WASHINGTON A crack is opening between alternative investment trade groups that are battling efforts on Capitol Hill to up taxes on limited partnerships.
Lobbyists are scrambling to confront a proposal from congressional tax-writers that would treat carried interest in limited partnerships as ordinary income, subject to an income tax rate of up to 35%. Currently, carried interest is considered capital gains, subject to a 15% levy. A change in the tax law would hit hedge funds, private equity, venture capital and real estate investors.
But the National Venture Capital Association, Arlington, Va., is trying to distance its members from hedge funds.
We are making distinctions between the long-term nature of venture capital investment vs. the shorter-term economics that hedge funds employ, said Emily Mendell, vice president of strategic affairs and public outreach for the National Venture Capital Association, Arlington, Va.
We dont do arbitrage, we dont do financial engineering; we build companies, she said.
Not surprisingly, hedge-fund lobbyists are trying to paper over the differences.
This issue affects all long-term investment partnerships, said Lisa McGreevy, executive vice president and chief operating officer of the hedge fund industrys Managed Funds Association, Washington, in a statement. The discussion on carried interest is focused on whether or not entrepreneurs will be able to continue to invest their intellectual capital and sweat equity for long-term investment purposes.
It appears to be open season on hedge funds on Capitol Hill. Under a separate legislative threat, tax-exempt institutions investing in hedge funds might become subject to unrelated business income tax. While that proposal is still in its early days, forcing pension funds and other tax-exempt investors to pay a tax on returns that are currently untaxed could harm returns.
Carried interest concerns
But the proposal that would tax limited partnerships at income-tax rates has generated the widest concern.
In an action alert posted on the website of the Real Estate Roundtable, Washington, the group is urging its members to express their concerns to federal lawmakers about the proposal to start taxing carried interest as income.
Despite our efforts, we are uncomfortable with the fact that the pressure on tax staff to find revenue to offset desired tax policies will push this proposal forward even in the face of sound and compelling arguments to the contrary, according to the alert.
Lobbyists warn that general partners might demand a larger share of the proceeds, reducing the potential payout to the institutional investors.
(An) important thing to remember about private equity is that 80% of the profits from private equity transactions flow to pension funds, university endowments, foundations and other limited partnership interests, said Robert Stewart, a spokesman for the Private Equity Council, Washington. A private equity company doesnt make money unless everybody else involved in the transaction makes money.
If you tax the managers more heavily, theyre going to take a bigger bite out of what goes to the investors, added Harvey Leiderman, a pension attorney in the San Francisco office of Reed Smith LLP. You may intend to tax Wall Street and end up taxing Main Street, he said.
In addition, the lobbyists said, lowering the potential investment returns for pension funds and other institutional investors could spur them to move their money to foreign funds, reducing the capital available for jobs in the U.S.
Capital runs scared, said Stephen Renna, the Real Estate Roundtables senior vice president and counsel. If it doesnt like what it sees, its going to go in another direction.
Something like that (legislation to tax the carry as income) would significantly hurt the venture capital model, and its not a model that I think Congress would want to hurt, given the job creation and revenue generation that venture-backed companies contribute to the U.S. economy, added the NVCAs Ms. Mendell.
Meanwhile, the idea of subjecting tax-exempt institutions hedge fund investments to UBIT alarms experts.
Returns on the investments are now tax exempt when invested through an off-shore fund, either by the pension fund directly or indirectly though the hedge fund.
Some lobbyists said the proposal is galling because Congress previously blessed the loophole in a 1996 House Ways and Means Committee report.
It would indeed be perverse for Congress now to undo what it consciously and carefully did in sanctioning this technique, said A. Richard Brick Susko, an ERISA attorney with Cleary Gottlieb Steen & Hamilton, New York.
If the proposal becomes law, institutional investors will have to reassess whether the diminished potential return is worth the bother, particularly because it would require them to file with the Internal Revenue Service, according to the lobbyists.
Even if its a good rate of return, some (investors) may not want to get in because they dont want to file a tax return, said Bill Sweetnam, a partner at Groom Law Group, Washington.
It would have an adverse impact on income flows for university endowments and make it very difficult for them to manage operations without raising tuition, MFAs Ms. McGreevy, said in her statement. In the pension community, it would be a shame to see retired workers jeopardized by constricting the pension funds ability to fund their obligations.
Despite the radical changes under consideration, not all pension fund executives are shaking in their boots and certainly not at the $245.3 billion California Public Employees Retirement System, Sacramento, which has more than $4.6 billion invested in hedge funds, $13.6 billion invested in private equity and venture capital, and another $19.5 billion invested in real estate partnerships, Clark McKinley, a CalPERS spokesman, said.
We dont think its going to have any impact on us, Mr. McKinley said, adding that fund officials didnt think the proposals were relevant to them.