FT editorial on the taxation of private equity

Forgot to post this yesterday. The Pink 'Un sets out in very unpolitical terms why the taxation of carried interest needs a revamp. All the signs are that the tax regime is in the Treasury's crosshairs...

The fair way to tax private equity
Published: July 18 2007 20:10 | Last updated: July 18 2007 20:10

Demands on both sides of the Atlantic for changes to the tax treatment of private equity managers are gathering force. Partly, no doubt, this is for bad reasons. Many of these managers have made fabulous sums in recent years. Such riches, and the boastful parties sometimes thrown to celebrate them, have drawn lascivious media attention. A desire merely to punish these extraordinarily successful financiers—whose clients pay without complaint—animates some of those calling for higher taxes. That is a harmful and unworthy instinct which ought not to be appeased.

The United States, even in its present mood of economic discontent, is less given than most countries to outbursts of animosity against the working rich. Strength of feeling on the subject is driven by the fact that the tax treatment of these managers, as compared to the treatment of other very highly paid individuals, really is anomalous. Take the anger and disgust away, and disinterested considerations of efficiency and fairness urgently demand a change.

At the centre of the tax issue is the treatment of ”carried interest”—an obfuscating term that simply means a share of profits, usually 20 per cent. Most of the compensation paid to successful managers takes this form. The other part, typically, is a fee calculated as a proportion of the assets managed; this is taxed as ordinary income, and gives rise to little controversy.

Carried interest, however, receives two great tax advantages. First, tax is deferred: it becomes due only when profits are realized. Second, the rate then levied is that for a capital gain, rather than that applied to ordinary income. In the US this means paying 15 rather than 35 per cent; in the UK as little as 10 per cent compared to 40 per cent higher-rate income tax. In this way, the burden is cut to much less than half of what would be paid by comparably successful chief executives or entertainment stars.

In both cases—deferral and treatment as capital gains—the underlying question is whether the funds’ managers are receiving income from an investment they have made, or a payment that is, in all but name, a performance-related fee. Managers may invest in their own private equity funds, in which case both tax advantages would rightly apply to that component of their income. But much the larger part of what they typically receive is exactly akin to a performance bonus, not a reward for capital put at risk, and to treat it otherwise for tax purposes is a gross distortion. Efforts are doubtless under way in other industries to disguise management fees as carried interest.

Correcting this anomaly might be done in different ways. To tax carried interest as ordinary income when granted would require an options-based valuation, which is not straightforward. Another complicated remedy would be to treat carried interest as an interest-free loan from the fund’s investors, and then collect tax in two parts: on the interest forgone, taxed as ordinary income, and on the subsequent capital gain, taxed at the current lower rate. But the simplest approach, and most likely the best, would be to set the question of deferral aside, and tax carried interest as ordinary income on realization. To emphasize, this would not be to single out private equity or hedge fund managers as deserving of a new or specially punitive regime. It is a matter of even-handedly applying the logic of the present tax codes.

This repair should be done at once. For another day are bigger questions of whether it ever makes sense to tax capital gains at a lower rate than ordinary income (the policy that gave rise to this problem in the first place), and in the American case, whether the tax system as a whole should be made more progressive. The case for reform on both points is strong, in fact. But the carried interest anomaly can be dealt with promptly, and should be.