Carried Interest and the FTC
The Senate is currently debating the American Jobs and Closing Tax Loopholes Act of 2010. Among the means of paying for the extension of various expiring tax provisions, it would raise revenues by changing the taxation of carried interest and restricting use of the foreign tax credit.
General
A May 28 report from the Joint Committee on Taxation of Congress provides a technical description of the proposed changes in the taxation of carried interest and the foreign tax credit.
Carried Interest
This is a term used to describe the special tax treatment of hedge funds, a type of highly risky and highly profitable investment vehicle generally available only to very wealthy investors. In effect, its managers are taxed at the maximum tax rate for capital gains—currently 15%--rather than at much higher ordinary income tax rates. The Fiscal Times reported details of the proposed change in taxing carried interest yesterday. Following are some important academic discussions of this issue.
In the first issue of the Columbia Journal of Tax Law for 2010, University of San Diego law school professor Karen Burke argues that the complexity of the carried interest problem would be better handled by Treasury regulations than legislation.
A September article in the National Tax Journal by economist Alan Viard urged caution in taxing carried interest because it would not improve the allocation of capital.
A July Congressional Research Service report provides an introduction to the carried interest issue and details about the nature of hedge funds.
Writing in the Summer 2008 issue of the University of Chicago Law Review, University of Pennsylvania law professor Chris William Sanchirico argues that the tax advantage of carried interest essentially exploits differences in marginal tax rates between hedge fund managers and hedge fund investors. He finds the idea that hedge fund managers’ profits are comparable to “sweat equity” is groundless.
A May 2008 article in the Virginia Law Review by University of Chicago law professor David Weisbach argues that hedge fund managers are essentially investors in their own enterprise and ought to receive capital gains treatment on their income just as other investors in the fund do. He urges that the current tax treatment of carried interest not be changed. (Note: this research was supported by the Private Equity Council, which is essentially the trade association for hedge funds.)
In an April 2008 article in the New York University Law Review, University of Colorado law professor Victor Fleischer argues that whatever reform is adopted, maintaining the status quo is untenable as a matter of tax policy. Taxing hedge fund managers less than their secretaries is too contrary to our notion of tax fairness.
In July and September 2007, the Senate Finance Committee held extensive hearings on carried interest.
Foreign Tax Credit
When U.S. companies do business in foreign countries they are subject to foreign taxes on their profits as well as U.S. taxes. To prevent double taxation, companies receive a foreign tax credit (FTC)—a direct reduction in their U.S. tax liability—for the taxes they pay to foreign governments. Economic theory generally considers the foreign tax credit as providing tax neutrality rather than a tax advantage for multinational corporations (MNCs). See this summary in the National Tax Association Encyclopedia of Taxation and Tax Policy. Historically, a principal justification for scaling back the FTC has been to increase domestic investment and exports. However, analysis shows that this is unlikely to be the case.
In a paper posted on June 3, New York University law professor Daniel Shaviro argues that the FTC is excessively generous and that it would be better to give companies a deduction for foreign taxes paid instead.
In a June analysis, Peterson Institute economists Gary Clyde Hufbauer and Theodore Moran are highly critical of proposals to raise taxes on the foreign source income of U.S.-based MNCs. They argue that the revenue increase will be elusive because such corporations will adjust their organization and operations to minimize it and that it will reduce domestic investment and exports.
● An August 2008 Government Accountability Office report found that 60% of the activity of U.S. MNCs is located in the U.S.
● A May 2005 article in the American Economic Review by economists Mihir Desai, Fritz Foley, and James Hines showed that increased foreign capital investment by MNCs is associated with increased domestic capital investment as well.
● A July 1999 study by economist Theodore Moran found that MNCs tend to export more than firms that have only domestic production facilities.
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Another sneaky tax break for rich guys
None of the arguments for the carried interest tax treatment make any sense to me.
Carried interest is not like a capital gain because the hedge fund managers have no capital at risk. If they want capital gains treatment they can invest in their fund. But their share of the fund's gain is incentive compensation. If the fund has an up year they get a percentage of the gain. If the fund has a down year they give back a percentage of the loss. Not!
I don't want to hear about allocation of capital or differences in marginal tax rates and sweat equity. Isn't it obvious this is just plain unfair? Am I missing something?
No legal bright lines
You wrote: "hedge fund managers have no capital at risk".
I disagree. Hedge fund managers are not guaranteed any particular return and what is at risk is their time and management input. Albeit not paid-in as money, it is nonehteless a capital investment made by the fund manager. The manager is not paid this as a salary, no amount is specified and it could range from a complete loss of his investment (he gets nothing for his management work - his capital contribution) to a huge payout if the fund is very successful (a very good return on his capital investment).
This is clearly to me a capital gains (or loss) situation; capital can be paid-in as cash or as intangibles (such as a manager's time and work - or an inventor's patent rights).
Unlike this situation, a salary is a guaranteed pay-for-work / pay-for-time compensation. If the venture fails, the salary recipient still wins, whereas the fund manager gets nothing for his time/work.
Capital at Risk?
Sorry, I don't buy it.
The standard compensation for hedge fund managers is "2 and 20". 2% of the fund assets plus 20% of any gains (but not losses). I would argue that the 2% is plenty to cover their sweat equity "capital". Mutual funds get by just fine at 1.1%, which includes the compensation of their portfolio managers. Granted, they are generally larger and enjoy economies of scale most hedge funds don't. That's what the extra 0.9% is for.
Should a sales rep who is paid $25k base and $250k commissions get capital gains treatment on the $250k? He worked hard for that $250k, which he may not earn through no fault of his own.
Remember, I am not arguing that hedge funds shouldn't get their 20%. I'm arguing that they shouldn't get capital gains treatment on that 20%. I don't believe the legislatures that created the capital gains tax, or the economists who argue in favor of it, had in mind an incentive bonus for hedge fund managers.