Saturday, November 27, 2010

Senate Extenders Legislation Contains Carried Interest Provision with Impact Beyond Hedge Fund Managers

Provisions in a Senate version of tax extenders legislation would expand the taxation of carried interest far beyond hedge fund managers, said the ABA Section on Taxation in a letter to Congress, and significantly alter fundamental aspects of partnership taxation. Proposed Section 710 to the Internal Revenue Code would recharacterize income allocations of an investment service partnership from capital gain to ordinary income and defer losses allocated by such a partnership. These new provisions would apply to a partner providing investment services to the partnership. The service partner’s interest would be defined as an investment services partnership interest (“ISPI”). Proposed Section 710 also would change the taxation of distributions by the partnership on ISPIs and dispositions of ISPIs. In addition, Proposed Section 710 would further add penalties with respect to disqualified interests and impose self-employment tax with respect to ISPIs.

While the general purpose of proposed Section 710 is to tax the compensation element of a carried interest granted to fund managers as ordinary income rather than the capital gain it is currently taxed at, the ABA group believes that Section 710 goes beyond that original purpose in several ways. For example, if the intent of the legislation is to convert capital gains to ordinary income, it is unclear why proposed Section 710 provides loss deferral and mandatory gain recognition for C corporations, which are not taxed at different rates on capital gains or ordinary income.

Proposed Section 710 would also treat all partnership interests held by a partnership as “specified assets” regardless of the underlying character of the lower tier partnership’s assets. The ABA is not aware of any significant policy rationale for including all partnership interests, especially those issued by partnerships with no securities, commodities or derivatives, such as operating small grocery stores. If the intent of Congress is to prevent taxpayers from circumventing proposed Section 710 by forming partnerships to hold securities, commodities or derivatives, reasoned the taxation section, this could be addressed in a manner similar to the approach used in IRC section 731(c)(2)(B)(v) and (vi),5 which treatx partnerships holding specified assets in a manner similar to the manner in which those assets would be treated (i.e., a look-through analysis) without causing all partnership interests to be treated as the specified “bad” assets.

Senate Amendment 4386 was introduced on June 23, 2010, by Senate Majority Leader Reid for Finance Committee Chairman Baucus, to amend the American Jobs and Closing Tax Loopholes Act of 2010 to alter the taxation of certain carried interests by adding a new section 710 to the Internal Revenue Code. On July 22, 2010, H.R. 4213, Unemployment Compensation Extension Act of 2010, Pub. Law 111–205, 124 Stat. 2236, was enacted into law. As enacted, H.R. 4213 did not include any provisions affecting the taxation of carried interests. On September 16, 2010, Chairman Baucus introduced S. 3793, Job Creation and Tax Cuts Act of 2010, which includes a proposal with respect to the taxation of carried interests that appears to be identical to proposed Section 710.

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