Hedge Fund Taxation

Saturday, September 1, 2007 - 01:00

Introduction

Hedge funds continue to grow in size, scope and influence. According to Bloomberg data, the number of hedge funds grew by 10% in 2006 to about 9,000 today, total assets under management by hedge funds have reached approximately $2 trillion and assets under management are expected to grow at an annualized rate of 15% between 2005 and 2008. Studies have estimated that hedge fund activity accounts for close to 30 percent of the average daily trading volume on the New York Stock Exchange.

The growth of hedge funds has been accompanied by increased regulatory scrutiny of funds' activities and investments. This article examines recent legislation targeting private funds, and describes various ways in which BLOOMBERG LAW information, available via the BLOOMBERG PROFESSIONAL service, can help lawyers, compliance officers and other financial market participants to understand, analyze and comply with laws and regulations affecting hedge funds and their managers.

Taxation Of "Carried Interest"

On June 22, 2007, Congressman Sandy Levin, a Democrat from Michigan, and others introduced H.R. 2834, a bill to tax the so-called "carried interest" earned by private fund managers as ordinary income rather than capital gains. Most private funds, including hedge funds, are organized as limited partnerships, with the manager serving as general partner. (Alternatively, private funds may be organized as limited liability companies with the manager serving as managing member.) In most cases, the manager is compensated in two ways: through a fixed management fee, often two percent of assets under management, and a share of the profits - the carried interest - often set at 20% of net realized profits. For example, if a fund had $1 billion in assets under management and a two percent management fee, the management fee would be $20 million per year. If that same fund had an annual return of 15% and the general partner was entitled to 20% of the profits, the general partner would receive a carried interest of 20% of $150 million, or $30 million. (The other $120 million would be split among the limited partners of the fund, including the general partner to the extent it invested capital in the fund in addition to managing it.)

Under current tax law, the management fee is taxable as ordinary income, at a maximum rate of 35%, and the carried interest is taxable, in most cases, as long-term capital gains, at a rate of 15%. In the example above, the general partner generally would owe taxes of $11.5 million (35% of $20 million, or $7 million, plus 15% of $30 million, or $4.5 million).

Carried interest is most often characterized as the right of the manager to participate in the profits of the fund. But there are at least two other ways to characterize it. First, carried interest can be viewed as a call option on a limited partnership interest in the fund, with a value equal to 20% of the future capital in the fund and a strike price equal to 20% of the initial value of the fund. A call option gives its holder the right to purchase an asset at a predetermined price. Consider again the example of the $1 billion fund with 20% carried interest and a 15% return. The general partner is entitled to 20% of $150 million, or $30 million. This outcome is equivalent to the right to receive 20% of the future value of the fund ($1.15 billion times 20%, or $230 million) in exchange for the payment of an "option premium" of 20% of the initial value of the fund ($1 billion times 20%, or $200 million).

Alternatively, the carried interest can be conceptualized as an interest-free nonrecourse loan from the limited partners of a fund to the general partner equal to 20% of the partnership assets, with the requirement that the loan proceeds be reinvested in the fund. (In a nonrecourse loan, a borrower is not personally liable for repayment of the loan amount, beyond the value of the pledged collateral, which, in this analogy, is the general partner's claim on the future profits of the fund.) Returning to the example of the $1 billion hedge fund with a 20% carried interest: if the general partner were to invest no capital, the 20% carried interest would entitle the general partner to the profits on $200 million (20% of the profits on $1 billion is equivalent to the full profits on $200 million). In this circumstance, it's as if the limited partners have contributed $800 million to the fund and then lent the general partner $200 million to invest in the fund, but without charging the general partner any interest on the loan.

These various ways of characterizing the carried interest are more than just idle exercises in analogy. Rather, what's at stake is the continued treatment of the carried interest as capital gains, as opposed to ordinary income, and the more favorable tax treatment that comes with the capital gains characterization. For example, viewing the carried interest as a non-recourse loan would counsel in favor of treating it as partially capital income and partially ordinary income. But nonqualified stock options generally yield ordinary income in the amount of the difference between the option's exercise price and the fair market value on the date of its exercise - so analogizing the carried interest to an option could argue in favor of characterizing the carried interest as ordinary income.

