The New York
Times in their Business section today published an informative article on
“carried interest” and private equity. As could be expected this tax planning
and financing technique is again on the radar screen for elimination due to a
variety of factors, including the odorous lust of revenue by liberals, notions
of tax fairness and a few other factors. Industries affected by a change are gearng up. The link to the piece can be found at:
http://dealbook.nytimes.com/2013/01/21/with-tax-advantages-looking-shaky-private-equity-seeks-a-new-path/
Carried
interests are a business and financial arrangement that have been and form an
essential structural element to almost every section of the U.S. economy
including, real estate development, private equity, hedge funds, health care,
mining, and oil and gas. Changes in the tax rules would have a profound impact
on how these businesses operate and their structure
I have written
on this subject several times. I thought it would be interesting to see
portions of one of the articles, which shows how the subject is much
broader than just some “fund manager” making more dough than the rest of us.
This was done in 2011. Here is
a shorten version:
The
Democrats are bent on raising taxes. Everyone knows that. The list is
long, the gimmicks plentiful and if you move the wrong way, you are in the
sights to be taxed more. However, it was interesting to note Democratic leaders
are again targeting repeal or at least a substantial modification of a “carried
interest”, despite repeated failures to eliminate it in recent years. The
concept has been in the President’s budget for some time and passed the
Democrat-controlled House in the last Congress.
Goodness, what can that be? “Carried” what? Who is “Carrying”
whom? Carried interests are a business and financial arrangement that form an
essential element of business in almost every section of the U.S. economy
(including, real estate, private equity, hedge funds, health care, and oil and
gas.) See, there are those oil and gas boys in the sights again. Changes in the
tax rules would have a profound impact.
In brief, the
tax treatment of carried interests allows managers of hedge funds,
private-equity funds, venture-capital funds and others to pay a lower 15%
income tax rate applied to investment income as capital gains, rather than
higher income tax rates.
How do
they do that? It is complicated and requires by starting with taxation of
partnerships. If you have an interest in a partnership, you are allocated a
share of that partnership's income. The income to the owner takes on the
same character, such as capital gains, that it does in the partnership's hands,
and the partner is taxed on it accordingly. Some investment partnerships,
particularly in the private equity industry, earn mostly capital gains by
buying and selling shares in other companies. The managers of these
companies thus receive their carried interest in the form of capital gains and
pay capital gains tax rather than ordinary income tax.
What many
policymakers object to is the fact the carried interest paid to partnership
managers is really compensation for their management services.
It is hard to
have crocodile tears for the hedge fund managers. However, there are other
industries where the carried interest is engrained and useful. No one knows how
any revisions, if included in the debt deal, will affect these other sectors
but it is useful to examine to see how they work by showing an example
involving the old whipping boy of oil and gas.
In oil and
gas development (and in most extraction industries) the term "carried
interest" refers to an arrangement where one co-owner of an operating
interest (the " carrying party") incurs an obligation to pay all of
the cost to develop and operate a mineral property, in exchange for a right to
recoup this investment out of the proceeds from the first production. After the
investment is repaid, any subsequent production is divided between the other
co-owners. The co-owner, not obligated to pay for the development and
operation, holds a “carried interest” in the mineral property until the
carrying party's initial investment is repaid. There are many different types
of carried interests, the details varying considerably from arrangement to
arrangement.
A simple
example is as follows:
Jack owns all
the working interest in an oil and gas lease and wants to drill a well but
cannot afford it. Jack assigns to Big Oil the entire interest in the property,
and Big Oil agrees to drill and complete a well bearing all the
costs. Big Oil will retain 100 percent of the working interest until it
recovers its entire costs (drilling, completing, equipping, and operating the
well) from the proceeds (or “runs” as they are called) of the production. After
cost recovery, a percentage of the working interest in the property
goes back to Jack with each party owning a share.
As far as tax
treatment, Jack realizes no gain or loss on the transfer of the property
even though drilling a productive well only increases the value of the property
interest returned to Jack. Jack has a basis equal to his basis prior to
transfer. Jack cannot deduct any of the cost incurred.
Jack can
receive his share of production income and report it as such, or he can sell
his interest as a capital asset. In this simple example, there is no tax
partnership arrangement, which can change the tax treatment. However, the point
being, this is a long-standing arrangement that serves a legitimate purpose.
Big Oil helped Jack finance the drilling of his well which otherwise would not
have occurred. Jack intends to take a well-deserved vacation.
The
question being, how will this be changed if the carried interested is changed,
decimated or otherwise hammered? Will the policymakers make an exception or is
any thing fair game in getting at oil and gas. I Carried interests are
a business and financial arrangement that have been and form an essential
structural element to almost every section of the U.S. economy including, real
estate development, private equity, hedge funds, health care, mining, and oil
and gas. Changes in the tax rules would have a profound impact on how these
businesses operate and their structure.
I can
understand the reasoning against the equity firms that are also providing
management services to earn their carried interest but I do not see the tax
abuse for Jack in our example.
Changes in the taxation of carried interests have passed a
Democrat-controlled House of Representative three times since 2007 and the
Obama Administration has included a carried interest tax increase in each of
its annual federal budgets where the current law on carried interests was
described as “an unfair and inefficient tax preference.”
Of course, the tax rate for capital gains has been increased reducing its benefit, but that is not enough for some. If tax reform goes forward this year, the carried interest is a likely target for major changes.