26 February 2016

Obama proposes big changes to US carried interest taxation (again)

While the UK private equity and venture capital industry is still busy with the detail of the proposed changes to the rules governing the taxation of carried interest, and eagerly awaiting the legislation due to be published in this year's Finance Bill, proposals to change the tax rules in the US would, if passed, have a big impact on private equity executive remuneration on the other side of the Atlantic.

President Obama's recent Budget Proposals include two items that could have serious consequences. The first proposal is not new, and has been suggested many times in the past by various lawmakers: to make carried interest receipts subject to tax as ordinary income. In most jurisdictions, carried interest is treated as a return on investments made by the fund and therefore taxed as a capital gain, which is usually at a lower rate than income tax. In the UK, the government's current proposals will mean this capital treatment remains if various tests are met, including if the average holding period of the assets of a fund is more than four years. But the US proposals make no such distinction, and propose to close what they refer to as the "carried interest loophole", meaning full income tax rates would be payable by US tax-paying executives on their carried interest.

The private equity and venture capital industry are quick to point out that capital treatment of carried interest is not the result of a "loophole" or clever tax planning, but merely the result of receiving a share of profits from a capital sale. The UK government's approach is to seek to maintain this treatment for "long term investment", with their stated aim being to ensure receipts from "trading" funds are taxed as income.  But the Obama reform would be much broader.

The second proposal looks at fund manager remuneration earned through fund management companies structured as limited partnerships or "S corporations", which currently does not attract self-employment taxes (the equivalent to social security and Medicare payments usually deducted by employers). It is proposed that a net investment income tax of 3.8% is applied to income through these vehicles to ensure that a tax similar to self-employment tax is paid by recipients of trading income.

It is difficult to tell whether these proposals will be successful, given that several similar attempts to change carried interest taxation have failed in the past, and much could depend on the outcome of the presidential election later this year. In this regard, it is notable that both of the current front-runners for the Presidency have declared themselves in favour of change, but there have been hints that Donald Trump could seek to distinguish between private equity investment funds and trading hedge funds – perhaps in a similar way to that advanced by policy-makers in the UK.

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