages.3 In the last…
Executive Compensation of Private Equity’s Elite
Executive compensation has long been a divisive issue, but in the wake of the economic recession and with the ever-increasing economic disparity that exists in the United States, it is an issue that does not seem to be going away. In 2012, with total compensation averaging $12.3 million, chief executives at the largest firms made…
Private Equity Funds’ New Tax Challenge: Tax Breaks Through Monitoring Fees
For years, regulators have scrutinized the tax practices of private equity firms on several fronts. One relatively recent example occurred in 2012 when the New York Attorney General led an investigation regarding private equity funds’ conversion of certain management fees into investments that are eligible for more favorable tax treatment, also known as fee waiver…
How the Foreign Account Tax Compliance Act Will Impact Foreign Financial Institutions and How to Incentivize Compliance
What is FACTA and who is affected by it? The Foreign Account Tax Compliance Act (FATCA), coming into effect in July 2014, requires any Foreign Financial Institution (FFI) that elects to comply with the Act to do three things: 1) identify its U.S. account holders; 2) annually report the account holders to the IRS; and 3) withhold…
Should You Form an LLC or C-Corporation?
If you are considering this question, you already have a business concept, a business plan (hopefully), and have done enough market research to ensure that your idea will have some traction and solve some pain point. But, you are unsure of which business entity to choose. Both entity types have their pros and cons, which…
PE Firms Managing Tax Rates: Is the Management Fee Waiver Legal?
Private equity firms are no strangers to controversy when it comes to their compensation arrangements. In the most recent presidential election, Mitt Romney and the entire private equity industry came under intense scrutiny from both the electorate and politicians for the tax rate paid on carried interest. Carried interest is taxed at the capital gains…
Private Equity Shares the Spotlight with Tax Reform
Post-2012 Presidential Election, the private equity industry is in the public spotlight simultaneously with the tax reform proposals. Throughout the election, private equity was a constant topic of conversation – especially Bain Capital. Acknowledging the media attention received from the election, Bain Capital addressed its investors in a formal letter thanking them for their support despite the increased scrutiny.[1] In this letter, Bain Capital attempted to portray the positive aspects of the business outside of its profits by asserting its creation of hundreds of thousands of jobs and support of hundreds of charities in its 28-year history. [2] These reassurances acknowledge the added scrutiny to the private equity industry that may not disappear post-election.
Tax reform is one topic that has emerged in response to the perceived inequities in the tax code and the need to reduce the national deficit. Earlier this year, President Obama proposed changes to the tax code to end corporate tax breaks and decrease the corporate tax rate from 35% to 28%. [3] Similarly, the top House Republican tax writer, Dave Camp, has vowed to pass tax reform legislation in 2013.[4]
With the private equity industry comprising a significant amount of the U.S.’s economic activity, this industry is not likely to avoid the effects of tax reform. Venture capital, one subset of private equity, alone provides 21% of the U.S. GDP.[5] If these efforts to close the gaps in the tax code are successful, private equity’s increased media attention comes at an inopportune time in light of the industry’s favorable “carried interest” rates.
Under the “carried interest” rule, private equity firms, alongside real estate and mining partnership structures, could lose its favorable tax treatment. In this provision, private equity firms are able to pay the capital gains tax rate, 15%, on a third of its profits rather than the income tax rate, 35%, paid on the remaining two-thirds of payments made on the guaranteed annual management fees. [6] Supporters of the favorable tax treatment argue that the private equity firms should be viewed as entrepreneurs whose risk-taking should be encouraged by this favorable tax rate.[7] Yet, some critics of the favorable tax rate state argue that private equity funds should be treated like investment bankers who use individual investor funds in these risky investments and retain approximately a 2% management fee and a 20% profit if they reach their target.[8]
Congress estimates that eliminating this favorable tax rate could generate up to $2 billion in tax revenues, increasing the attraction to close this provision. [9] Despite objections from the industry that investors would not receive adequate returns on their investments in this risky industry, there are admissions of some industry members that the “carried interest” provisions are generous.[10]
As the public and Congress continue to look more closely into the private equity industry, the favorable tax provision in private equity will not likely avoid review following the election. Consequently, as the support for tax reforms increases in the upcoming year, the media attention provided to the private equity industry makes the industry a prime candidate for tax reform in 2013, decreasing or eliminating the “carried interest provision”.
_____________________________________________
[1] Greg Roumeliotis, Bruised by Romney criticism, Bain Capital thanks investors, Reuters (Nov. 8, 2012, 8:31PM), http://www.reuters.com/article/2012/11/09/us-usa-campaign-bain-idUSBRE8A804220121109.
[2] Id.