Some commentators, including Eric Solomon, Assistant Secretary of the Treasury for Tax Policy, have rejected alternative classifications of the carried interest, and have opined that treating the carried interest as capital gain is consistent with tradition and IRS practice in related contexts. For example, Solomon noted in July 11, 2007 testimony before the House Committee on Financial Services that a sole proprietor who through his labor turns an idea into a valuable business generally will be taxed at capital gains rates upon the sale of the business. Likewise, when an employer makes a stock grant to an employee, the employee, under Section 83 of the Internal Revenue Code, recognizes compensation income in an amount equal to the fair market value of the shares on the grant date, and the employer is entitled to a tax deduction in an equal amount - but thereafter, the employee is treated as a stock investor and owes capital gains taxes on any gains from the sale of the stock. With respect to stock options, Solomon noted in his July 11 testimony that although the gain on the exercise of nonqualified stock options - the difference between the strike price and the fair market value - is taxable as ordinary income, there is a crucial difference between options and carried interests: options do not grant the holder any ownership rights until exercise, whereas a carried interest grants a private fund's general partner "an immediate ownership interest in the enterprise with all of the attendant rights and responsibilities."

Taxation Of Publicly Traded Partnerships

On June 14, 2007, Max Baucus, a Democratic Senator from Montana and Chairman of the Senate Finance Committee, and Charles Grassley, the Republican Senator from Iowa and Ranking Republican Member of the Committee, introduced in the Senate a bill, S. 1624, to tax as corporations certain publicly traded partnerships that directly or indirectly derive income from investment adviser or asset management services. As the Senators made clear in separate letters dated June 14, 2007 to Treasury Secretary Henry Paulson and SEC Chairman Christopher Cox, the bill aims to address "the serious tax policy questions raised by the Blackstone IPO." The Blackstone Group, L.P. filed an Amended Registration Statement with respect to common units representing limited partnership interests, and upon the initial sale of those common units to the public on June 22, 2007, Blackstone became a so-called publicly traded partnership (PTP).

For tax purposes, a PTP is any partnership whose interests are either traded on an established securities market or readily tradable on a secondary market (or the substantial equivalent thereof). See Internal Revenue Code of 1986, as amended (IRC), Section 7704(b). Generally, PTPs are taxed as corporations rather than partnerships, which ordinarily increases the tax burden on interest holders in PTPs because corporate shareholders are subject to two layers of tax while partnership interest holders are subject to only one layer of tax. That is, corporations pay tax on their income at corporate tax rates (usually 35 percent) and corporate shareholders pay tax on dividends received from the corporation at the dividend tax rate (usually 15 percent). By contrast, partnership interest holders do not pay any entity-level tax; they only pay tax, at ordinary income rates, on their distributive share of partnership income.

In 1987, however, Congress provided an exception to the rule requiring corporate taxation of PTPs: If 90 percent or more of a PTP's gross income is "qualifying income," then the PTP is taxed as a partnership, i.e, is only subject to one layer of tax. See IRC Section 7704(c)(2). (The exception does not apply to registered investment companies. See IRC Section 7704(c)(3).) For purposes of the exception, qualifying income generally includes passive income - such as interest, dividends, rents from real property, gains from commodities or commodity derivatives and gains from the disposition of capital assets held for the production of qualifying income. See IRC Section 7704(d). Qualifying income does not include income earned from the provision of services.

The bill generally provides that the exception from corporate treatment for a PTP, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that directly or indirectly derives income from investment advisory services or related asset management services. Accordingly, any PTP that provides investment adviser services or related asset management services - in other words, most public hedge fund and private equity fund advisers - would, under the bill, be treated as corporations for Federal tax purposes.

The Senate Finance Committee's "Technical Explanation" clarifies the proposed operation of the bill. According to the Technical Explanation, under the bill, the exception from corporate treatment for a PTP does not apply to any partnership that, directly or indirectly, has any item of gain or loss (including capital gains or dividends), the rights to which are derived from (1) services provided by any person as an investment adviser, as defined in the Investment Advisers Act of 1940 (Advisers Act), or as a person associated with an investment adviser, or (2) asset management services provided by an investment adviser, as defined in the Advisers Act, a person associated with an investment adviser or any person related to either, in connection with the management of assets with respect to which investment adviser services were provided. Importantly, under Section 1(a)(4)(B) of the bill and as stated in the Technical Explanation, determinations under the bill as to whether services provided by any person were provided as an investment adviser will be made without regard to whether the person is required to register as an investment adviser under the Advisers Act.

Michael Pereira is a legal analyst with Bloomberg Law, and previously worked at a hedge fund and a law firm. He can be reached at (212) 617-3136.

Please email the author at mpereira6@bloomberg.com with questions about this article.