Carried interest

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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.[1][2]

Carried interest or carry, in finance, specifically in alternative investments (i.e., private equity and hedge funds), is a share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that the manager contributes to the partnership. As a practical matter, it is a form of performance fee that rewards the manager for enhancing performance.[3]

In private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate" or "preferred return") to investors.[4] Private equity funds only distribute carried interest to the manager upon successfully exiting an investment, which may take years. The customary hurdle rate in private equity is 7–8% per annum.

In a hedge fund environment, carried interest is usually referred to as a "performance fee". Hedge funds, because they invest in liquid investments, often are able to pay carried interest annually, if the fund has generated a profit for its investors.

The manager's carried-interest allocation will vary depending upon the type of investment fund and the demand for the fund from investors. In private equity, the standard carried-interest allocation historically has been 20% for funds making buyout and venture investments.[5] Carried-interest rates – performance fees – among hedge funds have historically also centered around 20%, but have had greater variability than those of private equity funds. In extreme cases performance fees reach as high as 50% of a fund's profits, although usually it is between 15% and 20%.

Carried interest and management fees[edit]

Historically, carried interest has served as the primary source of income for the manager and respective firm in both private equity and hedge funds. Both private equity firms and hedge funds tended to have a small annual management fee (1% to 2% of committed capital); the management fee is meant primarily to cover the costs of investing and managing the fund rather than for meaningful wealth creation for the manager. As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007 initial public offering of the Blackstone Group.[6]

Taxation of carried interest[edit]

The taxation of carried interest has been an issue since the mid-2000s, particularly as the compensation earned by certain investors increased along with the sizes of private equity funds and hedge funds. Historically, carried interest has been treated as a capital gain for tax purposes in most geographies. The reason for this treatment is that a fund manager would make a substantial commitment of his own capital into the fund and carried interest would represent a portion of the manager's return on that investment. While hedge funds typically trade their investments actively, private equity firms tend to hold their investments for many years. As such, the capital gains from private equity funds typically qualify as long term capital gains, which receive favorable tax treatment in many locales. Critics of this tax treatment seek to disaggregate the returns directly related to the capital contributed by the fund manager from the carried interest allocated from the other investors in the fund to the fund manager.[6]

United States[edit]

Because the manager is compensated with a profits interest in the fund, the bulk of his or her 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.[7] 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, which are taxed the same as ordinary income), 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 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 the U.S. 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.[6]

To address this concern, U.S. Representative Sander M. Levin introduced H.R. 2834 on June 22, 2007, which would eliminate the ability of people performing investment-adviser or similar services to partnerships to receive capital-gains tax treatment on their income. On June 27, 2007, Henry Paulson said 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, although he was not speaking only about carried interest.[8] The U.S. Treasury Department addressed carried interest specifically in testimony before the U.S. Senate Finance Committee in July 2007.[9] U.S. Representative 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.[10] On April 2, 2009, Congressman Levin introduced a new and substantially revised version of the carried interest legislation as H.R. 1935. Proposals were again made by the Obama Administration for the 2010,[11] 2011,[12] and 2012[13] budgets. The issue of favorable tax rates for carried interest became an issue during the 2012 Republican primary race for president, because 31% of presidential candidate Mitt Romney's 2010 and 2011 income was carried interest.[14] On May 28, 2010, the House approved carried interest legislation as part of amendments to the Senate-passed version of H.R. 4213.[15] On February 14, 2012, Congressman Levin introduced H.R. 4016.[15]

On February 26, 2014, House Committee on Ways and Means chairman Dave Camp (R-MI) released draft legislation that would seek to raise the tax on carried interest to 35 percent from the current 23.8 percent rate.[16][17][18]

United Kingdom[edit]

The Finance Act 1972 provided that gains on investments acquired by reason of rights or opportunities offered to individuals as directors or employees were, subject to various exceptions, taxed as income and not capital gains. This may strictly have applied to the carried interests of many venture-capital executives, even if they were partners and not employees of the investing fund, because they were often directors of the investee companies. In 1987, the Inland Revenue and the British Venture Capital Association (BVCA[19]) entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income.

The Finance Act 2003 widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried-interest gains continued to be taxed as capital gains and not as income.[20] Such capital gains were generally taxed at 10% as opposed to a 40% rate on income.

In 2007, the favorable tax rates on carried interest attracted political controversy.[21] It was said that cleaners paid taxes at a higher rate than the private-equity executives whose offices they cleaned.[22] The outcome was that the capital-gains tax rules were reformed, increasing the rate on gains to 18%, but carried interest continued to be taxed as gains and not as income.[23]

See also[edit]

References[edit]

  1. ^ Fleischer, Victor (2008). "Two and Twenty: Taxing Partnership Profits in Private Equity Funds". New York University Law Review. Retrieved 5 March 2014. 
  2. ^ Batchelder, Lily. "Business Taxation: What is carried interest and how should it be taxed?". Tax Policy Center. Retrieved 5 March 2014. 
  3. ^ Lemke, Lins, Hoenig and Rube, Hedge Funds and Other Private Funds: Regulation and Compliance, §13:20 (Thomson West, 2013-2014 ed.).
  4. ^ "Hurdle Rate" explained by mergers-acquisitions.org.
  5. ^ Notable examples of private equity firms with carried interest of 25% to 30% include Bain Capital and Providence Equity Partners.
  6. ^ a b c Marples, Donald (2 January 2014). "Taxation of Hedge Fund and Private Equity Managers". Congressional Research Service. Retrieved 4 March 2014. 
  7. ^ See, e.g., Campbell v. Commissioner of Internal Revenue (8th Cir. 1991). This approach was adopted as a general administrative rule by the Internal Revenue Service in a notice in 1993 and again in proposed regulations in 2005.
  8. ^ [1] Bloomberg
  9. ^ 07.11.07 Testimony Solomon on Carried Interest.doc
  10. ^ [2]. See page 122 of the White House version of "A New Era of Responsibility – Renewing America’s Promise".
  11. ^ 2010 Budget: Tax Carried Interest as Ordinary Income
  12. ^ 2011 Budget: Tax Carried Interest as Ordinary Income
  13. ^ 2012 Budget: Tax Carried Interest as Ordinary Income
  14. ^ Mitt Romney’s carried interest tax problem
  15. ^ a b "H.R. 4016: Carried Interest Fairness Act of 2012". Democrats of the United States House Committee on Ways and Means. Retrieved 17 April 2014. 
  16. ^ Alden, William (26 February 2014). "House Proposal Would Raise Taxes on Private Equity Income". DealBook (The New York Times). Retrieved 17 April 2014. 
  17. ^ Norris, Floyd (6 March 2014). "Republican’s Tax Plan Awkwardly Aims at Rich". The New York Times. Retrieved 17 April 2014. 
  18. ^ "Camp Releases Tax Reform Plan to Strengthen the Economy and Make the Tax Code Simpler, Fairer and Flatter". United States House Committee on Ways and Means. Retrieved 17 April 2014. 
  19. ^ "Our Mission". BVCA. 2009-04-05. Retrieved 2012-02-09. 
  20. ^ "Memorandum of Understanding, 2003, Inland Revenue and BVCA" (PDF format; requires Adobe Reader). HM Revenue and Customs.
  21. ^ [3]. BBC News. July 3, 2007.
  22. ^ [4]. BBC News. June 12, 2007.
  23. ^ "HMRC PBRN 17" (PDF; requires Adobe Reader). HM Revenue and Customs. 9 October 2007.

Further reading[edit]