[3] See, Kevin Drawbaugh & Patrick Temple-West, Top U.S. House tax writer vows tax reform in 2013, Reuters (Nov. 15, 2012, 8:26 PM), http://www.reuters.com/article/2012/11/16/us-usa-tax-camp-idUSBRE8AF00620121116; Zachary A. Goldfarb, Obama proposes lowering corporate tax rate to 28 percent, The Wash. Post (Feb. 22, 2012), http://www.washingtonpost.com/business/economy/obama-to-propose-lowering-corporate-tax-rate-to-28-percent/2012/02/22/gIQA1sjdSR_story.html.
[4] Id.
[5] Brian McCann, Private Equity Searches for its Public Identity After the US Election, Opalesque (Nov. 15, 2012), http://www.opalesque.com/private-equity-strategies/2/private-equity-searches-for-identity-after-the.html .
[6] An end to the carry on, Buy-out firms face the prospect of a bigger tax bill, The Economist (Nov. 17, 2012), available at http://www.economist.com/news/finance-and-economics/21566647-buy-out-firms-face-prospect-bigger-tax-bill-end-carry.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
Should the Carried Interest Tax Loophole be Eliminated?
With the “fiscal cliff”[1] fast approaching and the federal budget taking center stage in national politics, legislators are under intense pressure to find politically feasible changes to the tax code that can be used to raise revenue. One feature of the tax code in particular – its treatment of the “carried interest” income earned by most private equity and hedge fund managers – has fallen squarely within these legislators’ crosshairs. It seems likely that this “loophole” will soon be eliminated, but current proposals for doing so miss the mark.
Most private equity firms’ fees are structured on the “2 and 20” model. The “2” refers to a baseline fee fixed at 2% of assets under management, which is taxed as ordinary income. The “20,” on the other hand, is the famous “carried interest:” fund managers also keep 20% of all gains realized by the fund. Because private equity funds typically enter relatively long-term investments, private equity fund managers can characterize their carried-interest income as long-term capital gains, which are taxed at 15%.[2] Thus, successful private equity fund managers – whose incomes routinely exceed seven figures – often have the bulk of their income taxed at the low rate of 15%.
Not surprisingly, this practice has drawn scrutiny from legislators in Washington. Congressman Sandler Levin has introduced a “Carried Interest Fairness Act” in the House of Representatives,[3] and President Obama’s 2013 budget specifically targets the loophole.[4] Both simply propose that carried interest be taxed as ordinary income. This is an enticing solution: it singles out these wealthy fund managers, a group many people find unsympathetic,[5] and it raises much-needed revenue.
However, resolving this issue may not be quite so simple. Whatever justifications exist for taxing other kinds of capital gains at rates lower than ordinary income may apply for carried interest income as well. For example, some argue that lowering capital gains taxes incentivizes risk-taking and investment; these incentives are certainly in play in the private equity world. The same is true of the “lock-in” rationale: some say lowering capital gains taxes prevents people from holding on to subpar investments simply for tax purposes, and the same considerations could affect the decision-making process of private equity fund managers deciding when to realize their gains.
A simpler solution would be to eliminate the distinction between capital gains and ordinary income altogether. Economic research has found little, if any, empirical evidence supporting the rationales described above.[6] More direct and effective methods can be used to achieve the purported benefits of low capital gains tax. Worst of all, this distinction encourages people to engage in inefficient rent-seeking. The time spent by accountants and tax lawyers thinking of ways to re-characterize income, and indeed the hours spent writing this very article, could be used for other pursuits. The most sensible solution, then, is to do away with this distinction and tax income of all types at one simple rate.
_______________________________________________
[1] I.e., the large number of scheduled tax increases and spending cuts set to go into effect in early 2013. See Jonathan Weisman, Q&A: Understanding the Fiscal Cliff, N.Y. Times Economix Blog (Oct. 9, 2012, 6:28 PM), http://economix.blogs.nytimes.com/2012/10/09/qa-understanding-the-fiscal-cliff/.
[2] Janet Novack, Romney’s Taxes: It’s the Carried Interest, Stupid, Forbes (Aug. 24, 2012, 6:03 PM), http://www.forbes.com/sites/janetnovack/2012/08/24/romneys-taxes-its-the-carried-interest-stupid/.
[3] H.R. 4016, 112th Cong. (2012).
[4] Cutting Waste, Reducing The Deficit, And Asking All To Pay Their Fair Share (2012), available at http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/cutting.pdf.
[5] (just ask Mitt Romney)
[6] See, e.g., Capital Gains and Dividends: What is the effect of a lower tax rate?, Tax Policy Center, available at http://www.taxpolicycenter.org/briefing-book/key-elements/capital-gains/lower-rate.cfm; Brendan Greeley, Study Finds Benefit is Elusive for Low Capital Gains Rate, Bloomberg (Oct. 4, 2012, 10:17 AM), http://www.bloomberg.com/news/2012-10-04/study-finds-benefit-is-elusive-for-low-capital-gains-rate.html